Four Little Words

We don't live and learn argues

Frank Lee

The four most expensive words in the English language is ''this time it's different.'' Sir John Templeton

In the Autumn of 1929 the prominent Yale economist, Irving Fisher, opined that 'Stock prices have reached what looks like a permanently high plateau.' A few weeks after this somewhat premature pronouncement the Dow Jones Industrial Average (the US stock market) was down by one third. By the summer of 1932 the Dow closed down nearly 90% lower than its 1929 pinnacle. Fisher and many others had made the mistake of thinking that the long bull-market of the 1920s (the roaring 20s) had assumed an unstoppable momentum and would go on rising forever. (An end to boom and bust if you will.) Throughout the 1920s the Dow Jones Industrial Average (DJIA) had risen inexorably; this was in part due to the new technologies and production methods which were allowing scope for considerable economies of scale and therefore increases in output so that a mass consumer society was to come into being. Moreover, modern management and marketing techniques could keep this consumer boom humming along in perpetuity. This situation of optimism and, as Keynes put it, rising animal spirits was conducive to the general propensity to invest in stocks and bonds. Everyone was playing the market; the party was in full swing even in this era of prohibition. Something of the flavour of the times is captured in the novels of F Scott Fitzgerald, The Great Gatsby or This side of Paradise. Of course this situation was never going to last: bubbles never do, no matter how big or irreversible they may seem at the time. It should also be noted that it is precisely when the bubble phenomenon and attendant growth levels reach their most febrile state that the correction becomes imminent. And so it turned out to be.

The impact on the real economy of the stock market crash was that by 1933 unemployment had reached 25% of the American workforce and the economy had contracted by 30%. Worse still the catastrophe had spread to Europe - Germany being particularly affected with unemployment levels comparable to the United States. Now the writer of the age was John Steinbeck graphically illustrating the conditions of life in 1930s America in The Grapes of Wrath. The UK also felt the chill winds of depression best expressed in the literature of Arthur Greenwood's Love on the Dole, or Orwell's The Road to Wigan Pier.

F.D.Roosevelt was elected US president in 1933 and immediately used active fiscal policy to create jobs and stimulate the economy. He did meet with partial success in that unemployment fell in the US up until 1938. However, there was a fresh recession and unemployment began to rise again. Eventually rearmament and the Second World War led the world out of the 30s depression.

At the present time we are experiencing a double whammy of a financial and increasingly economic collapse. What gave rise to this was the biggest credit and property bubble in the history of capitalism. The boom from the early 90s until mid-2007 was essentially floated on a sea of debt. Mortgages were advanced to almost anyone who wanted them regardless of their ability to pay; individuals spent freely on credit cards without a thought for the morrow. Their debts could be rolled over or compensated by increasing asset prices (property). So as consumers borrowed against the ongoing increase in their house prices, banks would lend them more. So we had an upward spiral: the increasing level of credit led to an increase in property prices and the increase in property prices led to an increase in the availability and uptake of credit; the classic bubble scenario. Worse still the mortgages held by the banks were repackaged (securitised) into new financial products, Mortgage Backed Securities (MBS) and Collateralised Debt Obligations (CDO) and often sold on to other financial institutions: Hedge Funds, Pension Funds, Insurance Companies and so forth. Okay so far, so good, the party roared on. However the weak link in the chain was the American sub prime market. A group termed NINJAS, No Income, No Job, No Assets. This group began to default and the banks were found to be holding assets of very dubious value. This initial default was the detonator which burst the house price bubble in all of those countries which had experienced a property boom - the US, UK, Ireland, Spain and Australia.

The meltdown also started to affect countries who had not experienced a property boom but whose banks had foolishly purchased mortgage backed derivatives (MBSs and CDOs). Banks in Germany, Switzerland, the low countries, Iceland, and more especially Eastern Europe, began to feel the heat. Many banks (and even countries - Iceland) were now insolvent and had to be rescued by the governments or loans from the International Monetary Fund (IMF).

Enter the credit crunch. Credit dried up even though property prices were falling. Since the US and UK economies had been essentially based upon the property market it was inevitable that the banking and property collapse would impinge very directly on the real economy. At the time of writing unemployment is rising very sharply, and deflation with falling (or static) prices and wages. Retailers are under the cosh with falling sales, and bankruptcies and boarded up shops are an increasingly common sight. We are already in a recession. Moreover there are likely to be further eruptions to come in the murky world of Credit Default Swaps and Derivatives. These are totally unregulated and highly leveraged markets involving literally tens of trillions of dollars. The only question remaining is how long and how deep this financial/economic downturn will be. More important still perhaps are the political ramifications of this situation.

What an ignominious end to the fatuous claim 'no more boom and bust'. The shame was that it was all so predictable. And the shaming part was the extent that the government of the day colluded in and made possible this bubble creation by the financial and banking sector.

It seems that the one lesson from history we learn is that we don't learn from history

Winter 2008/09