Ten years ago this month, the failure of Lehman Brothers exposed how cavalier the world had been towards risk. Households had bought homes they thought could never go down in price, banks had made loans they thought would never default and repackaged them into securities to make them seem riskless and governments, convinced depressions were a thing of the past, had stood by.
Since then, they have sought to ensure it never happens again. And thus, the world has retreated from risk. That retreat has reshaped institutions, regulations and attitudes, and in the process the economy: It’s why economic growth has been so durable yet so muted, with less of the risk-taking that both drives booms and busts and raises long-run growth.
With time, even the deepest traumas wear off, and there are signs that risk-taking is returning, though in different forms from before. What remains unclear is whether it paves the way for years more of stable, crisis-free growth, or yet another bust.
–– ADVERTISEMENT ––
The U.S. mortgage crisis and the eurozone crisis that soon followed were rooted not in the disregard for risk, but in its mispricing. The assumption that American home prices couldn’t fall much nationally (since they hadn’t since the 1930s) justified treating mortgages and the securities they backed as if they were government bonds. Lending to Lehman Brothers seemed safe since a systemically important U.S. financial firm had not failed since the 1930s. Lending to Greece seemed as safe as lending to Germany because they shared the same currency. That this sense of safety was so ingrained deepened the trauma when it was shattered.
Financial catastrophes usually alter attitudes to risk. Monetary historians Milton Friedman and Anna Schwartz wrote in 1963 that the Great Depression “instilled … an exaggerated fear of continued economic instability, of the danger of stagnation, of the possibility of recurrent unemployment.” Americans decided to hold lots of cash. The federal government became the guarantor of economic security: banks got federal deposit insurance, the Federal Reserve devoted itself to preventing recessions, and the safety net was born with Social Security.
The global financial crisis was less severe than the Depression so the changes have been less sweeping, but they go in a similar direction. Bank regulations have expanded and tightened, cross-border financial linkages (such as via bank lending) have been truncated, and the Fed has worked far harder to support growth.
Households and investors are much warier of risk: Look no further than Treasury bonds which, adjusted for inflation, have yielded on average just 0.7% since Lehman failed, compared to more than 3% in the prior three decades. This is due both to central banks buying bonds and holding short-term rates near zero and to investors preferring safe securities to risky ones. Nearly 30% of American households held stocks or mutual funds in 2007; in 2016, only 24% did.
Jason Thomas, chief economist at private equity manager Carlyle Group, examined the performance of hedge funds and concluded many spent the last decade preparing for the “next subprime” by investing in positions that lose modestly in ordinary times while yielding a spectacular payday when some market somewhere craters. Since the next subprime has yet to come, Mr. Thomas concludes this has cost them dearly: After outperforming the broader stock market by 6.6 percentage points per year from 1997 to 2009, hedge funds have since underperformed by 10.4 points.
This pessimism is why the bull market has lasted so long: There are fewer bulls forced to sell into downturns. The late economist Hyman Minsky anticipated the crisis with his thesis that “stability is destabilizing.” Long periods of calm induce behavior and innovation that make the next downturn more violent. The converse explains the aftermath: Instability is stabilizing. “The events of 2008-09 create appreciation for the possibility of events like 2008-09, which prompts risk-reducing behavioral changes that make the system more stable,” Mr. Thomas writes in a report. Among them: businesses hold more cash, banks are less leveraged, and policymakers intervene more to stabilize markets.
With less leverage and fewer channels of international contagion, financial disruptions burn themselves out before they become full-fledged crises, from the “taper tantrum” in 2013 when the Fed slowed its buying of bonds to the collapse in oil prices in 2014, China’s bungled devaluation in 2015, and the problems now engulfing Turkey and Argentina.
The risk aversion apparent in markets shows up in the economy. A house is the biggest investment most American families can make, and far fewer make it now. In previous expansions, about 1.5 million new homes were built each year. In this one it’s closer to 1 million. Young adults take longer to move out of their parents’ home, marry, and have children. Some of this reflects demographic shifts that predate the crisis. Some is due to the shortage of land on which to build. But the crisis bears a lot of blame: regulators and banks have made it harder to get a mortgage and many young families see it as too risky a commitment.
