Thursday, September 24, 2009

Economic Stability and the Credit Bubble

In a way, the ongoing collapse of Wall Street can be blamed on Alan Greenspan’s determined efforts to stabilize the U.S. economy. That, and the Law of Exploitation.

The Law of Exploitation basically says that any tendency you have will, sooner or later, be taken advantage of. So what happens when a nation shows a distinct tendency to have a stable economy?

As Fed chair, Alan Greenspan only wanted to keep the economy stable and predictable. The idea was that if you could keep economic uncertainty to a minimum, the economy could work out how to grow on its own. He was aided in this by Bill Clinton, who at least in his first six years as president, took much the same approach. The strategy worked reasonably well — well enough to overcome the “hard-core unemployed” myth.

Unfortunately, this extended period of stability led directly into the credit bubble that created the current recession. Rating agencies, which had always felt that they should caution investors about the way a security might perform if the economy went bad, decided to discount that possibility. The economy, they decided, would never really stagnate, and certainly would never face a crisis of any magnitude. They began, especially around 2003, to rate securities based on the assumption of economic stability.

Around the same time, Wall Street started to take huge chances with the economy. Their company would go bust if the economy went bad, but it was still a rational decision from the individual’s point of view. After all, if you’re a fund manager or trader, or even an executive, you’re not likely to be fired for taking risks — what are the chances that the economy falls apart before you move on to your next job? With this kind of thinking, people were exploiting the stability of the economy. They were creating points of economic instability, knowing that they were putting their own companies at risk, but not appreciating the magnitude of the risk, and not realizing or not wanting to believe that their actions were putting the whole economy at risk.

Consumers, business managers, and Congress added to the economic instability by being fully leveraged — borrowing as much money as they possibly could. The U.S. economy was as top-heavy as it had ever been. By 2006, when Greenspan was on his way out the door, the economy was obviously straining under the load. When things got shaky, lots of things fell over — and now, the economy is facing the possibility of a systemic collapse.

And it’s all happening because so many people — especially people with billions of dollars in their care — decided they could bet on the economy remaining stable. That is never a safe bet, but it looked safe to 30- and 40-year-old money managers who had never in their careers seen the economy stumble.

I have to admit, I was slow to make this connection between the stable economy and the credit bubble. The truth, though, is that even a stable-economy policy has its limits. Stabilizing the economy is a good strategy. It can produce real, robust economic growth. But stabilize the economy too well for too long, and you are doomed to see what we are going through now: a credit bubble and subsequent collapse.

Of course, now that we have experienced the link between economic stability and the credit bubble, it’s easy to say how the damage could have been minimized. After about 12 years of convincing economic stability, it is time to start clamping down on lenders, with rules that prevent gimmicks such as teaser rates, limit leverage for borrowers, and prohibit banks, at least, from concentrating too much risk in any financial category. These kinds of actions are necessary to limit the destabilizing effects of a credit bubble.

But imagine trying to tell that to Congress in 1999, or 2003. The thinking at that time was that you get the best growth by taking a mostly hands-off approach to business. It didn’t work — compare the economic growth of 1992–1998 to what we have experienced since, and you can see that the move to deregulate and encourage business has led to accounting fraud, concentration of wealth outside of the business world, and economic stagnation. But even to the extent that a hands-off approach might work, you still need to balance growth with stability, so that the economic growth you achieve doesn’t just fall away at the first bump in the road.