What Blew Our Financial Bubble So Big?

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Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes a bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.

— John Maynard Keynes

It’s not hard to notice that we are in the midst of Mr. Market swallowing a bigger dose of reality than he normally likes to take. One of my buddies who is quite cold blooded about investing cut her equity positions in a major way a few weeks back. What is perhaps more telling is that she had set up buy orders (she likes buying during dips) but has cancelled them. She also casually remarked that the Great Depression bear market was 20 years, but a more reasonable worst case scenario was the 1970s bear market, and that lasted 10 years.

She is comfortable she can see her way through that….but how many others can?

Now this may not be the start of a lasting deflating of a very big bubble. Plenty of very sound value oriented investment managers have been in a world of hurt for years expecting reversion to sensible valuations. And recall that Japan, which had an absolutely ginormous joint real estate and stock market bubble, didn’t have a dramatic unwind like our 1987 or 2008 crashes, but a fizzling over years.

But rather than trying to call a turn, since the market upset conditions do not come out of credit markets (which made it possible to foresee that the derivatives/subprime crisis of 2007-2008 could come to a very bad end), it might be more useful to ponder how we got into creating a hyper-speculative economy in the first place. Yes, I know some Howard James Kunstler/David Stockman/Caitlin Johnstone fire and brimstone might be more fun, in a world that has nor just normalized but even celebrated patent stupidity like NFTs and SPACs but maybe I’ll work myself up to that later.

Now of course one can blame neoliberalism. As Simon Johnson pointed out in his classic article The Quiet Coup, at the start of the 1980s, average banker pay was on a par with economy-wide compensation. But by the eve of the crisis, bankers earned a 80% premium to the average in the rest of the US.

The US has indeed become over-financialized, with societally-unproductive secondary market trading a big drain of collective resources. Yet it’s perfectly rational at the individual and firm level: you are twice as likely to become a billionaire in asset management as in tech.

The mess we are in has many causes, but let me single out a few, with emphasis one ones that may not have gotten the attention they warrant:

Credit markets explosion in the 1980s kicking off Wall Street brain drain. Remember Liar’s Poker? High and volatile interest rates turned bonds from a safe and sleepy backwater to one where investing was suddenly risky. Investors had to worry about interest rate risk as well as credit risk. Wall Street started hiring quants, both mathematicians and physicists, to do modeling.

Alan Greenspan’s misrule. Paul Volcker may have hated unions, but he wasn’t too keen about bankers either. Some of his major misdeeds:

Learning the wrong lesson from the 1987 crash and establishing the Greenspan put. Greenspan got all sorts of kudos for rescuing the stock market. What is not so widely recognized is he had the Fed prop up the Treasury market and even had the Fed call the Bank of Japan to have Japanese banks buy more Treasuries (I was in Japan during the 1987 crash and heard this first-hand from Sumitomo Bank staffer). Japan being a military protectorate of the US apparently meant it could be pushed around in other ways.

So Greenspan, the supposed ultimate libertarian, got into the business of bailing out markets. Even worse, he became obsessed with equities markets, when that was never the Fed’s job (I had suspected this in the 1990s, it was confirmed in a 2000 Wall Street Journal article).

He did it again during the S&L crisis by engineering a super-steep yield curve which enabled banks to earn unusually high profits from good old fashioned borrow short-lend long strategies (in fairness, this was a defensible rescue; the banks were chastened by their weakened state and it took them a while to earn their way out of their hole).

Greenspan actually noticed the markets were getting frothy in 1996 and made his famous “irrational exuberance” remark, which took over 140 points off the Dow. So Greenspan retreated.

So because Greenspan lost his nerve in 1996, we got a more spectacular dot com bubble than we might otherwise have had. And Greenspan was unnerved by its collapse. Mind you, there wasn’t enough leverage for the bust to blow back to the credit system. While there was damage in the real economy, it was contained.

But Greenspan overreacted, as if the loss of so much “easy come, easy go” wealth represented a serious blow to the economy (in fact, all that happened was a pretty mild recession). Greenspan dropped interest rates, not for the usual one quarter, but an unprecedented nine quarters, and with policy rates at negative real return levels.

Depriving investors of safe real yields produced the dysfunction of “reaching for return” strategies, particularly hedge funds and private equity funds. Without belaboring the point, to the extent that these strategies actually might be able to generate outsized alpha, the more money you threw at them, the less likely that outcome. By the time we started blogging, in 2006, it had been well established that hedge fund no longer generated alpha and you could generate “alternative beta” at much lower cost than typical hedge fund fees.

Promoting unsupervised derivatives casinos. I gasped out loud in 1996 or 1997 when I read that Greenspan washed his hands of having the Fed monitor derivatives risks of the large banks it supervised. He said he’d let a thousand flowers bloom, that they could all experiment with risk metrics and supervision and surely the best approach would prevail.

