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Generational Dynamics Web Log for 11-Oct-07
American Prospect's Robert Kuttner compares 2007 to 1929

Web Log - October, 2007

American Prospect's Robert Kuttner compares 2007 to 1929

His comparison is clearly generational, but he fails to notice it.

I can't prove it, but it seems to me that more and more people are comparing what's happening today to what happened in the 1929 crash. It just seems to me that I hear "1929" mention pretty frequently now.

A web site reader alerted me to the article "The Alarming Parallels Between 1929 and 2007," containing recent testimony to the Congressional House Committee on Financial Services by The American Prospect co-editor Robert Kuttner. The author has a book coming out in a few weeks on the subject.

He summarizes similarities between "the systemic risks of the 1920s and many of the modern practices" as follows: excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.

Generally, his comparison are very similar to those that I discussed in my article, "The bubble that broke the world." So I'll only expand on those similarities that present new information.

He gives the following similarities:

Creation of asset bubbles. "The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out."
Securitization of credit. "Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank -- e.g. Morgan or Chase -- as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks -- part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC."
In "The bubble that broke the world," we quoted examples of foreign bonds -- bonds issued by dozens of other countries -- that American investors purchased, receiving only a promise to redeem the bonds several decades later.
There are two major "advantages" to the securitization of credit: First, it separates the creditor from the debtor. The creditor lends money by purchasing a security; he has no idea who will use the money, or how the money will be used. And second, the sale of securities is handled by middlemen who have no reason to be cautious, since the money being loaned is not his own. The middlemen collect their fat commissions and are on their way.
Today, of course, the securitization of credit has been raised to a monstrous level, with $750 trillion of CDOs and other credit derivatives in the portfolios of organizations around the world.
Kuttner points out that since the repeal of Glass-Steagall, there is no longer any distinction between the banking system and the general economy:
"Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction -- assuming perpetually rising asset prices -- so in a credit crisis they can act as net de-stabilizers."
Kuttner makes an interesting new point at the end of the above paragraph: That all these credit derivatives are based on the assumption that the stock market will keep going up forever. The stock market never goes up forever, and once it starts going down, the market for credit derivatives starts crashing as a unit.

Excessive use of leverage.
"A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn't work so well on the downside, Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money."

Corruption of the gatekeepers.
"The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business -- the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC."

Failure of regulation to keep up with financial innovation.
"Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today's derivatives on which technical traders make their fortunes.
"By contrast, in the traditional banking system a bank examiner could look at a bank's loan portfolio, see that loans were backed by collateral and verify that they were performing. If they were not, the bank was made to increase its reserves. Today's examiner is not able to value a lot of the paper held by banks, and must rely on the banks' own models, which clearly failed to predict what happened in the case of sub-prime. The largest banking conglomerates are subjected to consolidated regulation, but the jurisdiction is fragmented, and at best the regulatory agencies can only make educated guesses about whether balance sheets are strong enough to withstand pressures when novel and exotic instruments create market conditions that cannot be anticipated by models."

Universal conviction that markets are self-regulating.
"A last parallel is ideological -- the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way."
This is an interesting one.

What's disappointing about Kuttner's testimony is that he completely misses the generational aspects, even though they're completely obvious.

"Beginning in the late 1970s, the beneficial effect of financial regulations has either been deliberately weakened by public policy, or has been overwhelmed by innovations not anticipated by the New Deal regulatory schema. New-Deal-era has become a term of abuse. Who needs New Deal protections in an Internet age?"

He goes on to list one thing after another that changed after the 1970s.

He even says:

"My perception as a financial journalist is that regulation is so out of fashion these days that it narrows the legislative imagination, since politics necessarily is the art of the possible and your immediate task is to find remedies that actually stand a chance of enactment. There is a vicious circle -- a self-fulfilling prophecy -- in which remedies that currently are legislatively unthinkable are not given serious thought. Mr. Chairman, you are performing an immense public service by broadening the scope of inquiry beyond the immediate crisis and immediate legislation."

It never occurs to him ask why this has happened -- why it happens more and more as the people in the generation that survived the 1920s and 1930s die out, leaving behind younger leaders with no personal memories of the horrors of the Great Depression. If that thought ever crosses his mind, then he might have realized that the features of the 1920s occurred when the generation of people who survived the Panic of 1857 died out, and he might have understood WHY "regulation is so out of fashion these days."

As I've said many times on this web site, with respect to many different subject areas, people are completely blind to generational issues, no matter how obvious they are, and this is pretty obvious. Apparently human beings come with some sort of mental block that prevents them, most of the time, from even allowing a generational trend to enter their minds.

Kuttner concludes as follows:

"The fact is that the economic fundamentals are sound -- if you look at the real economy of factories and farms, and internet entrepreneurs, and retailing innovation and scientific research laboratories. It is the financial economy that is dangerously unsound. And as every student of economic history knows, depressions, ever since the South Sea bubble, originate in excesses in the financial economy, and go on to ruin the real economy.

It remains to be seen whether we have dodged the bullet for now. If markets do calm down, and lower interest bail out excesses once again, then we have bought precious time. The worst thing of all would be to conclude that markets self corrected once again, and let the bubble economy continue to fester. Congress has a window in which restore prudential regulation, and we should use that window before the next crisis turns out to be a mortal one."

I'm not even sure what he means by this. A huge number of factory jobs have fled to China, and a huge number of service jobs have fled to India. It's hard to see why it's appropriate to simply call this "sound."

If Kuttner understood even the simplest generational theory, then he'd know that "dodging a bullet for now" doesn't mean that things get better, since generational changes always continue. The depraved use of credit that Kuttner has documented will only get worse as there are additional generational changes, and new regulations will have no greater success than the old ones did. His idea to "restore prudential regulation" is just part of the universal self-delusion that the entire world is suffering from in 2007, just as it did in 1929. (11-Oct-07) Permanent Link
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Generational Dynamics Web Log for 11-Oct-07 American Prospect's Robert Kuttner compares 2007 to 1929

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Generational Dynamics Web Log for 11-Oct-07
American Prospect's Robert Kuttner compares 2007 to 1929