The Panic of 2008

• Tweet

• Tweet

This week, finan­cial mar­kets tru­ly suc­cumbed to The Pan­ic. The US Dow Jones and S&P500 Indices lost 21%; Aus­trali­a’s All Ordi­nar­ies fell 16%. “Buy and Hold” gave way to “Get Out At All Costs”.

When we look back with the eyes of his­to­ry, the ninth day of the tenth month of 2008 will be the Black Thurs­day on which the world’s biggest ever spec­u­la­tive bub­ble final­ly burst.

The Stock Mar­ket Crash of 2008

 Fri­day’s wild gyra­tions on Wall Street–which saw the Dow down as much as 700 points and up as much as 140, before clos­ing down 128 points for anoth­er 1.5% loss on the day–are after­shocks from a finan­cial earth­quake dri­ven by tec­ton­ic shifts that have a long, long way to go.

The US mar­kets are down 21% for this week alone, and 45% from their peak; the Aus­tralian mar­ket has fall­en 16% this week, and 42% from its peak. The only oth­er stock mar­ket crash that com­pares with this is, of course, 1929.

Com­par­ing the Crash of 2008–thus far–to 1929

The fall in 1929 itself was much more sudden–the fall from the mar­ket peak of 381 to Black Tues­day’s plunge to 230 points took just over a month, ver­sus over a year this time. But the long grind to the bot­tom in the 1930s took three years (and the mar­ket did­n’t revis­it its 1929 peak until 1957). We may well face as long a wait before a new world finan­cial order is estab­lished.

If we can gain our sens­es this time, we may be able to estab­lish a finan­cial sys­tem that serves cap­i­tal­ism rather than sub­verts it. We need, as Hyman Min­sky argued, a good finan­cial soci­ety in which the ten­den­cy of mar­kets to indulge in spec­u­la­tive behav­ior is con­strained.

It is obvi­ous now that this will not be a dereg­u­lat­ed mar­ket. But can it mere­ly be a reg­u­lat­ed one? Will reg­u­la­tions alone–bans on short sell­ing, “Chi­nese Walls” between invest­ment and mer­chant bank­ing, quan­ti­ta­tive reg­u­la­tion of lenders, etc.–be enough?

Clear­ly they were not this time round. That is the world con­struct­ed after the Great Depres­sion (and its polit­i­cal after­math, the Sec­ond World War) when Keynes ruled eco­nom­ics. It fell apart over time because, as Min­sky put it, “sta­bil­i­ty is desta­bi­liz­ing”. A peri­od of eco­nom­ic tran­quil­i­ty ush­ered in by dras­tic reduc­tions in debt lev­els and firm reg­u­la­tion of finan­cial mar­kets leads us to for­get the tragedies of The Bust, and to believe that mar­kets are inher­ent­ly sta­ble.

This delu­sion was aid­ed and abet­ted by the eco­nom­ics pro­fes­sion, which react­ed to Key­nes’s argu­ments about the inher­ent insta­bil­i­ty of mar­kets like an immune sys­tem repelling a virus

Eco­nom­ics dreamt up such absurd notions as the “Effi­cient Mar­kets Hypoth­e­sis” (which assumes that mar­kets accu­rate­ly pre­dict future earn­ings and val­ue shares on that basis), the Modigliani-Miller Hypoth­e­sis (that the most ratio­nal fund­ing mod­el for firms is 100% debt if inter­est pay­ments are tax-deductible), and Ratio­nal Expec­ta­tions (mar­kets are always in long run gen­er­al equi­lib­ri­um, and gov­ern­ment is impo­tent to affect real eco­nom­ic activ­i­ty), and even invent­ed asset mar­ket val­u­a­tion con­cepts (such as the Black-Scholes Options Pric­ing Mod­el) that were inte­gral to the devel­op­ment of the deriv­a­tives mar­ket, the most desta­bil­is­ing force of all in mod­ern cap­i­tal­ism.

Cap­i­tal­ism will sur­vive this cri­sis, as it sur­vived 1929; and it will be reformed, as was the sober post-WWII sys­tem after its prof­li­gate pre­de­ces­sor of the Roar­ing Twen­ties. But with spec­u­la­tion on assets still a poten­tial path to indi­vid­ual riches–and with a dras­ti­cal­ly low­er lev­el of gear­ing, as the Great Depres­sion lev­el of debt unwound from its 215% of GDP peak in 1932 to a mere 45% at the start of 1945–the seeds for today’s repeat of the tragedy of spec­u­la­tion were sown.