Somehow the Fed-orchestrated bailout of LTCM in 1998, which threatened to become systemic, did nothing to discredit this faith, despite it having had derivatives experts uber alles Myron Scholes and Bob Merton at the helm.

And of course, the successful war against Brooksley Born’s efforts to regulate credit default swaps came out of this line of thinking. We explained long-form in ECONNED ho the 2007-2008 crisis was a derivatives crisis, triggered largely by a particular subprime CDO strategy that created a no-lose wager for traders, but put tons of leveraged subprime risk on systemically important, undercapitalized players.

Regulations ever and always favoring more liquidity and lower transaction cost. Here the SEC is guilty along with banking regulators. More liquidity is not virtuous. First, it deprives financial institutions of low risk transaction revenues. It is always better to keep financial institutions safe and stupid. Second, the lack of cheap safe income leads to financial firms becoming more dependent on trading. Who is the best source of trading profits? Customers! What’s the easiest way to profit from them? By cheating, like front running, less than full disclosures. Third, it makes it cheap for everyone to speculate. Policy makers should be promoting buy and hold investing, not trading.

Going to ZIRP. The Bernanke Fed panicked in the runup to the crisis. It dropped interest rates dramatically at key junctures, leading to the observation that “75 is the new 25” meaning the Fed was lowering interest rates by 75 basis points at a clip when 25 would have been seen as aggressive.

I knew it was a big mistake when the Fed dropped its policy rate below 1%, that it was painting itself in a corner. The lower interest rates are, the bigger the drop in bond prices or loan valuations on any given increase. A half a point interest rate increase whacks bond prices more severely at 0.50% than it does at 4%.

The failure to hold anyone at executive or board levels accountable for the 2007-2008 risk management disaster, let alone fraud. Regulators should have forced widespread blood-letting and early retirements. The failure to do so signaled that bad conduct would go unpunished and helped institutionalize the sort of elite impunity that has corrupted what passes for American leadership.

The successful cover-up of the second bailout, the “get of of jail almost free” for the widespread failure to conform to rigid mortgage securitization requirements, resulting in “securitization fail” and foreclosure fraud. We covered this at length in real time, and a team of activists, coordinated on Matt Stoller’s listserv, almost succeeded in getting some justice for wronged homeowners, via a group of dissident attorneys general led by Eric Schneiderman. But Obama flipped Schneiderman, the other attorneys general took a powder, and the banks got away with fake settlements (the hard cash portion was small; they were getting credits for things they would have done anyhow and in some cases, for conduct that was harmful to investors). Critically, there were no meaningful reforms to servicing practices, which set the stage for student loan servicing misconduct.

Bernanke and Yellen perpetuating the Greenspan put. We are told that by 2014, the Fed had come to realize that its super low interest rate experiment had been a bust. It did not stimulate the economy save for encouraging leveraged speculation. But Bernanke was too cowed by Mr. Market to beat a retreat. The taper tantrum of 2014 rattled the Fed, which thereafter engaged in only the most timid of rate increases now and again.

Readers no doubt have other critical decisions and actions that they deem played a big role in how we got where we are. But perhaps the fundamental failure was the lack of willingness to take action that would crimp financial services industry profits. As we wrote in ECONNED:

It is easy to be overwhelmed by the vast panorama of financial instruments and strategies that have grown up (and blown up), in recent years. But the complexity of these transactions and securities is all part of a relentless trend: toward greater and greater leverage, and greater opacity.

The dirty secret of the credit crisis is that the relentless pursuit of “innovation” meant there was virtually no equity, no cushion for losses anywhere behind the massive creation of risky debt. Arcane, illiquid securities were rated superduper AAA and, with their true risks misunderstood and masked, required only minuscule reserves. Their illiquidity and complexity also meant their accounting value could be finessed. The same instruments, their intricacies overlooked, would soon become raw material for more leverage as they became accepted as collateral for further borrowing, whether via commercial paper or repos.

But even then, the bankers still needed real assets, real borrowers. Investment bankers screamed at mortgage lenders to find them more product, and still, it was not enough.

But credit default swaps solved this problem. Once a CDS on low-grade subprime was sufficiently liquid, synthetic borrowers could stand in the place of subprime borrowers, paying when the borrowers paid and winning a reward when real borrowers could pay no longer. The buyers of CDS were synthetic borrowers that made synthetic CDOs possible. With CDS, supply was no longer bound by earthly constraints on the number of subprime borrowers, but could ascend skyward, as long as there were short sellers willing to be synthetic borrowers and insurers who, tempted by fees, would volunteer to be synthetic lenders, standing atop their own edifice of risks, oblivious to its precariousness.

Institution after institution was bled dry. Yet economists and central bankers applauded the wondrous innovations, seeing increased liquidity and more efficient loan intermedation, ignoring the unhealthy condition of the industry.

