Our third-quarter report in October drew water from the intellectual well of Robert Shiller’s latest book, Narrative Economics: How Stories Go Viral and Create Major Economic Events. The Nobel laureate delved into various perennial-narrative continuums—panic vs. confidence, priority of capital or labor, techno-philia or -phobia. These continuums are deeply rooted psychological frameworks for interpreting social life, and shifts along them have important economic effects as they embed themselves in the collective subconscious.
In his review of Shiller’s book, Barry Eichengreen, University of California (Berkeley) economic historian and former senior policy advisor at the International Monetary Fund (IMF), argues that Shiller could have drawn more heavily on historical analogy as a touchstone, particularly during crises. According to Eichengreen, analog reasoning, seeking out detailed relational patterns across episodes, is central to reasoning itself. He cites several examples. During the Cuban missile crisis, Pres. Kennedy turned to archival lessons from Pearl Harbor. Ben Bernanke sought analogs from the Great Depression in coping with the 2008 financial crisis.
Eichengreen’s latest of many books, The Populist Temptation: Economic Grievance in the Political Reaction in the Modern Era, is timely—both economically and politically. It examines recognizable patterns from prior episodes of populism in modern history. The risk of relying on historical analogy, which I believe was Bernanke’s bogeyman, is the ease by which one falls victim to the insidiously powerful confirmation bias.
Neither Shiller nor Eichengreen dives into the murky waters of complexity theory, the economic analysis borrowed from physics that sees the economy in perpetual motion and reformation. This contrasts with the neoclassical school that believes economic arrangements represent stable equilibriums. During their own travails, Kennedy and Bernanke no doubt came face to face with the limitations of historical perspective implicit in Mark Twain’s famous dictum: “History does not repeat itself, but it rhymes.” To climb farther out on the proverbial limb, attempting to use historical analogs to calculate systemic risk is, most would contend, reaching beyond one’s grasp.
A Limb Forward
We may turn to Nassim Taleb, contemporary interpreter of the Black Swan, to fashion an argument to justify extending our reach. Two examples of note. First is the popular HBO series recounting the 1986 Chernobyl nuclear accident in Ukraine. While the timing was unpredictable, the Soviet-style authoritarian command-control political system almost guaranteed that a manageable failure—a “normal accident”—at one of its many nuclear energy plants would eventually cascade into catastrophe. The second is similar, and contemporaneous. Images of the wildfires in Northern and Southern California are so visceral one can almost feel the heat and smell the smoke. Climate change, drought, backward-looking utility-line maintenance policies, and the expansion and migration of housing to riskier areas, when totaled together are the definition of a complex system. Both Chernobyl and California fires are the nonlinear, asymmetrical consequences of complex systems that finally fail.
The analogical similarities between Taleb’s Black Swan outliers make the case that history is replete with failures of complex systems. Moreover, because their occurrences lie beyond the realm of normal expectations—they lurk in the fat tails of frequency distributions—their consequences were often proportionately dire.
“Wind Extinguishes a Candle and Energizes Fire”
What if we combined stories that have as their roots actual events? Taleb succinctly distinguishes between benign and potentially catastrophic systems in the preceding quote that titles this section. Of particular interest to us, Rick Bookstaber characterizes the capital markets as complex systems because they are tightly coupled. Like a California forest fire fanned by the Santa Ana winds, once a chain reaction begins in markets, it’s nearly impossible to stop. Progress and technology, resulting in increased resiliency on many fronts, have rendered capital markets more fragile.
Markets also suffer from the seatbelt paradox. After authorities instituted safety regulations that required auto manufacturers to install seatbelts in their cars, drivers began driving more dangerously. Innovations designed to improve safety actually encourage increased risk taking, effectively neutralizing much of the anticipated benefit.
The Federal Reserve System has been a seatbelt for the market these last 10 years. Beyond the Fed’s official duties, the unspoken truth is that its emergency supply of liquidity serves as the last bastion against an unthinkable market collapse. Since its role is widely known and relied upon, its efforts all too often have merely encouraged market participants to take even greater risks. The more dangerous environment simply increases the plausible downside, likely leaving the Fed as powerless as a seatbelt in a 100-mph car crash.
Ignoring the Cassandras
“I cannot leave the truth unknown.” —Sophocles, “Oedipus”
In Greek mythology, Apollo granted Cassandra the gift of prophecy. When she spurned him, he retaliated by adding that no one would believe her. Every modern-day, would-be Cassandra faces a paradox: to see what others may not see and be despised for it. Whistleblowers, from Daniel Ellsberg to the current unnamed White House insiders, are invariably under siege for the truth they purport to reveal. Of course, for every true Cassandra, there are many times more who are masquerading, well-intended or otherwise.