We need instead to con­sid­er redesign­ing the finan­cial sys­tem so that the cur­rent­ly inher­ent prof­itabil­i­ty of lever­aged spec­u­la­tion on asset prices (when debt lev­els are low) is con­strained.

I pro­pose three such reforms, in full knowl­edge that they have Buck­ley’s of being imple­ment­ed now–but hope­ful­ly they will be con­sid­ered more seri­ous­ly when this cri­sis reach­es its sec­ond or third birth­day.

These are:

1. To rede­fine shares so that, as do cor­po­rate bonds, they have a defined expiry date at which time the issu­ing com­pa­ny repur­chas­es them at their issue price;
2. To impose “caveat emp­tor” on mort­gage agree­ments, so that the lender’s secu­ri­ty is lim­it­ed if poor cred­it eval­u­a­tions were done of the bor­row­er’s capac­i­ty to meet the pay­ment com­mit­ments in the con­tract (this will be fur­ther explained below); and
3. To base house price val­u­a­tions on a mul­ti­ple of the imput­ed year­ly rental of a prop­er­ty, rather than its poten­tial resale price.

The inten­tion of the first rede­f­i­n­i­tion of cap­i­tal assets (this is much more than a mere reform) is to put some effec­tive ceil­ing on how high a share price can be expect­ed to go, and to there­fore force val­u­a­tions to be based more on sober­ly esti­mat­ed future earn­ings (of the sort War­ren Buf­fett now does) than on the prospects of sell­ing a share to a Greater Fool–which is the real basis of mod­ern-day val­u­a­tions.

The inten­tion of the sec­ond, which may look para­dox­i­cal, is to impose the risk of reck­less lend­ing on the lender. Note that a sale of a house by the lender is called a Mort­gagEE sale–where the suf­fix indi­cates that the BUYER is sell­ing the house. The bor­row­er, on the oth­er hand, is known as the MortgagOR–where the suf­fix indi­cates that the bor­row­er is the SELLER.

What’s going on? Sim­ple: in a mort­gage con­tract, the lender BUYS a promise by the bor­row­er to pro­vide a stream of pay­ments in the future in return for a sum of mon­ey now. The lender is the buy­er.

What if the lender did­n’t prop­er­ly check the capac­i­ty of the bor­row­er to meet this com­mit­ment? If we imposed the old Com­mon Law prin­ci­ple of caveat emptor–“Buyer Beware”–the con­se­quences would fall on the buy­er. At the moment, lenders avoid the con­se­quences of poor research into a bor­row­er’s capac­i­ty to meet the pay­ments by get­ting absolute secu­ri­ty over the asset the bor­row­er sub­se­quent­ly pur­chased with the lender’s pay­ment.

Were caveat emp­tor imposed by the courts, I think that lenders would be rather less will­ing to indulge in the fren­zy of irre­spon­si­ble lend­ing that has marked the end of this long spec­u­la­tive bub­ble.

The inten­tion of the third reform is to base lend­ing for house pur­chas­es on the income-gen­er­at­ing capac­i­ty of the asset being bought, rather than as now on the resale price poten­tial. If a mul­ti­ple of, for exam­ple, ten times annu­al imput­ed rental income were the basis of val­u­a­tion, then it would be more than pos­si­ble for a land­lord to bor­row mon­ey to buy a prop­er­ty, and rent that prop­er­ty out at a prof­it.

This would estab­lish a firm link between the val­u­a­tion of a house, its rental income, and the max­i­mum loan one could secure to buy it. It would forge a link between an assets val­u­a­tion and its income earn­ing potential–a link that is so frag­ile in today’s spec­u­la­tion dri­ven mar­ket. It would also estab­lish a class of wealthy agents–landlords–who have  vest­ed inter­est in keep­ing house prices and loan lev­els low.

With such reforms, there is at least some prospect that I will not have a suc­ces­sor writ­ing of the fol­lies of the Stock Mar­ket and Hous­ing Mar­ket Bub­bles of 2060. With­out them or sim­i­lar­ly effec­tive struc­tur­al alter­ations, with mere­ly reg­u­la­tions as were imposed after the Great Depres­sion, we will be here again some time in the future.

All that is, of course, for the future. The imme­di­ate prob­lem is what to do now, if, as so many more expect than once did, this mar­ket crash is the pre­lude to the world’s sec­ond Great Depres­sion.