The Next Bubble: Priming the markets for tomorrow’s big crash - Harper's Magazine

Summary:
Eric Janszen: the only thing worse than another bubble is no bubble. No coincidence that the internet and housing hyperinflations transpired within a periord of ten years. The US can no longer function without them. The bubble cycle has replaced the business cycle. The cause for this transformation lies with the rise of the FIRE economy in the late 70s. Next bubble must be large enough to recover the losses from the housing bubble collapse. Many candidates, only one fits all the criteria: alternative energy. Will be accompanied by boom in infrastructure. Danger: hyperinflations, in the long run, are always destructive. Could have serious consequences, as alternative energy and the improvement of our infrastructure are both necessary for our national well-being. The author estimates estimate of $20 trillion in speculative wealth will be created in the alternative-energy/infrastructure bubble. Unfortunately, this money will inevitably be employed to increase share prices rather than to deliver “energy security.” (Published: February 08)

Notes:

• financial bubble: a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression
• note: term "bubble" confuses cause with effect
• a better descriptor would be “asset-price hyperinflation”
• the huge spike in asset prices that results from a perverse self-reinforcing belief system, a fog that clouds the judgment of all but the most aware participants in the market
• asset hyperinflation starts at a certain stage of market development under just the right conditions
• the bubble is the result of that financial madness, seen only when the fog rolls away.
• frequency
  
• bubbles were once very rare
• one every hundred years or so
• legislation enacted to prevent subsequent occurrences
• nowadays: barely a pause between such bouts of insanity
• before the dotcom bubble had deflated, housing bubble took off
• no coincidence that the internet and housing hyperinflations transpired within a periord of ten years
• the US can no longer function without them
• there will be many more such boom
  
• the bubble cycle has replaced the business cycle.
• how did this transformation come about?
• following WWI
• Wall Street wrote checks to finance new companies that were trying to turn wartime inventions into consumer products
• e.g. radio, refrigeration
• consumers of rising middle class were ready to buy but lacked funds
• banking system accomodated them with new forms of credit
• e.g. the installment plan
• brief recession in 1921, following which fed accomodated progress by keeping interest rates below rate of inflation
• "new era" of prosperity hailed until Black Tuesday, Oct 29, 1929
• crash, Great Depression and WWII
• brutal education for government, academia, corporate America, Wall Street and the press
• next 60 years, chastened generation managed to keep the fog of false hopes and bad credit at bay
• Keynes: emerged as the pied piper of a new school of economics that promised continuous economic growth without end
• doctrine: when a business cycle peaks and starts its downward slide, one must increase federal spending, cut taxes, and lower short-term interest rates to increase the money supply and expand credit
• the demand stimulated by deficit spending and cheap money will thereby prevent a recession
• aka. reflation
  
• WWII
• brought real recovery as a highly effective, demand-generating, deficit-and-debt-financed public-works project for the US
• war did what a flawed application of Keynes' theories could not
• Bretton Woods
• US succesfully pushed to peg the currencies of member nations to the dollar and to make dollars redeemable in American gold
• Americans could spend as wisely or foolishly as government policy decreed
• regardless of the needs of other nations holding dollars as reserves, as many dollars could be printed as desired
• 1971
• US balance of trade had run up its first deficit: $3.8b (adjusted for inflation)
• worries by Bretton Woods members that US intended to repay the money borrowed to cover its trade gap with depreciated dollars
• de Gaule demanded payment in gold
• Nixon, facing a run on the US gold supply, unilaterally ended the US legal obligation to redeem dollars with gold
• i.e. US defaulted
• decade of economic and financial-market chaos followed
• dollar remained the international currency but traded without an absolute measure of value
• inflation rose, not just in US but around the world
• Fed pushed interest rates into double digits
• set off two global recessions
• new international standards and methods for measuring inflation and floating exchange rates were established to replace the gold standard
• never again a US trade surplus after 1975
• decline of high-value finished-goods-producing industries as steel and automobiles
• new economy belonged to finance, insurance and real estate
• FIRE
• era of FIRE
• is a credit-financed, asset-price-inflation machine organized around one tenet:
• that the value of one’s assets, which used to fluctuate in response to the business cycle and the financial markets, now goes in only one direction, up, with no more than occasional short-term reversals
• free of the international gold standard’s limitations, US now had great flexibility to finance its deficits with its own currency
• massive external debts built up
  
• trade partners to the US balanced their trade surpluses with the purchase of U.S. financial assets
• especially the oil-producing nations and Japan
• process of financing our deficit with private and public foreign funds became self-reinforcing, for two reasons:
  
1. if any of the largest holders of our debt reduced their holdings, the trade value of the dollar would fall
• and with that, the value of their remaining holdings would be decreased
2. if not enough U.S. financial assets were purchased, the United States would be less able to finance its imports
• cfr. old rule about bank debt, applied to international deficit finance:
  
• if you owe the banks $3 billion, the bank owns you. But if you owe the banks $10 trillion, you own the banks.
• 1990s
• banking and securities markets were deregulated
• note: root of the 1920s bubble is believed to have been the conflicts of interest among banks and securities firms
• 1999: Glass-Steagall Act of 1933 repealed
• regulated banks and markets
• a servile federal interest-rate policy helped move things along
• FIRE rose in power
• so did a new generation of politicians, bankers, economists, and journalists willing to invent creative justifications for the system
• as well as for the projects that it financed: ranging from the housing bubble to the Iraq war
• high-water mark: the publication of the Cato Institute report “America’s Record Trade Deficit: A Symbol of Strength.”
  