The firms that had been silently drained of capital and tied together in shadowy counterparty links teetered, fell, and looked certain to perish. There was one last capital reserve to tap, U.S. taxpayers, to revive the financial system and make the innovators whole. Widespread anger turned into sullen resignation as the public realized its opposition to the looting was futile.

The authorities now claim they will find ways to solve the problems of opacity, leverage, and moral hazard.

But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

Magnetar and its imitators made unbelievable profits by finding a nexus of spectacular leverage, eager demand, and camouflaged risks. Whether you like the results or not, their novel use of an arcane instrument was exceptionally clever. If the world had been spared their cunning, the insanity of 2006–2007 would have been less extreme and the unwinding milder. But the hedge funds were not the only ones who fed this strategy; the other institutions who carried out the same correlation trade strategy and European bank staff padding their pockets with negative basis trades are just as culpable.

Viewing the underlying problem as one of bubbles misses the true dynamic. When borrowed funds pump up asset values, the unwind damages financial intermediaries, and that has far more serious repercussions than the loss of paper wealth alone. Leverage offers a strategic point at which regulators can intervene. Regulators can tackle debt levels surgically by barring certain types of instruments and practices. But this effort can take place only if authorities do not cede control of the financial system to the inmates. Unfortunately, to a large degree, that has already happened.

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44 comments

  1. bluedogg

    But when it does blow it’s going to be a dandy you can’t keep the Ponzi scheme going for only so long, with stock buybacks/cheap credit/government bail-outs for the business/banking sector and everything else and end up with a viable stock market.

    Reply
  2. James E Keenan

    This article seems incomplete, as its chronology leaves off in 1996. Is there more to come?

    Reply
  3. orlbucfan

    And Greenspan was unnerved by its ???? No offense meant, but Yves, where’s the rest of the post?

    Reply
      1. orlbucfan

        Thanks. I read the completed piece. I’m no financial/banking expert, but I can figure out enough of the jargon to get the basic message. What a rip-off joint/joke this country has become.

        Reply
        1. Yves Smith Post author

          The concepts behind most of the jargon are actually not hard to grasp. Once you understand time value of money, how discounting is done, and risk/reward (and the main ways it is measured), pretty much everything follows from that. Just takes time to become buzzword compatible.

          Reply
          1. Kris Alman

            Since I have had a hard enough time just wrapping my mind around the concept of fiat money, it’s ever more challenging to establish what is “real” versus “virtual” when it comes to the economy. Financial innovations that add complexity and opacity create the dynamics of class warfare through information asymmetry. I am reminded of Stiglitz’s work that won him the Nobel Prize.

            Can we revolt when the institutions that undergird our economy are fully enmeshed in this matrix?

            Or are we slaves to this virtual economy– doomed to take the whippings of gamed markets that never address negative externalities and leave us without a fallout shelter when they implode?

            Reply
            1. JTMcPhee

              Far as I can tell, you got it exactly right. The “regulators” end up being owned by the people who create these “risks.” Remember the “regulators” who tried to hit up Madoff for jobs in his Ponzi Parlor while supposedly investigating him?

              The MIT and B School “innovators” will always be miles ahead of the relatively few people who are moved to try to keep them from looting. Once the initial guardrails are off (what were those statues that used to be on the books again? The ones that that at least kept the casino banks from reaching into the real economy via old-fashioned banks? Of course there were looters and defrauders and “confidence men” who used the old-fashioned banks and savings and loans to rip the mopes off too, like C. Oran Mensik, who stole millions in pre-inflation dollars from the Polish and Bohemian immigrants who put their trust in his “savings and loan,” https://duckduckgo.com/?q=c.+oren+mensik+chicago+ponzi&t=ipad&ia=web Those folks had no “fallout shelter.”

              So the “real economy,” already stretched by all the other crap that’s going on (no oil, no fertilizer, maybe getting closer to a nuclear war, inflation and disease, somehow has to make good on all this thieving if the mope world is to continue living day to day while the smart sh!tes keep on figuring out how to bleed it dry.

              And I hear the oligarchs are being reined in by The Evil Putin, who has spent the last decade turning Russia into a bit of an autarky. And I bet the Rooskies have actual working fallout shelters…

              We have sown, now we are about to reap…

              Reply
  4. Wukchumni

    ‘Arbitrage Macht Frei’ sums it up nicely, the 40 year run of financializing everything possible, including squeezing profits out of thin air with everything centered on a 3 month plan, a 3 month plan.

    I see Bitcoin has dipped again to $31k, and although the goods are odd, odds are good those who fell for it hook online and sinker are going to be quite upset when things come a cropper, and not knowing the demographics of a Bitcoiner et al, i’d guess he ( 90% male investors perhaps) is in his 20’s or 30’s, just the right age to rage against the system somehow, and truth be said, if I was Wall*Street, the whole cryptocurrency shebang makes for a handy scapegoat… should KreditAnstaltCoin run into BlackSwanCoin.

