The Sky Falls, at Last

About 12 years ago, when I discovered Bill Strauss’s and Neil Howe’s book, I began a sustained campaign of evangelism among my friends, family, and students. Some of them (such as my son Tom, who was only 14 at the time) got the point immediately. Others have remained profoundly skeptical. As I have already mentioned, my review of The Fourth Turning in the Boston Globe in 1996 remains the only really favorable review that they got from any mainstream media outlet. I tried in the late 1990s to present their ideas to the American Historical Association in a panel, but that august body turned the proposal down. Several years later we did have such a panel at the Historical Society. I think that this week, even the most skeptical of my friends and family will have to admit that yes, they did have a point. The United States (and other nations) are destined to have a profound crisis every 80 years or so—and this is it. The subject of its nature, likely course, and possible results could, and will, fill many books over the next 30 years or more—that is, for the rest of my life—and will undoubtedly fill up a lot of posts in this space. As I have already suggested, the crisis—brought about, over several decades, by my own Boom generation—has resulted from fundamental aspects of our generational personality, including both an extreme feeling of entitlement and a contempt for our parents’ achievements. Its effects are visible in academia, industry, and government, as well as on Wall Street—and I personally know a lot more about their role in academia and government than in the financial world, where I lack real expertise. Still,.I remember a good deal of the economics I learned in college, and the news this week, combined with numerous revelations about contemporary financial practices over at least the last ten years, allows me to speculate, I think, about what has happened. I suspect that, as Joseph Nocera writes in today’s Times, things are actually quite a bit worse than they seem. I shall try to outline the story as I see it.

I have been reviewing four years of posts in preparation for publishing a collection, and I am astonished by how much of this I managed to anticipate at one time or another. First of all, in my review of Kevin Phillips’ book, American Theocracy, I stressed one of his main points—that the financial sector of the American economy had increased its share of our GDP to totally unprecedented proportions. In the 1920s Wall Street lived off of American industry, and the heads of giant manufacturing and transportation corporations rivaled, if they did not surpass, the financial titans of New York in influence and power. That has not been the case for many years. While Bear Stearns, Lehman Brothers, Goldman Sachs and the rest of them handed out multi-million dollar bonuses and hired a large proportion of the graduates of our best colleges every year, Ford, GM, US Steel, our textile sector, and even our transportation industries have been shrinking, cutting their work force, and fighting off bankruptcy. The new products that have fueled economic growth haven’t been automobiles or durable household goods (more and more of which are produced overseas), but derivatives and sub-prime mortgages. Phillips noted, too, that this trend has gone much, much further in the United States than in other major industrialized countries. All of this, of course, was celebrated as proof that we were on the cutting edge. It also enabled us to run huge trade deficits, because foreign countries were only too eager to take advantage of the supposed new financial bonanzas on Wall Street, too.

I strongly suspect that within twenty years the collapse of Enron will loom as the harbinger of the much larger disaster that is now overtaking us. The Enron managers were touted as geniuses because they created new assets to trade—various kinds of energy futures and derivatives. They succeeded brilliantly for years because they convinced financial managers with money to invest that they were worth buying. They turned out to be completely worthless. And that, I am sorry to say, seems to be the drama that is playing itself out now on Wall Street. Here, as far as I can tell, is what has happened.

With interest rates so low for the last four presidential terms, the country has apparently been awash in capital. (In the old days, of course, a country with balance of payments problems like ours would have had to raise its rates to attract foreign capital and reduce borrowing somewhat, but in the age of globalization, such restrictions have been held to be obsolete.) The problem for astute Wall Street investment bankers has been to find new assets in which people—and, more importantly, institutions—could invest. The great discovery of the last five years or so, of course, was subprime mortgages, which allowed Americans to borrow trillions of dollars that they could not afford to pay back, based upon the idea that the value of the houses they were financing would constantly increase. What I suspect—and I would welcome any information from those on the inside—is that, for investment bankers, the long-term prospects of such loans were much less important than the process of closing the initial deal, because that is where they make their money. They are essentially brokers on a large scale, whose income comes from transactions more than from profit and loss. And of course, the mortgage loans themselves were only the beginning of the story—those loans were then bundled and then sold as securities, generating more commissions, higher stock prices for their firms, and—critically I suspect—higher bonuses for the top people in the firm. (Earlier in this decade, I participated in a largely successful campaign to reduce the compensation of the men and women who managed the Harvard endowment, and who were receiving multi-million dollar bonuses every year based on the appreciation of the assets they managed. Such deals have become the norm among money managers—and without specifically accusing those at Harvard, I think they must inevitably lead to the overvaluation of assets. They are, in short, one reason why no one knows how much the assets of financial institutions are worth as I write this morning.)

