Frenzy, Folly & Future

By Wilfred Hahn

From the panicked conditions of only 6 months ago, when almost everyone was terrified that the world would end, an equally strong consensus has emerged in recent months. Now, sentiment polls and surveys are revealing a brazen optimism.

Commentators far and wide are now sure that another Great Depression has been averted. Economic recoveries are assuredly underway they say. China is leading the world back to economic growth and the G20 group of countries will sort out the problems and “rebalance” the world. Is this correct?

Apparently, investors seem to think so, having again driven up the price of financial markets to over-valued levels around the globe. Incredibly, despite what should have been received as harsh admonishments, the lessons of the Global Financial Crisis seem not to have registered at all with people. Remarkably, some measures of risk are again at the highs that preceded the recent crisis back in 2007.

It reminds of John Kenneth Galbraith’s quote:

“There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” (Source: A Short History of Financial Euphoria.)

The lessons of past history of even a few months ago already appear to have been forgotten. The reality of the matter is that neither sets of expectations that are behind the extremes — whether driven by fear or greed — are likely to be correct.

The Global Financial Crisis is not over. Far from it. However, that is not to say that improving developments could not intervene for a time. In fact, this is what we have expected. However, many corrosive trends are still at work and many of the problems that have been swept under the carpet (such as delaying mortgage foreclosures) are now coming back to the surface.

Though many of the big banks have been rescued to this point, more support will yet be needed. Quite a number of small banks will yet go under — hundreds of them — completely swamping the resources of the FDIC (Federal Deposit Insurance Corporation). Interestingly, the FDIC recently announced efforts to borrow money as a solution to its problems. It all begs incredulity. The FDIC exists to ensure that depositors are protected from banks that make bad loans. Well, now it will be bad borrowing of the FDIC that will protect depositors from the bad lending of banks. It has become folly.

Comically, some central banks — notably the U.S. Federal Reserve — have given speculation to the thought that they may soon be able exit from some of the unprecedented interventions and rescue operations that they have mobilized in the past year. This is quite ridiculous. It would be the same miscalculation if you pulled yourself up on the end of a winch, to then think that you are free to let go of the rope as you have now risen to the top. One forgets that it is the rope that is holding you up in the first place.

In like manner, the very reason that financial markets and all types of suspect and risky assets have risen in price so markedly over the past 6 months, is because they were pulled up by a winch. Interest rates were slashed and government guarantees were sprinkled around liberally. Moreover, the Federal Reserve undertook to buy mortgage-backed bonds and treasury securities to the tune of $850 billion. Just this past week, the Federal Reserve announced that they would increase and extend the time period for these purchases. This is an exit?

In normal times, such bond purchases by a central bank would be highly inflationary in the sense of leading to higher consumer prices. Many observers therefore worry about inflationary conditions in ensuing years. What they expect is rising prices of the things that are the product of current economic output (consumer prices). In this sense, some worry about an inflationary spiral similar to the one that occurred in Weimar Germany during the 1920s.

Vigilance against the effects of inflation are certainly not unreasonable. High alert is warranted. However, the type of inflation manifestation that Germany experienced and others since that time, is not likely to happen today (or anytime soon). Why not? Among a number of reasons, the inflation chameleon is much too devious to follow any pre-defined script. A knowledge of history alone is not a reliable help without the understanding of underlying causality. Inflation can express itself in different ways, running in channels determined by the financial and economic landscape of the time. Its quixotic and wily nature was noted by Keynes:

“By a continuous process of inflation […] engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose.”

While the Weimar-era hyperinflation is not likely to be repeated with all the same characteristics, there remain lessons that apply today. Certainly, the manifestations of inflation are different. This time, (at least to this point) its wealth-dislocating effects are bottled up in the high prices of financial assets and the mispricing of risks. The net effect, however, is the same.

Quoting from Otto Freidrich (Before the Deluge: Berlin in the Twenties):

“[…] the inflation was by far the most important event of the period […]. It wiped out the savings of the whole middle class […] Nothing ever embittered the German people so much — it is important to remember this — nothing made them so furious […] as the inflation.”

True to form, to date the North American middle class today has already been bruised with respect to relative net wealth declines. Incomes have fallen over the past decade. The inflationary effects of too much credit and the recent bust of asset inflation (both equities and real estate) accomplished a similar outcome. The final impact of inflation is the same … but happening differently.

Not to be forgotten, is the potential for a rapid behavioral change. This is a common feature of all major inflations. There comes a point where everyone finally wakes up to what is actually happening. They then can drastically change behavior en masse.

As the GFC (and recent recovery rallies) illustrate, never before in history has global opinion been galvanized by financial events so quickly. Never before has the entire financial world behaved so much as one monolithic culture as is now evident in global capital markets. Robert Shiller,in a recent commentary in the New York times, provides an insightful perspective:

“It is a large and diverse world, after all, so why should confidence have rebounded so quickly in so many places?...

...The popularity of the term ‘green shoots’ shows the kind of social epidemic underlying our changing thinking. The phrase was propelled in Britain by Shriti Vadera, the business minister, in January, and mutated into a more contagious form after Ben Bernanke, the Federal Reserve chairman, used it on ‘60 Minutes’ on March 15.

The news media didn’t need to change the term for different cultures around the world. With nothing more than a quick translation — brotes verdes, pousses vertes, grüne Sprösslinge, etc. — it is now recognized as a symbol of a revival coming soon.

All of this suggests that a social epidemic is supporting renewed confidence. This confidence can keep growing by contagion, as a kind of self-fulfilling prophecy, and we may see the markets and the economy recover further.

But in an economy that is still unstable, the stories could also morph into different forms, the price feedback could turn downward and the dynamic could turn ugly again — just as it has in the past.” (Source: Robert Shiller, An Echo Chamber of Boom and Bust, New York Times, Economic View, August 30, 2009.

Putting it all together, we crucially now recognize that the economic, financial and psychological conditions of global markets have come to the point where the mood can change quite suddenly. A viral media-generated chain can impact the sentiment of the entire world rapidly.

None of the problems that led to the Global Financial Crisis have yet been solved. In fact, if anything, underlying conditions continue to deteriorate in North American and overall debt-levels continue to rise. For example, if it was financial institutions that were too big to allow them to fail that forced governments to fork over hundreds of billions into the pockets of their owners, this treacherous condition is getting worse, not better. Says Joseph Stiglitz, former Chief Economist for the World Bank,

“In the U.S. and many other countries, the too-big-to-fail banks have become even bigger. The problems are worse than they were in 2007 before the crisis.”

We observe desperation, lawlessness and folly, proceeding to a future rendezvous with a time as it was in the days of Noe where “The LORD saw how great man's wickedness on the earth had become, and that every inclination of the thoughts of his heart was only evil all the time” (Genesis 6:5).

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