    Reply
  5. Watt4Bob

    I used to think that a proper description of the problem would have the effect of prompting corrective action.

    My mistake was in thinking there was some rational core at the center of our country’s leadership that might respond.

    I think witnessing the dims sink Bernie Sanders, the related capitulation of Elizabeth Warren to the under-tow of careerism, and the infliction of Joe Biden upon us, has put an end to any optimism that our leadership class might be stirred to action on our behalf, “If only they knew!

    The streets filled with unruly mobs are a reflection of the unruly mobs looting our futures.

    The rape, plunder and beatings will obviously continue, with no regard for whether morale improves.

    Reply
    1. wilroncanada

      When Robert Hare wrote “Snakes in Suits”the (mis)leadership of Western (un)democratic class. Adapted psychopaths and sociopaths.

      Reply
  6. Mikel

    “The lower interest rates are, the bigger the drop in bond prices or loan valuations on any given increase. A half a point interest rate increase whacks bond prices more severely at 0.50% than it does at 4%.”

    Why do I also read in some places that lower interest rates, yields cause bond prices to rise and higher yields cause bond prices to fall?

    And there are all kinds of bonds. The shorthand used everywhere “bonds” doesn’t help matters.

    Reply
    1. Yves Smith Post author

      Please reread my statement. It is accurate as written.

      At any prevailing policy interest rate (we are taking about the Fed funds rate) a half a point increase (from 0.50% to 1.0%) whacks (as in lowers) bond prices all across the yield curve more than a half point increase if the Fed funds rate were 4%, so the rate increase would go from 4% to 4.5%.

      A bond is a promise to pay interest and principal, and in the US, interest is paid semiannually. So the interest rate increases affect the value of each and every promised intermediary payment, not just the principal.

      Reply
  7. rhodium

    The criminal brilliance of this side of the financial sector is that what they do is just complicated enough, most people don’t readily understand its parasitical nature. When the shenanigans blow up there is public outrage, but who to blame isn’t clear. Politicians usually get the blame until they get booted at the next election (but ironically the same regulators tend to stay in place).

    End of the day, we don’t get meaningful reform because the industry knows they need to keep their tendrils rooted in the political sphere, and politicians (and the Fed) don’t want to be blamed for the fallout from reform, not to mention pissing off their buddies and donors who like the game as it is. As long as the voters are largely ignorant with a poor memory then it never becomes a forefront issue and the game continues. It’s like a bad movie stuck on repeat but you can’t leave the theater.

    Reply
    1. Adam1

      Henry Ford, “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

      Reply
  8. Mikel

    There is.not only opacity, but they now see the algos as a way to avoid accountability.
    The biggest heist is yet to be seen?

    Financial bubbles of all sorts are happening to cover-up:
    Trade inbalances.
    Wages not keeping up with the cost of living.
    Falling worker participation rate.

    And NC has covered the sociology of “elite reproduction” (class, not biological).
    The financial bubbles give Chad a white collar job as some version of money middle man.

    And they started helicopter parenting the financial and tech sector because those are the industries the elites’ offspring deemed as “cool”.

    NC also had an article once about how the stock market is an expression of power.

    Additionally, seeing what has happened to the small business landscape and industrial landscape between outsourcing, Walmart, and Amazon…I’m wagering the financial sector stays on the receiving end of bailouts or handouts in some form or fashion.

    It’s all they got.

    Reply
  9. TimD

    It is not just the Fed that is pumping the economy. On this day in 2000, the US national debt was $5.7 trillion, today it is $30.4 trillion. During the same period the economy averaged real GDP growth of just under 2% – for a $20 trillion economy, that means around $400 billion per year. So with the annual deficit averaging $1 trillion what happened to that $600 billion per year? I would think a good chunk of it ended up in stocks and real estate – both of which have been growing faster than the economy.

    Reply
  10. The Rev Kev

    Don’t know why I never thought about it before but what people like Greenspan did with their federal ‘put’ device was to remove negative feedback from the financial system. First, a definition-

    ‘Negative feedback (or balancing feedback) occurs when some function of the output of a system, process, or mechanism is fed back in a manner that tends to reduce the fluctuations in the output, whether caused by changes in the input or by other disturbances.’

    So what does negative feedback look like in the financial system when it is working? It is companies having to go into bankruptcy, no matter their size. It is the parts of those companies being taken up by other more efficient companies. It is company executives knowing that there will be consequences for making corrupt, illegal decisions. In the end, it is former executives being forced to share tiny cells with 300-pound weight-lifting prisoners named Casper or Myran.

    Imagine the financial history of the US the past 40 years if there had never been a put device accepted into the system. Then again, maybe that history would be a lot like the financial history of the US from 1930 to 1980.

    Reply
    1. Bellatrix

      Joseph Schumpeter called this process Creative Destruction and believed it was an essential element of capitalism. It creates dynamism and builds resilience and if you resist it, it leads to stagnation and fragility.

