By Martin Hutchinson
October 06, 2008
SourceSince November 2000, this column has warned of a wide variety of economic and market disasters that have appeared impending. With almost 400 columns, a number have been plain flat-out wrong, as well as the innumerable ones that were more or less repetitive of previous effusions. Nevertheless, in the last few months, this column’s varying predictions of doom have had a markedly better track record: as Rudyard Kipling would have put it, the Gods of the Copybook Headings appear to have reawakened and to be taking their revenge for even minor economic transgressions.
Kipling wrote “The Gods of the Copybook Headings” in 1919, at a time of sadness and disillusionment after losing a son in World War I. The central theme of the poem is that whatever temporary beliefs we may acquire through market fluctuations or fashionable collectivist nostrums, eventually the old eternal truths of the children’s copybook return and punish us for our deviation from their instructions:
<blockquote>
“Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters and Two and Two make Four
And the Gods of the Copybook Headings limped up to explain it once more.”</blockquote>
Kipling was an instinctive economist; that verse of the poem describes pretty well how the wizards of the tech boom and the housing boom withdrew at the peak of the market, and the Gods of the Copybook Headings took control of the subsequent debacle. Traditional truths about the market that had been thought outdated and irrelevant were revealed to be the factors in underlying control.
Copybook Headings whose Gods have come back to haunt us already include the following:
“Don’t inflate broad money faster then nominal GDP”. This modernized version of the Gold Standard is the Copybook Heading by which monetarists seek to control inflation and suppress asset bubbles. It was followed by Paul Volcker and by Alan Greenspan in his first 7 years in office, then abandoned in early 1995, since when M3 money supply has increased 70% faster than nominal GDP. Its abandonment resulted in series of asset bubbles, the more dangerous of which was that in housing because of the debt involved. Its God appears to have been rather sleepy, allowing 12 years of misbehavior from 1995 to 2007, but is exceptionally powerful and malignant when roused, as we are now discovering.
“Initial Public Offering Companies should have a solid earnings track record before venturing into the market.” We had fun tickling the sleeping nose of this one in 1998-99, but he eventually awoke. A very noisy God, but only moderately powerful, he caused a substantial stock market crash but failed to suppress market “animal spirits” altogether.
“Average house prices should not rise much above 3.2 times average earnings.” This God’s Copybook Heading had controlled the housing market from World War II until the late 1990s, but we flouted him after 2000. A God who is not often ignored, he has a vindictive tendency, and makes sure we remember not to mock him for at least a generation after he awakens.
“Whoever makes a loan has responsibility if it goes wrong afterwards.” This Copybook Heading principle of traditional banking was flouted by the securitization market, in which loan originators were able to escape responsibility for poor credit decisions. The result was an orgy of poor housing lending, involving not simply poor credit decisions but outright fraud, connived in by loan originators who collected their fees and passed the fraudulent paper on to Wall Street and international investors. In this disaster, Wall Street was self-deluded, drunk with excessive money supply; the real crooks were the mortgage brokers, mostly a bunch of used-car salesmen who had never been closer to Wall Street than a day trip to the Statue of Liberty. The securitization market will only survive under careful limitations which ensure that, at least to some degree, this God is obeyed.
“Don’t take risks that you don’t understand.” Flouted openly in most bubbles, this God was drugged during this one by perverted science, the “Value–at-Risk” Risk Management technique, which controlled risk just fine provided that the markets involved were not in fact risky. In Wall Street’s defense, the proof that VAR was a load of codswallop required fairly sophisticated mathematics and so was available to only a few noisy skeptics like myself and Benoit Mandelbrot, whose previous invention, fractal geometry, was unknown to the intellectually uncurious workaholics of Wall Street.
“The maximum safe leverage is 10 to 1 for banks and 15 to 1 for brokers dealing in liquid instruments.” Not only was this Copybook Heading flouted, its flouting was made worse by two insidious techniques. First, banks pushed assets off their balance sheet by use of “structured investment vehicles” funded by commercial paper. Second, brokers started buying illiquid assets such as real estate and private equity participations, which had been at most a modest part of their balance sheets traditionally. This God’s revenge is traditionally very costly, and is proving so again.
“Investments should be recorded in the books at the lower of cost or market value until they are sold.” This time around the accounting profession adopted “mark to market” accounting which allowed investments to be “marked up” on rises in value, with mark-up earnings reported and bonuses paid even when the investments had not been sold. Wall Street is now bleating about “mark-to-market” because it requires mark-downs of investments that have fallen in value; the real reason why it should be dropped is its enabling of spurious mark-ups, of which the Street took full advantage. Mark-to-market is highly pro-cyclical and provides counterproductive incentives to fallible and greedy bankers. This Copybook Heading God is rather young and junior; it is not yet clear how severe his revenge will be.
As well as the above Gods whose revenge has already become partly or fully apparent, recent events have flouted further Copybook Headings and will also in due course produce appropriate retribution:
“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.” It is not clear whether Treasury Secretary Andrew Mellon was acting merely as the mouthpiece of the Copybook Heading Gods when he made this pronouncement in December 1929, or whether he then or subsequently became such a God through apotheosis. In any case, Presidents Herbert Hoover and Franklin Roosevelt ignoring this advice in 1929-41 gave us the Great Depression, and ignoring it in the 1990s gave Japan its 13-year downturn. With the $700 billion bailout plan we have ignored it again; we are devoting newly scarce capital to the most unproductive possible use, propping up the price of dead assets. In an era of capital scarcity, the bailout will undoubtedly prolong and deepen the recession. Mellon, a kindly man, would probably not wish this fate upon us, but maybe as a God he has a duty to enforce the Copybook Headings strictly.
“Allow capital to flow to its most productive uses.” This Heading is always flouted during bubbles, when capital is allocated to innumerable unproductive dot-coms or ugly undesirable McMansions. However it can also be flouted during downturns, when the government rescues failing industries, devoting capital to the dying and unproductive. Examples of this abound, notably in Britain in the 1960s and 1970s and in France in the 1980s and 1990s. In this case there is not just the $700 billion debt bailout, but the $200 billion rescue of Fannie Mae and Freddie Mac, the $50 billion rescue of the automobile industry and the clearly impending bailouts of various states and municipalities to be considered. In downturns, capital is scarce, insufficient to fund all the good investments available. Hence flouting this Copybook Heading during a downturn produces a much nastier revenge by its God, killing off far more new and productive investments than it would in a boom and slowing long-term economic growth to a crawl.
“Keep the fiscal deficit to a level that prevents the public debt/GDP ratio from rising.” This, originally propounded by Gordon Brown, when UK Chancellor of the Exchequer, is the wimpiest possible version of the Copybook Heading warning against budget deficits. It is true that stricter versions of the Heading can be relaxed if we are using a fiat money, since monetary policy can accommodate moderate deficits more easily than a Gold Standard. However the above is the bare minimum, which the United States is about to flout, both in the short term through $1 trillion deficits from recession and bailouts and in the long term through the actuarial problems in Social Security and Medicare. The revenge of this God is exquisitely cruel; he turns the country into Argentina.
We can speculate why the last decade has seen such a record level of Copybook Heading flouting. Maybe the Baby Boom generation, who have been in charge, were affected so badly by the permissive theories of Dr. Spock and the “flower-power” 1960s that they have an excessive tendency to reject conventional wisdom in the form of the Copybook Headings. In any case, market behavior in the last year is pretty good evidence that the Gods are not happy.