Friday, June 05, 2009

Booms, Manias, Windfalls and Die-Offs

Perhaps financial booms and busts share characteristics with windfalls and the resulting die-offs.

Longtime correspondent Michael Goodfellow mades these astute comments about booms and busts from a perspective I would characterize as sociobiological:

I was thinking about financial booms and busts the other day. I think we both believe that crashes are just the price of bubbles. Which is why I'm suspicious of any statement that the 1929 stock market crash "caused" the depression. The crash was just the end of the bubble, and the depression was the prolonged unwinding of excess debt and poor investments. Prolonged by government attempts to reflate the bubble, among other things.

So the real problem here isn't unwinding debt and so on. We know that happens eventually. Systemic effects (dominoes crashing into one another) are important, but overrated in my opinion. The real problem is manias and bubbles. Why do we do this to ourselves?

Two points:

1. No living thing (there's a general argument for you!) can ignore windfalls. If for whatever reason, the grass is greener this year, if you are a rabbit, you eat more of it. And have more kids, which survive in greater numbers. If you were some "sustainable" cautious rabbit that only had 2 kids and only ate what it usually ate, you'd lose out to the greedy ones. Nature selects for optimists that grow more or less as fast as they can.

2. We are social animals and there's a huge cost to being an outsider. Living alone is deadly -- you have no one to help you if you get into trouble, no one to look out for you, no one to hunt or gather with, and no one to share food with if you don't do well today. One mistake and, like solitary animals, you may be finished.

Similarly, we worry about our status in the group. Being unpopular means getting beat up a lot, getting no help, having to give up your food/mates to the stronger members. Also very bad news from an evolutionary standpoint.

So as social animals, we crave status (or at least acceptance) by the group. This is why group-think has such a power over us, from fads and manias to adulation of heros and kings, to religious movements, wars, and revolutions. We think of ourselves as rational beings, but it's just a gloss over those social instincts.

As long as we are human, we will have these crazy bubbles from time to time. Because as animals, we don't ask why times are good, we just try to take advantage of it. And because as primates, if everyone else is buying houses, we will too.

Regulators are just as caught up in this as the general population. They don't want to do the unpopular thing, and they don't want to kill off a boom. No one does, except cynical "doom and gloom"-ers. Wishing it were otherwise is just futile.

Instead we should be asking, "when the inevitable booms and crashes happen, how do we avoid systemic risk?" I don't think we're asking that question as we deal with this crisis. All the debate I read is about more regulation, as if there weren't enough already.

Thank you, Michael. Excellent points. Now that all the happy little consumer-rabbits have eaten all the once-lush green grass of consumer/home-equity-line-of-credit down to bare earth, we might ponder what happens next in Nature when the grass fails to grow back.

Most of the rabbits die off, leaving only the hardiest, most adaptable of their numbers.

If we extend this cruel aftermath of "windfall exploitation" from green grass and rabbits to HELOCs (home equity lines of credit) and other forms of once-abundant credit now shriveled or consumed, we get to a consumer-borrowing/spending "die-off" in which spending that was based on housing/credit bubble "windfalls" vanishes.

The consequences are rather obvious:

1. Businesses which depended on this spending die off.

2. Tax revenues based on this spending die off.

3. Lenders dependent on this borrowing die off.

4. Households which depended on credit to remain solvent die off.

5. Asset classes like residential housing which depended on abundant "windfalls" of credit to fuel valuation increases also stage the equivalent of a die-off.

6. Exporters who depended on this credit expansion to sell their goods in the U.S. will also suffer a die-off.

Hmm, now we're talking about a significant chunk of the global economy, aren't we?

Extending the "windfall exploitation/green grass" analogy a bit further, we can anticipate that the consumers who require little to no new green grass (credit) will be the survivors. Everyone dependent on abundant cheap credit for their survival, from consumers to governments to enterprises to entire nations, will suffer financial starvation.

That's the inevitable consequence of "windfall exploitation."

"Quantitative easing" is supposed to sow millions of new little green shoots, but the dirt (the collateral needed to justify and support new credit) has dried out. All QE does is burden the government with collossal new borrowing; all the seeds sprouting will wither because the consumer rabbits have eaten through or lost their collateral and so there is simply nothing left on which to "grow" more credit.

Once all the grass and seeds have been consumed, starvation is the result. There is no collateral left in the U.S. except the "full faith and trust of the U.S. Treasury" and that is now (rightly) drawing mocking guffaws from university students in China.

Some see "green shoots" but the ground (collateral) is rock-hard; expect not lush new fields but numerous expired rabbits.

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