      And here we are!

      Reply
  11. jefemt

    Listening to the local ag reports out in bumphuc flyover MonDak… commodity futures and crop prognostications for the US producers looks GRIM, especially wheat.

    There is evidence of continued and deepening drought to be viewed at 60 MPH from the car window. 45% of normal wheat crop?

    $5.39 or $130.00 to get 22 gallons of # 2 diesel at the farm coop Cenex fuel station. Producers appeared to be out plowing, seeding, spraying, so Big Oil is still quite essentially evident in every facet of life on the rural high plains.

    Many pump jacks for horizontal oil play in the western flanks of the Bakken conspicuously statue-like in their lack of motion. Production plots look like Biden popularity trend lines.

    Next autumn and winter will be dark days for human beans in first-world nations, especially Europe, but I think New England may get shellacked vis a vis heating the non-adobe abodes.

    The NPR blah blah ironically featured a story about a small-scale NM green chile farmer who was significantly reduicing his planting, due to input costs. So, less money for him, less product to market, yet MORE shortfall and money chansing scarce goods driving prices higher.

    Hatch Green Chile futures!!!

    The global ‘south’ has already arrived to this. Spaceship Earth? We, the people?
    To the lifeboats, devil take the hindmost!

    Frogs in a boiling pot, images of Mad Max. I have to admit, as the snowpack retreats, the uplands are still brown, little green-up yet to occur, and all of the trash and detritus of ‘modern world’ in the secondary road borrow pits and interstate on-ramps— the earth really looks haggard and disrespected.
    And there I wuz, driving along, a Happy Idjut, working for the legal tender…

    We are a Plague that makes covid look tame. We, starting with me….

    Who said we will have no whine before its time?

    Reply
    1. Tom Pfotzer

      jefemt:

      A most interesting and black-comedy-entertaining post.

      I hope you’ll keep us apprised of the production status as the year progresses.

      This is one of the shoes-to-drop that I am keeping my eye upon; grain production – not just what comes out, but what goes in – is a major part of our economy, and directly affects bread-basket attitudes.

      I expect that weather-induced reduction in grain production will be the first major 2×4-to-head whack that successfully transmits environmental degradation to nation-wide personal welfare.

      ========

      Regarding the rise in interest rates:

      The Fed appears committed / compelled to raise rates. They also announced QT (selling off their bond portfolio, effect is raise rates) or at least stop QE (buying bonds, effect is to push down rates).

      So, it seems they’re actually going to do this. They took away their own wiggle room / temporizing mechanisms.

      Here are a few of the questions I’m asking myself:

      a. Is the effect of this interest-rate rise mainly confined to the financial / bubble part of the economy, or will there be impacts on the real economy?

      b. How much pain (loss of value) of financial assets will be tolerated before the tightening policy is reversed? How much pain, and whose pain?

      c. What problem is the Fed actually addressing? Is it just inflation, or something else?

      This seems like a major shift away from the policy that kept our economy afloat over the past … 15 years, at least…and as Yves points out, going back to Greenspan, that’s 25 years or so.

      Does rising interest rates (curtailing credit-creation by banks) and no QE (curtailing money creation by the Fed) mean that stimulus-at-the-first-sign-of-trouble is less likely?

      Does it mean that we’re in a long-term structural program of draining the air from the stock, bond, RE, commodities, and everything else asset values?

      This looks like a big deal to me. Does it look that way to you?

      Reply
      1. Grumpy Engineer

        @Tom Pfotzer:

        I like your questions. Very relevant. I’ll take a crack at some answers, but they’re obviously just my opinions rather than statements of hard fact.

        a. Is the effect of this interest-rate rise mainly confined to the financial / bubble part of the economy, or will there be impacts on the real economy?

        I suspect most of the impact will be in the financial sector, but there will be some real-world impacts.

        [1] In the short term, housing will become even more unaffordable, and I suspect housing markets will seize up until there is a general realization that prices must be lowered. People who purchased homes recently will probably end up underwater.
        [2] Companies that borrowed gobs of money in the past and simply rolled their debt into new loans every quarter will be in for a rude surprise. They’ll be looking to cut costs to pay down the debt, and that could mean layoffs.
        [3] Stock-heavy pension funds may see their funding ratios drop precipitously. Perhaps to the point of crisis.

        b. How much pain (loss of value) of financial assets will be tolerated before the tightening policy is reversed? How much pain, and whose pain?

        I have no idea how much pain will be tolerated, but the people making the most noise will be the 1%, people looking to buy or sell homes, and the pension funds. I have very little sympathy for people who took out second mortgages to buy stocks (a.k.a. gambling with borrowed money), but I do worry about people whose pensions get screwed up or who end up underwater on their mortgage.

        c. What problem is the Fed actually addressing? Is it just inflation, or something else?