Businesses have similarly lost their taste for gambling. Investment has been muted (relative to profits) while cash goes toward share repurchases and dividends. Iconic entrepreneurs like Jeff Bezos of Amazon.com Inc. and Elon Musk splurge on long-shots with high probability of failure, but it’s striking how exceptional they are. Rather than become the next Google or Facebook , many startups aspire to be bought by Google or Facebook. Oil companies used to spend billions searching for oil and gas in remote and dangerous places until BP PLC was bled white by penalties and lawsuits for the Deepwater Horizon oil spill in 2010 and Royal Dutch Shell PLC spent $7 billion fruitlessly exploring north of Alaska. Now big oil ploughs its money into extracting oil from shale formations in the continental U.S. using hydraulic fracturing, a methodical, factory-like process with more predictable returns than deepwater drilling.
Today, nine years into a business expansion, residential and business investment together equal 17.6% of GDP, well below similar stages of previous cycles. Since investment booms often lead to busts, muted investment helps explain why the expansion is now the second longest on record. But because investment also drives productivity, it helps explain why it’s one of the weakest.
One of the lessons of financial history is that risk-taking never disappears, it just changes shape, often to slip past the institutional and psychological defenses erected after the last crisis. That is already happening. Low interest rates have already bred imbalances: U.S. property and equity values are roughly back to the peaks, relative to national income, reached before the 2001 and 2007 recessions. In some foreign markets, property prices are even more extreme. Pessimism about stocks has faded, and regulators are chipping away at post-crisis financial rules.
Banks are certainly stronger than before the crisis, but innovation continues apace in the less-regulated “shadow” banking system. For example, in 2014, regulators cracked down on bank lending to highly leveraged companies. A study by three economists at the Federal Reserve Bank of New York found that leveraged lending migrated to investment banks, private-equity funds and business development companies, many of whom borrowed from banks. So it’s not clear if the financial system is safer as a result. Certainly, corporate leverage is at extremes, though companies have lately curbed their borrowing.
Mortgage borrowing, the culprit in countless crises through history, looks tame. But in its place a student debt bubble has inflated. Borrowing for higher education seems prudent, but then borrowing for a home was a no-brainer, too, until a decade ago. Student loans, even those that financed worthless degrees, won’t tank the financial system: there aren’t enough and most are federally guaranteed. But they can’t be discharged in bankruptcy either (with rare exceptions), which means they’ll haunt millions of borrowers for years to come.
Most emerging economies long ago abandoned the fixed exchange rates that encouraged foreign borrowing and precipitated the Mexican and Asian crises of the 1990s (and the eurozone crisis, since the euro is a type of fixed exchange rate). Yet that discipline has slipped in recent years: near-zero American interest rates encouraged emerging-market companies and governments to gorge on dollar loans, and they are being squeezed as the dollar rises against their own currencies. Turkey and Argentina may be isolated cases, or they may be the tip of the iceberg. An International Monetary Fund study recently found China’s booming credit growth bore the hallmarks of an economy headed towards crisis.
The U.S. government has long been a stabilizing influence in past crises thanks to the stature of its currency, its debt, and its institutions such as the Fed and Congress. Yet arguably it is becoming a source of instability. In the last year Congress has passed a gargantuan tax cut and spending increase that, according to Deutsche Bank, represent the largest stimulus to the economy outside of a recession since the 1960s. It sets the federal debt, already the highest relative to GDP since the 1940s, on an even steeper trajectory, stimulates an economy already at or above full employment which could fuel inflation, and pressures the trade deficit—even as White House imposes tariffs on numerous trading partners in an effort to narrow it.
The U.S. can pursue such an unorthodox policy mix because in the post-crisis world investors seem ready to absorb any amount of super-safe Treasury debt, the Fed is willing to err on the side of higher inflation and the rest of the world is reluctant to antagonize the world’s military and economic superpower. If any of those factors were to change, all bets are off.