The other massive problem—an echo of 1929—is leverage, or, as it used to be called on the stock market, margin. In 1929 one could buy $100 worth of stock for $10, borrowing the rest and listing the stock (which, of course, everyone knew would rise) as collateral. When stocks crashed the collateral vanished, and bankruptcies and suicides resulted. I well remember my Economics 1 section man in 1965-6 explaining that margin was now at 50%. But the new financial sector represented by the investment banks (not to mention totally unregulated hedge funds) has not had to face such tough restrictions, and in the last four years—for reasons that will eventually come out—they have been allowed to leverage on an unprecedented scale. Nocera writes today that in that period the allowable debt ratio has risen from 12 to 1 to 30 to 1. Using my historical analogy, that means that the situation was about as unstable in 2004 as it was in 1929, and that it is three times more unstable now. The results of a crash may be correspondingly worse.

This morning Joseph Nocera identifies the heart of the problem as the billions or trillions of dollars in mortgage-backed securities held by our major financial institutions—the assets whose value is now in question, and which the new Bush Administration rescue plan intends to buy. (I need clarification on this point. A lawyer involved in finance told me yesterday that the rescue money actually will go to buy up the bonds issued by the financial institutions to borrow the money they needed for 30 to 1 leverage—a plan that would not reward the firms. But that isn’t what Nocera thinks—he thinks the government is going to buy the assets from the investment banks. In fact, it may well be that no one knows the true answer yet.)

Nocera gets to the bottom line late in his piece. Everyone knows that the mortgage-backed bonds held by financial institutions here and elsewhere are overvalued—but by how much? He suggests, in effect, that they are overvalued by at least 50%, and maybe by 80%. If the government decides upon the latter figure, firms may go bankrupt even if the government buys them. But he is shying away from the worst case—what if, like shares on Enron, they are actually worth nothing? That is a possibility that I don’t think we can exclude—and if it is true, I don’t see how we are going to avoid a real financial collapse. (Nocera himself, without going as far as I just did, is skeptical that the current plan can work.)

And then, as if this were not enough, we have further hundreds of billions of credit default swaps lying around in financial institutions—perhaps the most mindless evidence of eternal optimism at all. No one will admit to understanding exactly what these are, but they seem to be insurance against the failure of investments. Now insurance works, I believe, when it pays off on catastrophic outcomes which, in the nature of things, only happen to a small number of policy-holders every year. The credit-default swaps, on the other hand, seem essentially to have been insurance against a financial downturn—something which by its very nature affects everyone at the same time, and which is bound to happen sooner or later. It’s rather like starting a life insurance agency for people who smoke, weigh too much, and practice extreme sports. This was one brilliant financial instrument no one in 1929 even dreamed of.

Globalization may be another casualty of the crisis—as it was in 1929-32. Preliminary reports this morning suggest that the Treasury Department has no plans to buy up worthless assets in foreign hands—and they must be at least as numerous as those here in the US. If we stick to that plan we are very likely to face some form of economic retaliation. And, in contrast to every economic crisis of the second half of the twentieth century, the leading powers of the world are not going to feel it necessary to give the U.S. a break because we defend and promote world stability. We have become the main threat to world stability in the last seven years.

All this feels so much like the great depression that I wish I could talk to someone who lived through it, at least as a young adult. But I can’t—that generation has passed away. That, of course, is part of the generational dynamic that makes these catastrophes take place. Those who had lived through one depression were determined to prevent another—and they did. Their children, like front line soldiers going into battle for the first time, assume it can’t happen to them—so it does.

The illusion that financial manipulation can actually create new wealth will eventually emerge, I think, as the great failing of the late twentieth century. We will have to relearn that real wealth comes from actual production of goods and services, and redesign our economy and our educational system so as to draw more of our best and brightest into endeavors that involve real products. That will be the great task of today’s younger generation, and they will enjoy it. Meanwhile, hard times are ahead—but so is, perhaps, our eventual rebirth. Having squandered our inheritance, the Boom now has to do what we can to bequeath to our sons, daughters and grandchildren a world with some of the safety, stability, and common sense of the one in which we grew up—so that the whole cycle can begin over again.