Every Crisis is Just Like All the Others
September 28, 2008
In the popular imagination, every financial crisis is like all the others. It takes some attention and study to understand the causes of a crisis. Once you understand the causes, you have a pretty good idea of the resolution. However, this is almost never done, even by specialists like academic economists or investor economists, because it is imagined that every crisis is just like all the others. We don’t have to study causes because the causes are all the same. Every crisis is caused by …. crisis. Their economic understanding divides history into Good Times and Bad Times, and that’s about as far as the analysis goes. (Sometimes they don’t even get that right.)
The narrative goes something like this: asset market prices go down. Marginal, overaggressive, and heavily leveraged players go spectacularly bust. Banks collapse. Businesses go bankrupt. Jobs are lost. Maybe there is currency turmoil. Important men in expensive suits have all-night discussions. Congress gnashes its teeth.
Recently, we have seen comparison between the recent crises and historical events. Some say it is like Japan in the 1990s. Some say it is like the 1970s (not so many right now). Some say it is like the Great Depression. Some say it is like the Panic of 1907. In the popular imagination, all these events are very similar.
The attentive economist understands that all these events are very different. I’ve talked about this before, but it’s particularly appropriate now. Let’s take a look:
Japan: the primary problem in Japan was radical currency deflation (rising currency) combined with tax hikes. Not surprisingly, this led to problems at banks. Asset markets (stocks and property) were rather extended in late-1980s Japan, and were due for a correction or bear market, but that would not have led to extended economic problems if there hadn’t been monetary deflation and tax hikes. There was a similar asset-market blowoff in the early 1960s, which led to the first failure of Yamaichi Securities in 1965 among other things, but that didn’t really change the overall situation at the time, which was one of dramatic growth. (There was a recession in 1965, in which the official GDP real growth rate fell to 5%.) Banks would have had some problem with their property loans, but it would have been much, much, much less, and probably resolved by 1994 or so. Bank management was basically OK. The extended nature of the recession was not caused by banks, credit or lending, but the continuation of monetary deflation.
1970s: the primary problem during the 1970s was of course currency devaluation, combined with tax hikes. Some tax hikes were automatic, via bracket creep (tax brackets weren’t adjusted for inflation in those days). Some tax hikes, especially in places like Britain and Italy, were legislated. There were high asset prices at the beginning (stocks and property), but that was reflective of the sunny economic environment and were not overextended. There was no apparent credit bubble.
Great Depression: the Great Depression was characterized, first, by dramatic increases in tariffs around the world, which naturally led to economic difficulties everywhere. This in turn led to declines in tax revenue, which were addressed with rather dramatic domestic tax hikes (income taxes, corporate taxes, etc.). In the deteriorating economic environment, governments reached for currency devaluation, which introduced new turmoil. There were “systemic” issues, primarily related to the banking system. Stocks were extended in the late 1920s but not excessively so — the U.S. stock market traded for about 20x trailing earnings (not forward earnings) at the 1929 peak. Property values reflected prosperity, but do not seem to have been excessive except in some localities like Florida. There was some credit expansion, but it does not seem to have been excessive.
This is a popular chart these days. It shows a whopping spike … sometime between 1924 and 1944 … which we are led to believe was some sort of late-1920s credit bubble. Not so. As is labeled here, the spike was in 1933. Why 1933? Because banks were going crazy with property loans? No, because nominal GDP, the denominator, dropped about 46%. And, the government was running huge deficits. Instead, this chart shows that credit in the late 1920s more-or-less kept pace with economic growth, which is about what you would expect to see in an economic boom that was not driven by silly credit. We can also see from this chart that the 1950s-1960s period, which was really the most successful economy of U.S. history in the time period of this chart, was also not characterized by undue credit expansion.
Asia Crisis: the Asia Crisis (1997-1998) was primarily one of currency collapse, exacerbated by corporations’ heavy borrowings in foreign currency. IMF recommendations including tax hikes and destructive high interest rate target monetary systems made problems worse. Stock markets were rather highly priced (about 25x trailing) at the time, but that was reflective of high growth expectations and not what I would consider “bubble” territory. The credit situation reflected expectations of dramatic growth, but were not unusually extended in my opinion.