        Well, they say they’re addressing inflation, but they’re also fighting excessive asset appreciation whether they realize it or not. And I think this is a net good, even though there will be some real pain that accompanies it. Ultra-low interest rates have contributed to a housing affordability crisis and stupendous levels of income/wealth inequality, and these are both problems that will never be solved by inflating the bubbles forever.

        Reply
        1. Tom Pfotzer

          G.E.:

          Thx for reply. All your points make sense to me.

          Here’s some of my opinions / answers to my own Qs:

          Impact on real economy:

          a. Housing. Housing is based on house-payment size; interest rate hikes have increased mortgage rates about 2 full points (from 3.25, that’s around 60% increase). House-payment size is main driver of affordability, so, as you pointed out, we should expect house prices to start trending down pretty sharply if Fed keeps on hiking. House construction is major part of economy, and if buying slows down, construction slows, too. Puts some people out of work. It’ll also take the bloom off the inflation. Lot of inflation-driver in housing cost and housing mat’ls.

          b. Consumption. One big driver of the blow-an-asset-bubble rationale was “wealth effect” – stocks go up, the 1% that own stocks feel rich, they buy more stuff. If asset prices fall, so does consumption. That’s not a rapid effect, but it gathers momentum if the effect stays “on” for a year or 2

          c. I don’t see corporate / business investment being impacted much, as there isn’t much happening. Aggregate demand is on life support, will fall w/o the stims, so no reason to make investment in productive cpy.

          How much pain will be tolerated?

          Not that much. We’ve got prez election in about 2 yrs, Trump might win, and he’ll definitely run, that means more Fed bashing if the Fed happens to be on a crush-inflation trajectory at the time. Also: gov’t is run by and for the rich. Rich don’t like
          asset deflation.

          Is it just inflation…or something else?

          I suspect that there is more to this than just inflation-busting. I think systemic / financial-plumbing risk is present, known, feared. We’re in a bit of a new place, because _every_ asset class and _every_ major Western nation got pumped up in unison / synchronized; we’re _all_ all-in.

          Is the road ahead sans bumps?

          I have an instinct (can’t justify it yet, just a feeling) that one can’t distort an economy (all these economies) this much, for this long, and not have some structural damage, or weak spots that can’t handle much stress. All the press I’m reading at the moment says “consumers are solid, banks are solid, corporate profits good, all OK!”. The conservative old turtle in me says ‘….nah. It’s BS”.

          Wildcard Item

          Another factor is stimulus. Our economy is “doing great” because of fiscal and monetary stimulus. Can you do fiscal stimulus if you can’t (aren’t simultaneously) do (ing) monetary stimulus? This one’s over my pay-grade, I was hoping Yves would chime in.

          Reply
      2. jsn

        It looks like the Fed is trying to hand off fiscal policy to Congress.

        Cares showed what it could do and terrified Schumer and Pelosi.

        These sociopaths will let as many poor people die as they can get away with to prevent ANY policy that re-directs ANY of the current redistribution towards the rich towards anyone else for any reason.

        Reply
      3. Ed S.

        Tom, Grumpy – great questions and answers. I’ll throw in my two cents as well.

        First, the proposed the interest rate increases will have a huge, negative impact on the real economy. As you’ve both noted the interest increase will have a tremendous impact on housing and the purchase and sale of homes. The 30-year fixed rate mortgages have increased from 3% to approaching 6%; it’s easy to see how a 30 year fixed rate mortgage could be at 7 or 8% within the next 12 months. So that will have a downward pressure on prices. In addition, many individuals are listing homes today at prices that are double or triple what they paid only a few years ago. The combination of the end of price increases (and transitioning to price decreases) along with an enormous increase in the cost of financing will, in my opinion, crush the housing market. Having said that, don’t expect this to play out in the next 90 days: 18 to 24 months is probably a realistic time frame. The knock-on effects from the downturn in housing are apparent but will impact anything financed (cars, machinery, not to mention “toys”).

        So I think the Fed trying to deflate the housing bubble (and the stock bubble – which will also have huge knock-on effects in real and psychological terms) but I also think the Fed genuinely concerned about supply chains generally and is trying to, as best as it can, rein in the economy. The current situation with Russia and sanctions on and by Russia has potentially serious long-term blow-back to the US and to the entire West. I believe there’s an underlying assumption by our leadership that once the situation with Russia and Ukraine settles that we will go back to business as usual with Russia. I think that’s a very dangerous assumption that “they need us more than we need them”. Russia may not be the only source for many critical commodities, but it is a major producer, and our sanctions will hurt Russia but will also hurt us. As mentioned elsewhere we have a serious problem with diesel. We are refusing to purchase oil from Venezuela or Iran both of which would enable us to alleviate some of the pricing pressure. But we will not for political reasons.

