The deleveraging of the economy
It's easy to explain the continuing financial chaos -- and the failure of governments to control it -- as the triumph of psychology. Fear reigns, and panic follows. Everyone dumps stocks, because everyone believes that everyone else will sell. Only rapidly falling prices attract sufficient buyers. All this is true. But it ignores the real engine of mayhem: "deleveraging." That's economic shorthand for purging the financial system of too much debt.I was about 10 years ahead of this trend. It does require some readjustments in your life style to live within your current cash flow instead of using credit. It can be both easier and tougher than you think, but it can be done.Just how this "deleveraging" proceeds will largely determine the fate, for good or ill, of the present crisis. The turmoil has already moved beyond "subprime mortgages," which (it now seems) merely exposed widespread financial failings. These were global, not just American, and their pervasiveness explains why leaders of the major economies have struggled, so far unsuccessfully, to fashion a common response.
Alone, American subprime mortgages should not have triggered a global crisis. Losses are smaller than they seem. Mark Zandi of Moody's Economy.com estimates that all U.S. mortgage losses will ultimately reach $650 billion. But that hefty amount pales against the value of all financial assets -- stocks, bonds, bank loans. For the United States, these totaled almost $60 trillion at year-end 2007; for the world, the comparable figure exceeded $250 trillion.
Such a vast financial system should have routinely absorbed the subprime losses. By way of contrast, the stock market's drop since its peak in October 2007 to last Friday was $8.4 trillion, or 42 percent, reports Wilshire Associates. The official response to the subprime losses also seems larger than the problem. The government has taken over mortgage giants Fannie Mae and Freddie Mac; the Federal Reserve is pumping out short-term loans of $1 trillion or more; and Congress' $700 billion rescue allows the Treasury Department to buy subprime securities and to make direct investments in banks.
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What we've discovered is that the real problem is bigger. Large parts of the financial system are too thinly capitalized and too dependent on unreliable short-term debt. Leverage ratios often reached 30-1 for investment banks and hedge funds ($30 of debt for every $1 of capital). The presumption was that the MBA types had learned how to "manage risk." That false conceit backfired. Low capital didn't adequately protect against losses. Confidence and trust evaporated, because no one knew which institutions held suspect securities, how much the losses were and who was ultimately safe.
"Deleveraging" -- a shift from excessive debt toward more capital -- is inevitable and desirable in the long run. The trouble is that, in the short run, it may destabilize the economy if it proceeds too rapidly.
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The present challenge is far more complicated than merely quarantining dubious mortgage-related securities. What's involved is a fundamental remaking of the global financial system, from one that was inherently fragile to one that rests on firmer foundations. But if the change proceeds too quickly and haphazardly, it risks a hugely destructive credit implosion. All the policies undertaken so far will ultimately be judged by whether they succeed in managing the transition and restoring confidence in financial markets that self-correct naturally -- as opposed to submitting to the continuing mayhem of uncontrolled "deleveraging."
One of the things I learned in watching the investment business for around 40 years is that a few great fortunes can be built on leverage, but even greater losses can be experienced. It takes leverage to go below zero in your portfolio. If you borrow money to invest you are also increasing your risk. What this credit debacle has demonstrated is that some of the smartest people in the world did not comprehend the risk they were incurring and we are all having to pay the price for that miscalculation.
The market is and was distorted by the government, so it doesn't matter how smart investors are. E.g., investors in a free market have no choice but to make use of the low interest rates set by the government, even though these artificially low rates seems to be one of the primary factors that have led to this crash. It is absurd to blame businessmen and a lack of regulation now, as everyone is doing. Government manipulation of the economy is THE efficient cause of booms and busts. The brains of investors will create maximum wealth and justice in a free market (if we ever get there), but those brains are turned into tools of self-destruction where statist policies are involved. All government needs to do is protect against fraud.
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