This is the first of a 3 part series on:

1.        How the current economic crisis occurred,

2.        What needs to be done to fix it and

3.        Tracking how successful the government is in taking the needed steps

How the Economy Failed Again or “Dragons We Know”

2 recent NY Times articles show the blindness that led to the failure of today’s economy. First, the No Instruction Manual as Stimulus Bill Takes Shape article stated that we don’t know how to develop a plan to solve the current crisis, ignoring the lessons of the fight against the Great Depression.  Second, Risk Mismanagement  showed how “quants” (the wiz kids who did the mathematical investment models that failed so spectacularly) underestimated the risk of low probability events.   One quant labeled the 1% probability tail as TBD, not standing for “to be determined” but rather “There be Dragons.”   This is a great analogy because not only does it illustrate that low probability events can kill the unwary but also that the really dangerous ones are identifiable.  Just like St. George, if you fight dragons you might survive and prosper but you will eventually be destroyed if you ignore the potential dragons.    

So what did we forget that caused the current financial crisis?  The primary cause is the deliberate avoidance of looking for “dragons” (potential problems) that resulted from the revival of Laissez-faire economics (called variously Austrian, Supply Side, or classical economics).   Laissez-faire advocates state that free markets will regulate themselves; therefore, there is no need to look for problems.  In fact, Dick Cheney stated that “I don’t think anyone saw it coming”.    Actually, problems were easy to see coming due to historic highs in stock Price to Earnings (P/E) and housing rent-to-own ratios.  Amazingly accurate predictions were made by many widely read individuals (such as Bill Fleckenstein, Doug Casey or Nobel laureate/NY Times columnist Paul Krugman).

 Historically, the idea that free or unregulated markets will have any sort of acceptable performance has been proven wrong by the Panics of 1873, 1884, 1890, 1893, 1896, 1907, and the Great Depression, among others. Besides, the concept of self regulating markets does not fit with human experience: 

If it takes 3 to 5 referees to regulate 22 people in a game of football (depending on which continent you are on) why would business people who are playing for real money not need supervision to prevent cheating?  (See End Notes 1 and 2 below)

The current crisis is almost identical with the Great Depression: 

National Deflation in overvalued assets (housing and stocks) leading to:


Banking Crisis that reduces lending and financial liquidity which causes a:


Consumption Recession (as opposed to a business cycle recession where business activity slows first) where:

·         Excessive consumer debt limits most consumers’ ability to borrow for current purchases and

·         Affluent consumers reduce consumption as they increase savings or pay off debt.

The causes are also similar (which is why so many people could predict it):

1.       National Deflation – is the result of asset bubbles caused by unregulated debt expansion outside on the regulated banking and investment areas. 

·         While all of banking had minimal regulation in the 20’s, today’s loose housing lending started around 2002 when

·   A new government program to help low income people get houses with no down payment

·   Intersected with new unregulated derivatives.

 The derivatives market allowed banks to lend to high risk borrowers and make money by selling (securitizing) these high default rate loans to investors.  Loosening of government regulation of Fannie Mae and Freddie Mac in 2005 accelerated the search for bad loans to securitize.   Rising housing prices and easy money brought in speculators which pushed prices above what wage earners could afford (a bubble.)  Prices declined once housing became unaffordable, bankrupting zero down payment speculators and starting the deflationary spiral.

·         Both the 1920’s and today’s stock market bubbles were caused by excessive and/or unregulated leverage (a form of lending) at hedge fund equivalents and investment banks which drove stocks to historic high P/E values (a bubble.)  Once housing started to decline and the economy slowed as a result, prices had to come down to match declining corporate profits.   The profit declines caused P/E declines so the decline in the stock market accelerated.

2.       Banking crisis – Deflation in asset values (housing, stocks and commercial bonds) caused some banks to become insolvent and lowered trust in all banks. Runs by consumer depositors on banks during the Depression have been eliminated by FDIC insurance. Today, banks are reluctant to lend to other banks due to uncertainty of their financial health causing more bank failures.  The ongoing deflation in asset values causes a Liquidity Trap, reducing all lending. 

·         A Liquidity Trap occurs when banks expect better returns by holding money instead of making loans.  Declining real estate, securities values and corporate profits and rising unemployment make banks tighten lending standards to the point that few consumers or businesses can qualify, thereby drying up the funds or “liquidity” that makes the economy work.  Normally, the central bank can increase liquidity by lowering interest rates but the expectation of deflation means that banks expect negative returns on loans so even a interest rate of zero (like today) won’t make them lend  – In a Liquidity Trap banks won’t lend until convinced that deflation will stop (that is, inflation starts) or they can pay back less than they borrow to make the loan (termed negative interest rates .)

3.       Consumption Recession – was caused by the failure of median income to keep up with consumption opportunities (as shown by GDP growth.)  In order to take advantage of consumption opportunities, consumers took on more debt with the aid of banks and retailers/manufacturers (GMAC, for example.)  This is what happens instead of Say’s Law2 when production exceeds consumption capability in a modern debt generating environment.

·         Middle and lower class income growth stalled out in 1982 when the upper income tax rates were brought down from 50% to levels last seen right before the Great Depression.  With the tax disincentives on excessive compensation removed, executive pay and other compensation soared from 35 times the average workers income in 1978 to 262 times in 2005, a repeat of the Great Depression play book.  In the words of Marriner S. Eccles, FDR’s Fed Chairman, “had there been less savings by business and the higher-income groups and more income in the lower groups — we should have had far greater stability in our economy”

·         The decline is made worse by declines in consumer confidence to historic lows, which causes more affluent consumers (those with sufficient income and assets to be able to continue spending at previous levels) to reduce consumption in reaction to a world where economic opportunities are reduced.

The solutions to these problems are fairly cut and dried, having been worked out after the Great Depression.  For those doubters: 

Why didn’t the US economy experience another liquidity trap until the dismantling the checks and balances put in place in the 30’s was completed by the Bush Administration?

Read my next post to see what needs to be done.

End Notes:

1.       Laissez-faire economists counter that markets are self correcting if governments don’t interfere and need the “creative destruction” that comes from corrections to grow.  Unfortunately, modern markets (where information is quickly distributed) are not self correcting as proved by The Great Depression and Japan’s stagnant economy in the 1990’s.  Lots of reasons why today’s markets can’t self correct without government help but it’s irrelevant because democracies are for the people and the people have spoken:  The “creative destruction” of the unregulated Panics of the 19th and early 20th Century caused unacceptable hardships therefore there is going to be government intervention and regulation to try to smooth them out.  Live with it and make sure government intervention works.

2.       As a business man, I find it fascinating that Laissez-faire economics depends on an 18th century theory called Say’s Law that essentially states that “if you build it they will buy it.” No way this works in a market based economy with rapid technology change and environmental laws.  In the 18th century, any manufactured product had some utility, if only for scrap so inventories could be cleared by market pricing action.  Nowadays, you can build the wrong thing and it can not only be unsalable but also be toxic waste that costs money to get rid of, becoming a burden on the government when the manufacturer goes bust.