        Between the economic slowdowns and the pricing increases yet to come I think we’re going to have a very serious economic slowdown the likes of which we haven’t seen perhaps in 40 years. With cheap money gone I wouldn’t be surprised to see half or more the highflying tech stocks bankrupt and for those that survive dramatic and permanent reduction in the value of their shares. If you want to take a trip down memory lane look at the price of Corning Glass from 1995 to the present day. From bubble peak to bubble trough it lost close to 99% of its value (peak in August 2000 @ $113/share; trough in October 2002 @ $1.45/share; current value $36/share).

        I could go on, but I think you understand the gist of what I’m describing. And oh boy do I hope I’m wrong.

        Reply
    2. Pat

      I’m going to be selfish.

      Not less Hatch Green Chili! Nooooooooooo.

      A sad world will be even more depressing.

      (Haven’t lived in NM for decades and I still prefer and crave green chili. It is an addiction.)

      Reply
  12. John Wright

    One can remember Paul Woolley opining on the financial industry, from almost 12 years ago.

    https://www.newyorker.com/magazine/2010/11/29/what-good-is-wall-street

    This begins with “Much of what investment bankers do is socially worthless”

    “Why on earth should finance be the biggest and most highly paid industry when it’s just a utility, like sewage or gas?” Woolley said … “It is like a cancer that is growing to infinite size, until it takes over the entire body.”

    Woolley asserts “the financial sector should be. “About a half or a third of its current size,”’

    And the financial sector has probably grown relatively even larger since 2010.

    Will the USA “FIRE” economy start to downsize to become the “been FIRED” economy?

    Reply
  13. Bellatrix

    One thing is absolutely crystal clear: excessive debt/credit and money printing got us here, so more of the same will not solve the problem.

    I think the process had become largely irreversible by the time Greenspan left the Fed in early 2006. He could have turned the ship, but didn’t, which is inexplicable to me, especially considering that he was a disciple of Ayn Rand and a believer in the gold standard.

    Reply
  14. Susan the other

    Apologies for this rant. Thanks for this little walk down nightmare alley, Yves. It all still turns my stomach into a big knot. We came so close to losing everything back then. And nobody in “government” would discuss how they planned to save the economy when finance had just strip-mined the entire country. “Tapping the tax payer” is a euphemism for devaluing assets slowly – but keeping the dollar strong – aka austerity – which prevents progress – brilliant. I don’t think we have learned anything, except the potential value of good regulation, because we are still unable to control finance – because “free markets”. So naturally, the Fed was free to buy up all those stocks and bonds – it’s a free country. Another case in point – cryptocurrencies. And what looks like intentional ignorance about money in general. It isn’t for lack of trying. We’ve tried just about everything to avoid facing the truth. The problem is denial. (Not to even mention peak oil.) We refuse to admit that profiteering and free-market-foolery kills economies. And one proof of our denial is that we actually think that we can replace economies with fake currencies (and derivatives) which is nuts on at least two levels – all currencies are tokens, and the only thing of value is sovereignty, aka cooperation. Oh but wait, we can always dig ourselves out by going to war, or black-market looting – and let’s not forget we can always sell gold we don’t own. It makes me think we might have good common ground with China after all. We can ask them for advice. How do we create a well regulated domestic finance sector which can be integrated in a like-minded multi-polar world? It’s our move. If we can only find the humility.

    Reply
  15. Matthew G. Saroff

    I think that one of the things that you are missing is the increasing pressure to repeal SEC Rule 10b-18 , which has allowed upper management to steal from companies through a combination of stock options and stock buybacks.

    If that form of control fraud is made illegal, there are 4 decades of unjustified stock price gains that will vanish.

    Reply
    1. Yves Smith Post author

      As described with the much bigger dot com bubble, where buybacks were not even remotely part of the picture, stock market crashes, when there is not a lot of margin buying, do not result in large scale economic damage. The 1929 crash did feature a highly leveraged stock marker; that’s why it precipitated so many bank failures. We don’t have that any more, at least in the US (China is a different story).

      The buybacks do (even more) distort the allocation of capital. Companies that do buybacks rather than investing in their business are effectively liquidating.

      Reply
  16. Dick Swenson

    Nothing shows just how silly thr phrase “economic science” is than this and other discussions of how bad economic predictions are.

    Maybe we can also recognize that there is no such thing as a Nobel Prize in Economics. It’s a prize awarded by a bank to help foster conservative economic thinking.

    Perhaps economic departments in our universities might want to sit down and utter a few “mea culpas” and adopt a greater humility. It might also be nice if all the well paid and over paid economists would adopt a bit of humility, also.

    Reply
  17. Willis

    I can’t help thinking we haven’t learned much since the Financial Crisis of 2007 – 2008. During this last financial crisis, massive losses were created when investors poured imprudent and highly leveraged sums into mortgage backed securities that were filled with questionable consumer loans. These consumer loans were called ‘subprime’, and many were questionable because underwriting deteriorated to the degree that many borrowers had No Income, No Job, No Assets (colloquially called “NINJA” loans).