We contend that the global economy and the exceedingly interdependent financial and currency systems, which are its life blood, have reached a critical state. Recalling Mark Twain’s aphorism, the circumstances today are quite different from the domestic housing bubble that enabled financial innovation to morph into a systemic threat in the mid-2000s. They do, however, rhyme, as we will demonstrate through reference to the IMF’s Global Financial Stability Report of October 2019, from which we will tee off in subsequent posts. As you will see from the material below, IMF work has been valuable to us in the past.
A Historical Analogy
The two long block quotations that follow were shamelessly excerpted from A Decade of Delusions, Chapter 9, are drawn from the Martin Capital Management annual reports of 2005 and 2006. To the skeptical reader, they may offer some credibility as to our capacity of playing the role of Cassandra, in this instance offering unheeded warnings leading up to the financial crisis. To be sure, many gave lip service to potential risks. Apparently, the number whose conviction rose to the level of putting their careers in jeopardy was small enough that the markets were unfazed until the evidence had become undeniable. By then it was too late.
We’ve always prized out-of-the-box thinking (see italicized quote from Charlie Munger below). The developments in the housing market and the financial economy—which became the “Perfect Storm,” a euphemism for a complex system that imploded—might well be applicable today as a global slowdown intersects with excessive financial leverage.
Excerpts from A Decade of Delusion
How much anecdotal evidence do we need to confirm that the financial economy continues to reach recklessly for new extremes of brashness? The “Perfect Storm” section reached beyond my traditional grasp by thinking outside the box, which means thinking about the “(housing) box,” to dissect what appears to be a house pricing anomaly. Of what relevance are levitating real estate prices, or the schemes to finance the boom in housing, to a firm that does not invest in other than marketable securities? We believe that the argument we will propose forthwith is an essential part of an interdependent larger mosaic that requires some familiarity with multiple disciplines—and feel we would be remiss in not disclosing housing’s role in this increasingly interconnected financial and economic world. The following snippet from Charlie Munger brings this circuitous venture to a just and proper close: “… [A] curious mind … loves diagnoses involving multiple variables.” First, what constitutes a housing bubble? By way of background, I return again to Robert Shiller, whose scholarly book Irrational Exuberance was published near the market peak in 2000. Capitalizing on the success of his first book, Shiller published Irrational Exuberance, Second Edition, copyrighted in 2005. In the latter he has amassed impressive evidence in support of his belief that the recent housing-market boom bears many similarities to the stock market Bubble about which the earlier book was written. To start off, Shiller, rather effectively, in my judgment, dismisses the traditional glib explanations for housing booms, including the shortage of land, rising building costs that depart from past patterns, and low interest rates …
In 2005 and 2006 most pundits seem unconcerned about the threat to financial stability that could be posed by the housing bubble. As late as in a May 17, 2007, speech, Fed Chairman Ben Bernanke famously opined that subprime market woes won’t seriously hurt the economy, that the contraction being experienced will be moderate, and that house prices will soon resume their advance. Any self-respecting Cassandra would’ve stepped back from the plate. Read on.
If Housing Prices Roll Over
… The economic consequences of deflation in the housing Bubble, should it occur, may prove to be as misjudged and unanticipated as to its repercussions as was the (relatively benign) economy’s reaction to the most recent stock market swoons, those of October 1987 and the collapse of the Nasdaq stock Bubble in March 2000. It is my contention, as noted earlier, that Greenspan may have drawn a faulty conclusion in implying that the economy, because of newfound “resilience and flexibility,” is no longer easily derailed. Even Greenspan says the steep rise in the ratio of household net worth to disposable income beginning in the mid-1990s, after a half-century of stability, has had a salutary effect on consumers’ propensity to spend. A central thesis of this essay is that a diminution in that ratio is likely to have a more deleterious effect on the economy if the shrinkage in the numerator is predominantly from the decline in the value of one’s home as contrasted with one’s 401(k) plan or other portfolio of marketable securities.
