The current recession has been lengthy and continues on. It has followed an unusually long period of prosperity, or at least the perception of prosperity. In reality, the previous period included artificial prosperity, which led to the significant economic challenges we now face.
The perceived prosperity that proceeded the current recession included bubbles and periods of relatively minor economic downturns. Neither type of event is unusual for economies that are growing. However, it is the way the government responded to these events that caused each to morph into something far worse.
Bubbles and Crisis
The bar for what is considered an economic crisis has changed dramatically over the years. Less than 40-years ago President Nixon put in wage and price controls when inflation reached the then unacceptable level of 4%. In 1979 the Carter Administration bailed out Chrysler Corporation with a $1 billion loan. Today such numbers are trivial.
Since Nixon’s and Carter’s interventions, the crises “requiring” intervention have become more frequent and costly, as the following partial list indicates:
- 1987 – The Dow Jones Industrial Average dropped 500 points, then considered to be a calamity. The government responded with massive liquidity injections.
- Late 1980’s – The savings and loan crisis costs taxpayers about $125 billion and contributed to huge budget deficits on the early 1990’s.
- 1997 – The South American, Asia and Russian currency crises hit with governmental interventions required on a world-wide basis.
- 1997 to 2000 – The Dot.com and Telecom bubbles burst, costing investors billions.
- 2001 – 9/11 caused a rapid economic slowdown. The government responds with massive liquidity injections, historically low interest, and other incentives for consumers and businesses to take on debt and spend.
- 2002 – Enron and Arthur Andersen meltdowns cost society billions.
- 2007 – The housing bubble pops resulting in the Subprime Mortgage and banking crises of 2008. The government then implicitly takes on responsibility for Fannie Mae’s debt with a potential obligation of $5 trillion
- 2008 to 2009 – Government bailout of AIG cost taxpayers about $150 billion.
- 2008 – Government bails out banks through TARP to the tune of about $700 billion.
- 2009 – Government bails out of GM and Chrysler in excess of $50 billion.
- 2010 – Most recently, sovereign debt is becoming problematic. Greece will require a bailout from the European Union as it debt is in excess of $400 billion. Spain, Portugal, Ireland and Italy are also on shaky ground.
It is not by coincidence that each of crises listed dwarfs the cost of the original Chrysler bailout of 1979. Government intervention merely plugs the dyke. Economic problems are not resolved, but instead the pressure builds for even larger.
What is next for the economy? Economists use empirical evaluations to determine likely scenarios. Given that their track record has not been stellar, and that the numbers used are often wrong, I believe that a simpler approach based on understanding how we got here, trends and human nature, to be a more valid method of forecasting.
Human Nature: Greed
Adam Smith’s, The Wealth of Nations, offers insight into human nature and the way we respond to needs and emotions. His basic thesis is that in the long term, the balance of varying human behaviors is the best and most efficient way to manage a complex macro economy and will lead to the greatest wealth for all.
Example of Smith’s thesis: An economy is made up of two farmers and two staples for the village. Farmer A raises corn and Farmer B, tomatoes. Being the only corn grower, Farmer A’s greed leads him to raise corn prices to increase his income, but at a greater cost to the villagers. Seeing the profit made on corn, Farmer B switches all of his production from tomatoes to corn. An oversupply results and corn prices significantly drops, decreasing the profit for both farmers. This also causes a tomatoe shortage for which the villagers are now willing to pay higher prices. Both farmers then take a portion of their land to grow tomatoes. Prices and the supply of both commodities ultimately stabilize, as well as each farmer’s profit. Should either farmer try to increase the price of either commodity, the other will undercut him to increase market share. The system remains in balance in the long term, but could have short-term imbalances.
With Smith’s thesis, why then has the economy of recent decades not been able to correct huge imbalances? Why have we jumped from one bubble to another? Have the rules of human nature changed making Smith’s thesis outdated or is something else at play?
Smith’s Thesis in a Modern Economy
The significant economic imbalances of recent years have not been caused by any change in human behavior since Smith’s time. Instead, governments have tinkered much with the opposing economic checks and balances allowing greed to become unchecked, making the economy neither efficient nor in equilibrium.
In the two farmer example, let’s add a new player, the Farmers Protection Bureau (FPB). The FPB’s charter is to protect the income of farmers so that they remain growers and therefore insure adequate food supplies. In our example, when Farmers A and B put all of their production into corn, instead of letting prices drop to allow supply to match demand (and lower margins both farmers), the FPB purchases the excess supply of corn to support the higher price so that the farmers keep their profit margins. Happy ending? Not quite. To pay the FPB subsidies, the government had to raises the villager’s taxes. Just as problematic, both farmers decide to not produce tomatoes creating a tomato shortage. The government’s intervention removed the risk of loss from over production and created market inefficiency. At the same time it told the farmers that if they miscalculate on production planning, the FPB will come to their rescue in the future causing future market disruptions.
Response to Bubbles and Crisis
The government’s intervention in the example above mimics the real-world response governments have used when economic imbalances have occurred in recent decades.
The interventions listed above from the relatively small 1979 Chrysler bailout to huge bailouts of the past two years has resulted in a slippery slope that led to our growing economic crisis. With each intervention, investors were taught that the government would do whatever was required to avoid market meltdowns, thus mitigating investor downside risk. This has created an upward spiral of ever increasing risk taking during the past 30 years. No matter how good the logic or intentions of the interventions, the unintended consequences have been ever increasing economic pain. We have not seen the last bubble or crisis in this cycle.
Private Sector Culpability; The Neo-Capitalist
The government is not solely culpable for the economic imbalances. Capitalists have run amuck with unchecked greed, the result of governmental bailouts that have taught them that risky behavior is not risky. Investors rightfully believe they will be bailed out of any hair-brain investment that goes sour. Special interest lobbyist from investment banks to labor unions use their clout to insure that the Washington politicos bail them out, even if not in the best interest of the country.
Another key item in the distortion of the moral hazard is the capitalists’ ability to use other people’s money (OPM). OPM takes risk and responsibility from neo-capitalists. Take the airline industry that was deregulated thirty years ago. While lower fares have been the result, the entire industry has been on the brink of collapse for years. This distortion occurred because the money invested in the airline industry was not that of the decision makers. The professional managers and unions took their money when the companies should have said “no”.
Commercial banks are another example. In the “old days” mortgages were given by local banks who kept the paper and risk. They required 20% down and proof of a borrower’s ability to make payments. What an outdated concept! Bring in the Neo-capitalists and the result was the sub-prime mortgage mess. Risk was moved from the mortage brokers to others through Wall Street, separating decision making from the “pain”.
History, common sense and understanding basic human nature are good tools for predicting future economic events. Based on these items, it is probable that the real economic crisis remains in front of us. The historical trends are clear. Major economic disruptions are occurring with increased frequency. The costs of the governments’ interventions are increasing. Finally, the long-term effects of the damaged moral hazard are yet to play out.
Adam Smith’s theories remain relevant today. The market will ultimately take corrective action to bring supply and demand back into equilibrium, no matter how many times the government attempts puts its finger in the dyke. The longer they hold back correction of the imbalances, the more serious the corrective action will be.
In 1979, the bailout was a mere $1 billion for the third largest American auto manufacturer. Now, the problems are no longer a failing company, but a failing nation with Greece’s debt in excess of $400 billion. How much better off would the economy would be now had we let Chrysler fail in 1979?