Wednesday, August 15, 2007

How the Current Stock Market Crisis Grew in the Tulip Garden

Another day, another 207 point drop in the Dow. When you're feeling pain, it's hard to think about anything else. But it might help to step back and think about why we have this pain.

The current market turmoil is a consequence of the loose credit policies of the Greenspan era at the Federal Reserve. We've discussed how repeated loosening of credit in response to market instability created expectations that the Fed would always step in to protect asset values. See Low interest rates facilitated the boom in the stock markets. A years-long policy of very low interest rates after the terrorist attacks of 9/11/01, supposedly intended to prevent price deflation, triggered a massive inflation of real estate values. Apparently the Fed, and in particular Chairman Greenspan, thought that a vibrant real estate sector would stimulate the economy and keep things humming. A busy real estate market would employ a lot of people: construction workers, real estate agents, mortgage brokers, title company personnel, bank loan staff, investment bankers packaging CDOs, hedge fund managers, and even an occasional home inspector (although not at the height of the lunacy).

Even more importantly, home values rose. That gave homeowners greater equity, even if they had done nothing to earn it. Simply holding title to real estate meant greater wealth. And you know what they say about easy money: easy come, easy go. The banks made it even easier, offering home equity loans and lines of credit to anyone with a home and a pulse. People eagerly converted their no-sweat equity into cars, big-screen TVs, overseas vacations, backyard grills large enough to roast an ox, bathrooms that cost more than a year at a private college, kitchens that cost more than a full-size luxury sedan, and diverse and sundry other indicia of prosperity.

Given that you could buy a home with no money down and no proof of your income, and then get access to rising home equity that would finance a lifestyle that your earnings, if any, couldn't begin to cover, who wouldn't buy a house? Come up enough eye-hand coordination to sign some paperwork, and you'd be driving the car of your dreams to the home of your dreams for the backyard barbecue of your dreams. And your guests would be too busy sticking their faces in two-inch thick steaks to notice that you hadn't gotten any smarter, worked any harder, earned any more, or saved a penny.

The asset boom had a wonderful quality of rotating from a faltering market to a fresh market ripe for exuberance. When the real estate market peaked in 2006, the stock market took off. Much of its rise was fueled by speculation in the stocks of companies thought to be good candidates for going private transactions. Hedge funds, as well as individual investors, used leverage to buy stocks of companies they hoped the private equity firms would use leverage to acquire.

The loose credit policies of the Greenspan era rewarded asset speculation. Further, as asset prices rose, speculation on a leveraged basis was rewarded even more highly. The financial services industry, ever eager to pounce on a profitable trend, developed ways for every Tom, Dick and Harry, however indigent, to engage in leveraged speculation.

On the other hand, those dull, boring and unimaginative people who worked hard, lived within their means, paid their debts, and saved were duly punished. The ultralow interest rates of 2001 to 2005 drove interest rates paid on bank deposits and money market funds below 1%, not enough to begin to offset inflation. Why save a downpayment when: (a) you would lose value from inflation on your short term investments, and (b) you could buy a house without a downpayment--or any other verifiable financial resources? Old-fashioned virtues such as moderation, thrift and long term planning had sand kicked in their faces by the luxury car leasing, credit card wielding, minimum monthly payment making swells of the leverage loving classes.

Now, however, the chickens have come home to roost; and the home is in foreclosure with hardly a hot dog to throw on the grill. Here's the problem: you can't build true economic wealth by speculating in asset values. No asset will increase in value indefinitely. The Dutch learned that lesson from their little spending spree on tulip bulbs. While the commodities markets provide valuable grease to keep the wheels of the economy turning, you can't have an entire society trying to get rich from speculative investing. That would lead to a cycle of asset sales at ever escalating prices, where recklessness and, ultimately, stupidity are the only things keeping the lemmings going. However, since no asset can rise in value indefinitely, when the lemmings reach a cliff, Newton's law of gravitation becomes operative.

True economic wealth comes from productive activity (meaning work). Okay, work stinks, but it's better than losing your house to foreclosure. True personal wealth means having a positive net worth, not a lot of debts. True national wealth comes from production of goods and services, not asset speculation, and requires having a positive savings rate that provides capital to finance investment.

The loose credit policies of the Greenspan Fed penalized work and saving, which would generate income taxable at ordinary income rates. The same policies rewarded speculation in assets, which would generate capital gains taxable at lower rates, or real estate gains that wouldn't be taxed at all. Interest paid on mortgage debt would be deductible, while interest received for savings would be taxed as ordinary income. Granted, the Fed didn't create the tax code. But it knows how the tax code works and doesn't have to misallocate resources worse than the tax code already misallocates them. A rational, thrifty and hardworking person would think the entire world had fallen down a rabbit hole.

The Greenspan Fed's loose credit policies were a form of pump priming, deficit spending that is leaving a lot of people with individual real estate or stock holding deficits. While these policies temporarily provided some stimulus, the piper meticulously kept a ledger and now has come around to be paid.

Norman Rockwell wouldn't recognize today's America. McMansions consume the entire lot, even the edge where the white picket fence once stood, and soda fountains now charge $5 for a cup of coffee. The current Fed's kabuki dance to maintain confidence by infusing liquidity, while keeping interest rates stable in order to discourage the speculative use of credit, may be the right medicine. The Fed seems intent on not administering narcotics this time, so we will probably continue to feel some pain. Addictions are hard to break, but being sober and healthy would be worth the pain.

Legal News: no CSI for jurors. Is it any wonder people don't like jury duty?

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