Panic of 1907: the Panic of 1907 was primarily a liquidity shortage crisis, which was unfortunately common in the 19th century but is practically unheard-of today. These are characterized by super-high short-term lending rates (in this case over 100%), reflecting a shortage of base money available. For some reason, people have been making comparisons between the Panic of 1907 and recent events. This seems to be because prominent bankers are gathering for meetings. Such is the level of economic analysis today.
I wrote about all these events in more detail in my book Gold: the Once and Future Money. Some readers wondered why I went into all that heavy history. This is so you can learn how to analyze and distinguish different kinds of economic causes and effects.
It is hard to find any example of a crisis that was caused simply by excessive stock prices. We saw that the TMT bubble of 1999-2000 (it really was a bubble, with 100x+ p/es for those companies that had earnings) went spectacularly bust without too excessive an effect on the rest of the economy. Taiwan’s stock market hit 100x p/e in 1989 — and so what? Of course it collapsed afterwards, and nothing particularly horrible happend to the Taiwanese economy. Even the huge bankruptcies of the 2002-2003 period (Global Crossing, Enron, etc.) didn’t dent things too badly. This was in part because the monetary and tax situations were improving, with monetary reflation from the deflationary conditions of 2000, and the Bush tax cuts. (Things were improving around the world, too.) I don’t think the emergence of the housing/credit bubble in the 2002-2003 period was the sole preventative of widespread disaster, although it certainly helped keep things afloat more than they would have otherwise.
Nor have I seen many examples where a major economic event was caused by widespread credit stupidity. There have always been a few bubble pockets, like Florida real estate in 1925 or U.S. commercial real estate in the late 1980s. In most cases, loans were made on a reasonable basis on reasonable assumptions, such as a healthy economic environment. When the environment changes, many loans go bust, but at the time and conditions and expectations they were made, they were relatively prudent. Banks don’t take stupidly excessive leverage either. The typical 10x leverage of banks has enough of a cushion to keep them going even when they have credit issues. All of this can lead to a recession but rarely to a disaster.
The present situation is something of an anomaly in that regard. There have always been property bubbles, but rarely have they been so broad in extent. The result is that the nationwide statistics, such as price/rent, price/income, cap rates etc. reached unprecedented extremes. This was combined with leverage at banks (mostly off-balance sheet via derivatives) reaching similarly extreme levels. Underwriting standards absolutely collapsed, due to the loan securitization process which made things so opaque that rating agencies could declare it all investment grade and nobody thought it unusual. (Normally, property prices are somewhat restrained by underwriting standards, since at some point bankers determine that borrowers are unable to pay the inflated prices. Obviously, that went out the window.) Similar lending practices were widespread in credit cards and auto loans as well, not to mention the idiocy of private equity “levered loans.” None of this stuff could withstand even a typical recession. The result, of course, is that financial companies are almost universally insolvent. Those that seem OK, like JP Morgan/Chase, BofA and Wells Fargo, mostly have been lying in my opinion, and have friends in high places. Normally, typical banking practices (typical leverage and semi-prudent underwriting standards) have enough margin of safety that it takes serious errors on the part of the government (tax hikes and currency issues, for example) to put banks into crisis. However, banks today not only chewed through all that margin of safety, they got themselves into a situation where failure was basically assured, no matter what happened. (We haven’t even had the great CDS unwind yet!)
Other governments have had bank insolvency issues in the past. Usually, the government recapitalizes banks via common or preferred equity, in effect nationalizing them in extreme cases, and eventually things work out. This is much like Warren Buffett’s recent investment in Goldman Sachs, and completely unlike Hank Paulson’s proposal, which is just a scheme for Wall Street to steal from the taxpayers.
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The doomer types are on overdrive. This crisis is really a reflection of Peak Oil, they write, or environmental degradation/climate change. Sorry, this crisis is 100% financial. We may soon have a Peak Oil crisis or a rising-seas crisis. But not yet.