    The current situation in our markets is imprudent and highly leveraged sums have now been poured into questionable corporate investments. These corporate investments include venture capital, IPO’s, equities, leveraged loans, and high yield bonds. Many of these investments are questionable because the corporations backing them have Negative Income with no path to profitability, No Governance, and (almost) no Physical Assets to liquidate in bankruptcy (what you could colloquially call “NINGPA” investments). This is essentially the same greater fools game that was played with housing prices before the 2007 crash.

    So similar playbook to 2007 – 2008 Financial crisis, except what backs these investments has switched from consumer to corporate obligations.

    This might seem like I’m stating the obvious but any company that constantly generates massive losses, and has virtually no assets will not be able to pay back its investors.

    Reply
  18. David in Santa Cruz

    Keynes wrote about speculation and the casino about a hundred years ago. Greed is nothing new.

    What has changed is the cynical and pervasive corruption of our political institutions. There was a complete loss of faith in government during the decade spanning the assassination of JFK and the resignation of his rival Tricky Dick. The murderous and pointless occupation of Vietnam paralleled a civil rights movement that only served to move the immiseration of Black people from the plantation to the ghetto. The economic recoveries of Germany and Japan, which we had temporarily bombed into the Stone Age, shocked American Exceptionalism to its core when faced with actual competition for the first time in a quarter century.

    In the wake of these shocks, beginning in 1978 an empty-headed nihilism elevated self-regarding mediocrities to positions of power, from where they granted the indulgences of elite impunity to any and all with the means to pay the bribes. The hallmark of American “democracy” is its sweeping and casual corruption. One Dollar; One Vote.

    All of the litany of “economic” failures listed above are down to the collapse of regulation, meaningful enforcement, and the rule of law, not just in finance, but throughout the American polity.

    Reply
  19. tommy strange

    Another reason I always love NC. Often re caps of historical stuff. Even among the ‘converted’ whether to MMT, or comrade farther leftists of mine, when I post this kind of re cap on FB, they really like it. And I need a refresher to just not feel like a dumb insane uneducated worker type silly person….

    Reply
  20. Young

    How about the captive clients (think 401k) sending billion dollars, month after months, for decades to the casino?

    I think they contributed (pun intended) to the bubble by paying rich fees to the financial institutions and supporting the political institutions who make policies to enable bubble.

    Reply
  21. Sound of the Suburbs

    Neoclassical economists have always had a few problems.

    What is wealth creation?
    That’s a hard one.
    We don’t actually know; we just associate it with things like rising asset prices, making money and trade.

    They soon get into trouble.
    At the end of the 1920s, the US was a ponzi scheme of inflated asset prices.
    The use of neoclassical economics, and the belief in free markets, made them think that inflated asset prices represented real wealth.
    1929 – Wakey, wakey

    Things haven’t been the same since we forgot what real wealth creation was.

    Neoclassical economists think rising asset prices are creating wealth, but this isn’t true.
    Neoclassical economists have always excelled in creating wealth of the evaporating kind.
    Inflated asset prices.

    GDP measures economic activity in the economy; the new items produced and sold every year in the economy.
    That’s where the real wealth in the economy lies.
    They worked it out after they used neoclassical economics last time.

    The belief that inflating asset prices is creating wealth leads to financialisation.
    On a BBC documentary, comparing 1929 to 2008, it said the last time US bankers made as much money as they did before 2008 was in the 1920s.
    The bankers are doing something that appears to be good on the surface, but underneath the problems are building up, out of sight and out of mind.

    Existing financial assets, e.g. real estate, stocks and other financial assets, were traded and bank credit was used to fund the transfers.
    The money creation of bank credit inflated the price.
    They ended up with a ponzi scheme of inflated asset prices that collapsed and fed back into the banking system.
    The money creation of unproductive bank lending made the economy roar as they headed towards a financial crisis and Great Depression.

    Reply
  22. Forklift Driver

    The need to encourage capital formation with fixed capital gains rates has long passed. End speculation and encourage investment by taxing capital gains progressively (just like earned income), except the rate would be the inverse of the term of the investment. Gains from millisecond front-running are taxed @ 100%, but gains from the sale of a home after 30 years of mortgage payments or a 30-year corporate bond are tax-free.

    Works for me. But then again, I don’t own a private equity company.

    Reply
  23. RICHARD DOMINGUE

    One wonders how long Mr. Powell will bravely raise rates to quell inflation as Mr. Market seems to have caught cold again. Yves, this continued tendency toward accommodation due to a fear of upsetting Mr. Market is an institutional legacy – an unwritten change in the Fed’s charter. Yet, Fed policies (i.e. zirp and taking non-governmental bonds as collateral) facilitated a tripling of stock value over ten years (2010-2020), while the economy grew very little – a clear bubble. It seems the Fed, regardless of the name of its chair, does the bidding of Mr. Market before that of the USA. I hope you write another book.

    Reply

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