Moved to http://www.populardelusions.typepad.com/

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This time it's different, even though it isn't

"Unprecedented" is fast becoming the adjective of choice when it comes to the current financial farce. No less august reputations than Paul Volker, Forbes magazine and the World Bank have been amongst those making such definitive pronouncements.

Yet any reading of financial history shows that the current mess has fallen neatly into the same stylised template as all the others. So with apologies in advance to the memory of the great Charles Kindleberger, here are the four conditions which seem to be common to bubble formation:

1. Inappropriately accomodative monetary policy.  The gold rush of 1849-1856 leading to crash of 1857, reparations from the Franco-Prussian War in the early 1870s causing the German crisis of 1873; the Fed inflating in 1927 for international reasons leading to 1929; Japan easing to offsett the yeb appreciation in late 80s leading to the Nikkei crash of 1989, Greenspan cutting rates during the Asian crisis of 1997 leading to the tech bust of 2001;
2. Industrial innovation involving some new "change the world" type of technology. Canals in late 18th century UK, railroads during various 19th century manias in the US, autos and radio in the 20s, internet in the 90s.
   
3. Endogenous financial innovation. The joint stock company during the South Sea Bubble, Trust companies in the run up to 1907, Investment Trusts in the run up to 1929;
   
4. Change in regulations US Banking Acts of 1863/1864 for the panic of 1873, Federal Reserve act 1913 leading to the Florida Land bubble of 1924 and arguably even the crash of 1929.
   

Actually, you don't need all four of these ingredients. For example, during this episode we've had no world-changing industrial innovation. But the more we have, the more likely we are to bubble up and we certainly had three of the above. The overly accomodative monetary policy, according to no less an authority than Anna Schwarz occured when central banks world wide (not just the Fed) were very slow to remove the "precautionary" monetary stimulus left in place during the deflation scare of 2002 (we are reassured the same thing won't happen again this time). We had the compounding effect of endogenous financial innovation in the form of hedge funds and the CDS market. And we had arguably the origins of it all in changes in the regulatory regime, one of which was the removal of the 12x leverage ceiling on broker dealers allowing them instead to leverage 30x or even 40x.  

So unprecedented this crisis is not. But is its magnitude unprecedented? I doubt very much if this compares to what the Asian economies had to deal with during their crisis of 1997, where entire nations went bust pretty much over night and the IMF provided the lender of last resort facility only on the condition that recipient countries tightening monetary and fiscal policy. 

Is its magnitude unprecedented in developed economies? I don't think so. What about the Scandinavian real estate/banking collapses in the early 90s? They then, like us today, had a cataclysmic property market collapse which bust the banks, forced massive private sector deleveraging (the bad assets were effectively nationalised in a "bad bank") and decimated aggregate demand. And they then, like us today, were working in a global economy which was completely flat (the Japanese bubble had just burst, the US was living with the after effects of the S&L crisis while Europe was struggling to deal with the high Bundesbank interest rates required by reunification, which would eventually lead to the ERM crisis.)

So ugly as it is (and as a prop trader who's just found himself unwittingly sitting on a land mine I appreciate that this fiasco isn't much fun as well as anyone), I don't think this crisis is inprecedented in form or magnitude. Why do I care? Because the more I think about it the more it seems to me that "unprecedented crisis" is the bear market brother of "this time it's different" which we're all rightly taught to be deeply suspicious of. So I just wonder to what extent it really is ... 

... and then I realise. What I think isn't relevant. None of the above is relevant. Because perception is reality, and the perception among policymakers is that this is all unprecedented. Which means that the stimulus we're now seeing and are about to see in response is also unprecedented. That is very real, and that's what will count ...     

   

Reflating the ponzi

Well, thanks to what appears to be the biggest scam in the history of mankind I currently have more time on my hands than is strictly economic. Every cloud has a silver lining though and on what the BBC say is the gloomiest day of the year with most workers returning to the trenches after the festivities, and with an absence of anything better to do, To Believe is to See is back ... 

At the weekend there was a conference held by the San Fransisco Fed at which the economy experts who not so long ago scoffed at the idea that the current slump might turn out this badly agreed on the need for "unprecedented" stimulus to ward off what, e.g. former governor Mishkin called an "unprecedented" crisis. Interestingly, bleating along with the rest of the herd was Chicago Fed president Charles Evans who as recently as October 2008 was publicly fretting about inflation expectations becoming embedded in the economy. With monetary policy already in completely unchartered waters their call is now for similarly aggressive fiscal policy. 

Why? Because we're all slaves to a defunkt economist of our choosing. In the absence of such stimulus, we are earnestly assured, the economy will do what the US economy did after the Crash of 1929, or what the Japanese economy did after it's crash of 1989. How do we know this?Because that's what the theoretical models tell us and what history demonstrates. Only an idiot wouldn't see something so obvious. 

That the same body of theory at best failed to anticipate the current mess and at worst caused it isn't something too many people seem to be dwelling on. Neither is the possibility that that we may have learned the wrong lessons from our two illustrative episodes of choice. The truth is that the US in the 30s and Japan in the 90s aren't the only examples of post-crash economies we might be able to learn lessons from. Off the top of my head, the UK in the early 90s, all of the Scandinavian economies in the early 90s and the Asian economies in the late 90s suffered extreme macroeconomic post-bubble distress without suffering the "lost decade" currently being peddled as the inexorable trajectory we'll be on without such measures. 

Indeed, the Asian economies recovered pretty smartly from a crisis far worse than the current one despite the IMF imposing the harsh stabilisation policies of fiscal and monetary constraint in the name of restoring credibility - incidentally, the very same policies which supposedly caused the Great Depression. I bet we end up overstimulating.