Since then, they have sought to ensure it never happens again. And thus, the world has retreated from risk. That retreat has reshaped institutions, regulations and attitudes, and in the process the economy: It’s why economic growth has been so durable yet so muted, with less of the risk-taking that both drives booms and busts and raises long-run growth.
With time, even the deepest traumas wear off, and there are signs that risk-taking is returning, though in different forms from before. What remains unclear is whether it paves the way for years more of stable, crisis-free growth, or yet another bust.
–– ADVERTISEMENT ––
The U.S. mortgage crisis and the eurozone crisis that soon followed were rooted not in the disregard for risk, but in its mispricing. The assumption that American home prices couldn’t fall much nationally (since they hadn’t since the 1930s) justified treating mortgages and the securities they backed as if they were government bonds. Lending to Lehman Brothers seemed safe since a systemically important U.S. financial firm had not failed since the 1930s. Lending to Greece seemed as safe as lending to Germany because they shared the same currency. That this sense of safety was so ingrained deepened the trauma when it was shattered.
Financial catastrophes usually alter attitudes to risk. Monetary historians Milton Friedman and Anna Schwartz wrote in 1963 that the Great Depression “instilled … an exaggerated fear of continued economic instability, of the danger of stagnation, of the possibility of recurrent unemployment.” Americans decided to hold lots of cash. The federal government became the guarantor of economic security: banks got federal deposit insurance, the Federal Reserve devoted itself to preventing recessions, and the safety net was born with Social Security.
The global financial crisis was less severe than the Depression so the changes have been less sweeping, but they go in a similar direction. Bank regulations have expanded and tightened, cross-border financial linkages (such as via bank lending) have been truncated, and the Fed has worked far harder to support growth.
Households and investors are much warier of risk: Look no further than Treasury bonds which, adjusted for inflation, have yielded on average just 0.7% since Lehman failed, compared to more than 3% in the prior three decades. This is due both to central banks buying bonds and holding short-term rates near zero and to investors preferring safe securities to risky ones. Nearly 30% of American households held stocks or mutual funds in 2007; in 2016, only 24% did.
Jason Thomas, chief economist at private equity manager Carlyle Group, examined the performance of hedge funds and concluded many spent the last decade preparing for the “next subprime” by investing in positions that lose modestly in ordinary times while yielding a spectacular payday when some market somewhere craters. Since the next subprime has yet to come, Mr. Thomas concludes this has cost them dearly: After outperforming the broader stock market by 6.6 percentage points per year from 1997 to 2009, hedge funds have since underperformed by 10.4 points.
This pessimism is why the bull market has lasted so long: There are fewer bulls forced to sell into downturns. The late economist Hyman Minsky anticipated the crisis with his thesis that “stability is destabilizing.” Long periods of calm induce behavior and innovation that make the next downturn more violent. The converse explains the aftermath: Instability is stabilizing. “The events of 2008-09 create appreciation for the possibility of events like 2008-09, which prompts risk-reducing behavioral changes that make the system more stable,” Mr. Thomas writes in a report. Among them: businesses hold more cash, banks are less leveraged, and policymakers intervene more to stabilize markets.
With less leverage and fewer channels of international contagion, financial disruptions burn themselves out before they become full-fledged crises, from the “taper tantrum” in 2013 when the Fed slowed its buying of bonds to the collapse in oil prices in 2014, China’s bungled devaluation in 2015, and the problems now engulfing Turkey and Argentina.
The risk aversion apparent in markets shows up in the economy. A house is the biggest investment most American families can make, and far fewer make it now. In previous expansions, about 1.5 million new homes were built each year. In this one it’s closer to 1 million. Young adults take longer to move out of their parents’ home, marry, and have children. Some of this reflects demographic shifts that predate the crisis. Some is due to the shortage of land on which to build. But the crisis bears a lot of blame: regulators and banks have made it harder to get a mortgage and many young families see it as too risky a commitment.
