The False Prophets of Wealth

A Sunday Sermon

Watch out for false prophets. They come to you in sheep's clothing, but inwardly they are ferocious wolves. By their fruit you will recognize them. (Matthew 7:15-23)

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In a world where debt expands much faster than our ability to put it into productive use generating income, are we cursed to lurch from one asset bubble to the next?

In the late 1990's we experienced one of the most powerful popular delusions in financial history: that the average person could sit in front of a screen and get rich by day-trading shares of companies with little intrinsic value, other than a dot.name and a Hail Mary business plan. Popular Capitalism, we called it, blissfully ignorant of the inherent oxymoron. The end came swiftly and painfully. Within just two years in 2000-2002, $7.1 trillion of stock market wealth evaporated, representing an astonishing 73% of GDP.

The shock to the economy was expected to be so severe that the Fed, perennially terrorized by its institutional memory of the Great Depression, went into panic mode, slashing interest rates to fifty-year lows. The objective was to prevent the stock crash from turning into something far more menacing - and it succeeded, at least temporarily.

Data: FRB and World Fed. of Exchanges

The sector chosen to produce America's urgently needed rebound was real estate. Mr. Greenspan made no bones about it: he constantly emphasized that average Americans had much more wealth locked up in housing than in stocks and that low interest rates would release this "frozen" capital, letting it loose upon the economy as debt-driven consumption. Moreover, the low cost of borrowing would increase new housing demand, create jobs in construction and finance, and raise existing real estate prices. When the follow-up effects of new housing were added (furniture, appliances, services), the economy was expected to enter another virtuous cycle.


It all went according to plan, until greed once more overcame common sense and yet another pernicious bubble formed. As the nation had already become accustomed to viewing capital gains as a birthright, people predictably jumped from flipping stocks to flipping houses. Stock margin was replaced with no-money-down liar loans and house prices were off to the races. The asset class that was supposed to act as the golden anchor of family savings was pulled up, melted into coin and spent like so much pirate loot. By the time the real estate market peaked in 2006, all it took to go from one bubble pop to the next was a breathtakingly short six years.


The mess is only now starting to hit home. Structured finance vehicles like CDOs, SIVs and ABCP allowed mark-to-market losses to be obscured by opaque pricing. For as long as end-user investors did not need the money, it mattered little; dealers could claim that prices were whatever came out of mark-to-model black boxes. But when the money was needed - for example, to pay schoolteachers in Florida - the trouble surfaced to the "real" economy. Investment bankers now blame it all on unpredictable 20-sigma events, but this is like Casablanca's Capt. Renault professing to be "shocked, shocked to find that gambling is going on here", while a croupier hands him a pile of money, saying: "Your winnings, sir".

As with stocks in 2000-02, real estate wealth is wasting away. The drop isn't as fast or as severe, but it affects a far greater number of Americans. What Greenspan saw as the main advantage of a housing boom, i.e. wide participation, is its greatest shortcoming, as it turns into a bust. When stocks drop $100 the loss to 80% of Americans is just $9. But in the case of housing they lose $35 - four times as much. The impact on the mood of the consumer, the so-called "wealth effect", is likewise severe - though with a significant delay, because house prices are not tied to a daily Dow Jones-type ticker. People have difficulty accepting that their own house is now worth significantly less. They too, are marking to model or, more accurately, marking to dream.

This is not lost on the Fed and the administration, both of whom are once more in thinly-veiled panic mode. They keep throwing up all kinds of misbegotten plans to save the day: the super-SIV, lifting lending restrictions to bank subs, encouraging Discount window borrowing, freezing ARM rates - BandAids, all. Perhaps they will try another tax cut soon?

The false prophets of wealth are finally seen for what they really are: pushers of debt and needless consumption. They preach that if debt is made cheaper, if the liquidity taps are opened wider, if we just borrow more, we us all shall be wealthy. But in a global financial system that is already awash in liquidity, what need have we of more? What is there left to speculate on margin, that is not already levered to the hilt? Nothing.

Enough with the sermonizing. The practical question is: what should be done? If lower interest rates and the various government plans are not the solution, what is? I shall revert with concrete proposals, but in the meantime please read what someone had to say about this very subject over two thousand years ago. It is to be found underneath the blog title at the very top. Some things never change.