First, there’s the matter of financial leverage. Unjustifiably high financial leverage has been the cause of more investment failures than any other variable. It allows you no wiggle room, no slip ’twixt the cup and the lip. For purposes of comparison, the typical homeowner’s marketable securities portfolio is not financed with borrowed money. New York Stock Exchange Member Firms Customers’ Margin Debt of $212 billion as of October 2005 was a mere pittance relative to the total value of all U.S. stocks, which is estimated at $15.8 trillion at year end. By stark contrast, thanks to the panoply of creative real estate financing options discussed above, the surge in prices since 1997 has converted homes into two-, three-, or four-bedroom ATMs.
Homeowners use the equity in their houses to pay off credit card debts (home-equity loan interest rates are much lower and are deductible for tax purposes) and to finance personal-consumption expenditures at a time when real earnings growth has been negligible. By some calculations, roughly 60 percent of consumer spending is financed through those down-home ATMs. As for the other newly created jobs, they’re concentrated in the likes of McDonald’s, KFC, Starbucks, Walmart, temporary and contract jobs, and those consumer-unfriendly security jobs in airports and office buildings. In a June 16, 2005, article, The Economist averred that, as a result of such borrowing, “housing booms tend to be more dangerous than stock market bubbles, and are often followed by periods of prolonged economic weakness.”
Second, the wealth in the form of the housing stock is much more broadly dispersed than the wealth held in the form of intangible assets, and it’s generally held directly in the name of the owner, and not held by a trustee in a 401(k) plan or such. Again by contrast, for a broad demographic (probably not much different from that which owns much of the owner-occupied housing) intangible assets—stocks, bonds, and mutual funds—are held at comparatively inaccessible arm’s length. When equity prices rise there is no doubt that many people rationalize the increase in the market value of their securities as a substitute for a conscious act of deferring consumption, otherwise known as savings.
There is little evidence to support the notion that holders of financial assets, particularly those invested in tax-deferred 401(k) plans, profit-sharing, and other such plans, who felt, at least temporarily, less wealthy as a result of the recent bear market in stocks, stepped up their savings to compensate. The impact of rising or falling stock prices on spending is indirectly proportional to the extent that the savings are invested in tax-sheltered plans because of the practical inaccessibility of the assets and the financial penalties on monies withdrawn prematurely. Moreover, just as folks’ 401(k) plan was shrinking in value, their house price was going the other way.
Third, housing bubbles, when the process of purging of excesses takes place, follow a pattern similar to that of a stock bubble, except they’re in slow motion. The majority of homes are owner-occupied. Think about the many factors one must take into account when a family moves from their house to other housing. The markets are geographically, topographically, and climatologically diverse. Arbitrage (derived from arbitrate: to settle or reconcile differences) doesn’t work effectively because of these dissimilarities (how would you compare Naples, Florida, with Baltimore, Maryland, if you were actually so inclined!) and because there are no centralized markets like the NYSE or Nasdaq, and trading costs are enormous, compared with a few cents a share for common stocks.
Confirming the points above with empirical evidence, I quote work done by the International Monetary Fund (IMF). The IMF published an in-depth analysis of equity market and real estate crashes in its April 2003 edition of World Economic Outlook. The average real decline in prices in a housing market crash (30 percent after four years) was found to be less than for a stock market crash (45 percent decrease in equity prices, on average, after two and a half years), but at the end of each of those periods, GDP (or “output”) had fallen 8 percent after a housing bubble burst, compared with 4 percent after a stock market bubble burst.
Chapter 10 of A Decade of Delusions, which was lifted from the MCM 2007 annual report published in February 2008, goes on to address the interdependence of the collapse in housing prices and the esoteric shadow banking system through which pools of mortgages were financed. It was the penultimate complex system, and it failed spectacularly. We felt, as it turns out, correctly, that the major investment banks would be at the epicenter.
In the spirit of full disclosure, we—really I—mistakenly took Ben Bernanke’s assurance in September 2007 at face value: “But I believe that, in the long run, markets are better than regulators at allocating credit” (see footnote 5). I couldn’t have been farther from the mark. More than a decade later the Fed, and other central banks around the world, have strong-armed the credit markets, struggling to ward off deflation and stimulate economic growth.
above, the consequences of central banks wresting control of the credit markets
away from the free markets for so long may have finally come home to roost…
 Rick Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, 2007.
 Frank K. Martin, A Decade of Delusion, 2011.
 Ibid, 300–301.
 Although it received little press then or now, the irony of the following quotation from the conclusion of that speech serves as a constant reminder of how big the problems of the future are and how small we must seem as we attempt to solve them: “But I believe that, in the long run, markets are better than regulators at allocating credit.”
 Ibid, 308–309.