Businesses have similarly lost their taste for gambling. Investment has been muted (relative to profits) while cash goes toward share repurchases and dividends. Iconic entrepreneurs like Jeff Bezos of Amazon.com Inc. and Elon Musk splurge on long-shots with high probability of failure, but it’s striking how exceptional they are. Rather than become the next Google or Facebook , many startups aspire to be bought by Google or Facebook. Oil companies used to spend billions searching for oil and gas in remote and dangerous places until BP PLC was bled white by penalties and lawsuits for the Deepwater Horizon oil spill in 2010 and Royal Dutch Shell PLC spent $7 billion fruitlessly exploring north of Alaska. Now big oil ploughs its money into extracting oil from shale formations in the continental U.S. using hydraulic fracturing, a methodical, factory-like process with more predictable returns than deepwater drilling.
Today, nine years into a business expansion, residential and business investment together equal 17.6% of GDP, well below similar stages of previous cycles. Since investment booms often lead to busts, muted investment helps explain why the expansion is now the second longest on record. But because investment also drives productivity, it helps explain why it’s one of the weakest.
One of the lessons of financial history is that risk-taking never disappears, it just changes shape, often to slip past the institutional and psychological defenses erected after the last crisis. That is already happening. Low interest rates have already bred imbalances: U.S. property and equity values are roughly back to the peaks, relative to national income, reached before the 2001 and 2007 recessions. In some foreign markets, property prices are even more extreme. Pessimism about stocks has faded, and regulators are chipping away at post-crisis financial rules.
Banks are certainly stronger than before the crisis, but innovation continues apace in the less-regulated “shadow” banking system. For example, in 2014, regulators cracked down on bank lending to highly leveraged companies. A study by three economists at the Federal Reserve Bank of New York found that leveraged lending migrated to investment banks, private-equity funds and business development companies, many of whom borrowed from banks. So it’s not clear if the financial system is safer as a result. Certainly, corporate leverage is at extremes, though companies have lately curbed their borrowing.
Mortgage borrowing, the culprit in countless crises through history, looks tame. But in its place a student debt bubble has inflated. Borrowing for higher education seems prudent, but then borrowing for a home was a no-brainer, too, until a decade ago. Student loans, even those that financed worthless degrees, won’t tank the financial system: there aren’t enough and most are federally guaranteed. But they can’t be discharged in bankruptcy either (with rare exceptions), which means they’ll haunt millions of borrowers for years to come.
Most emerging economies long ago abandoned the fixed exchange rates that encouraged foreign borrowing and precipitated the Mexican and Asian crises of the 1990s (and the eurozone crisis, since the euro is a type of fixed exchange rate). Yet that discipline has slipped in recent years: near-zero American interest rates encouraged emerging-market companies and governments to gorge on dollar loans, and they are being squeezed as the dollar rises against their own currencies. Turkey and Argentina may be isolated cases, or they may be the tip of the iceberg. An International Monetary Fund study recently found China’s booming credit growth bore the hallmarks of an economy headed towards crisis.
The U.S. government has long been a stabilizing influence in past crises thanks to the stature of its currency, its debt, and its institutions such as the Fed and Congress. Yet arguably it is becoming a source of instability. In the last year Congress has passed a gargantuan tax cut and spending increase that, according to Deutsche Bank, represent the largest stimulus to the economy outside of a recession since the 1960s. It sets the federal debt, already the highest relative to GDP since the 1940s, on an even steeper trajectory, stimulates an economy already at or above full employment which could fuel inflation, and pressures the trade deficit—even as White House imposes tariffs on numerous trading partners in an effort to narrow it.
The U.S. can pursue such an unorthodox policy mix because in the post-crisis world investors seem ready to absorb any amount of super-safe Treasury debt, the Fed is willing to err on the side of higher inflation and the rest of the world is reluctant to antagonize the world’s military and economic superpower. If any of those factors were to change, all bets are off.
No comments:
Post a Comment