• Freedom had become slavery; persistent deficits had become economic power.
• the bubble machine
• often starts with a new invention or discovery
• internet bubble
  
• Mosaic, graphical Web browser, released in 1993
• began to transform the Internet into a set of linked pages
• suddenly websites were easy to create and even easier to consume
• industry lobbyists stepped in, pushing for deregulation and special tax incentives
• by 1995, the Internet had been thrown open to the profiteers
  
• four years later a sales-tax moratorium was issued
• opening the floodgates for e-commerce
• such legislation does not cause a bubble, but no bubble has ever occurred in its absence.
• otherwise rational men and women fall under the influence of a fast-flowing and, it was widely believed, risk-free flood of money
• logic and historical precedent pushed aside
• deregulation had built the church, and seed money was needed to grow the flock
• mechanics of financing vary with each bubble
• what matters is that the system be able to support astronomical flows of funds and generate trillions of dollars’ worth of new securities
• internet bubble: seed money came from venture capital
• a few startups like Netscape went public, netting massive returns
• such liquidity events came faster and faster
• loop was formed:
  
• profits from IPO investments poured back into new venture funds, then into new start-ups, then back out again as IPOs, with the original investment multiplied many times over, then finally back into new venture-capital funds.
• public was exposed to constant reiterations of the one true faith
• government stood back
• little incentive for lawmakers to intervene
• Members of Congress, who influence the agencies that oversee market-regulation functions, have never been unfriendly to windfall tax revenues
• the FIRE sector has very deep pockets
• 2000: millions of investors with unrealized gains in mutual funds sold stock to raise enough cash to pay taxes on their capital gains
• the mass selling set off a panic, and the bubble popped.
• fictitious value
• is the delta between historical-trend growth and growth brought on by asset hyperinflation
• “One added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently, all the fictitious value must be a loss to some persons or other, first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost.” (anonymous, South Sea Bubble pamphleteer)
• goes away when market participants lose faith in the religion—when their false beliefs are destroyed as quickly as they had been formed
• Janszen: "Since the early 1980s, the free-market orthodoxy of the Chicago School has driven policy on the upward slope of an economic boom, but we’re all Keynesians on the way down: rate cuts by the Federal Reserve, tax cuts by Congress, deficit spending, and dollar depreciation are deployed in heroic proportions."
• brief national recession in the early part of 2001
• result of layoffs, cutbacks, and the collapsing stock market rippled through the economy
• despite a concerted effort by the Federal Reserve and Congress to avoid it
• despite the technology industry representing only a small fraction of the U.S. economy
• crucial dilemma: how to counter the loss of that $7 trillion in fictitious value built up during the bubble
• housing bubble
• new boom
  
• McMansions on the ground: wood and nails, granite countertops
• as opposed to castles in the sky of electrons and monetized eyeballs
• price-inflation process was traditional:
  
• way too much mortgage money chasing not enough housing
• at the bubble’s peak, $12 trillion in fictitious value had been created, a sum greater even than the national debt
• should have known better: historically, the price of American homes has risen at a rate similar to the annual rate of inflation
• Why, then, did housing prices suddenly begin to hyperinflate?
  
• formative stage of the bubble:
  
• changes in the reserve requirements of U.S. banks, and the creation in 1994 of special “sweep” accounts, which link commercial checking and investment accounts, allowed banks greater liquidity
• meant that they could offer more credit
• next, 2001 - 2002: hypergrowth
  
• Federal Reserve Funds Rate was reduced from 6 percent to 1.24 percent
• in wake of dotcom crash
  
• led to similar cuts in the LIBOR that banks use to set some adjustable-rate mortgage (ARM) rates
• drastically lowered ARM rates
  
• meant that in the US monthly cost of a mortgage on a $500,000 home fell to roughly the monthly cost of a mortgage on a $250,000 home purchased two years earlier
• demand skyrocketed, though home builders would need years to gear up their production.
• with more credit available than there was housing stock, prices rapidly rose
• supply of new capital needed to sustain hypergrowth: securitized debt
• turned out to be economic poison
• securitization
• to make a new security out of a pool of existing bonds, bringing together similar financial instruments, like loans or mortgages, in order to create something more predictable, less risk-laden, than the sum of its parts
• many such “pass-thru” securities, backed by mortgages, were set up to allow banks to serve almost purely as middlemen
• if a few homeowners defaulted but the rest continued to pay, the bank that sold the security would itself suffer little
• or at least far less than if it held the mortgages directly
• in theory, risks that used to concentrate on a bank’s balance sheet had been safely spread far and wide across the financial markets among well-financed and experienced institutional investors
• happens with most bubbles: a perfectly good idea is taken to an extreme
• in the case of the housing bubble, the new securitized debt product that drove the final stage was the collateralized debt obligation (CDO)
• CDO is a class of instrument called a credit derivative;
  
• specifically, a derivative of a pool of asset-backed securities.
  
• parts of pools of asset-backed securities that were e.g. rated at a moderately high risk of default—junk grade, such as BB—were modeled, packaged into CDOs, and rated at lower risk-investment grades, such as AAA
• these were used to finance the more creative mortgages
• stated-income or “liar loans”
• subprime mortgages were only a sideshow that appeared late, as the housing-bubble credit machine ran out of creditworthy borrowers
• main event was the hyperinflation of home prices
• risks are embedded in price and lurk as defaults
• even after the faith that supported a bubble recedes, false beliefs continue to obscure cause and effect as the crisis unfolds
• compare with chemical industry
• 40 years ago: “the solution to pollution is dilution”
• mixing toxins with vast quantities of air and water was supposed to neutralize them
• big mistake
• modern bankers have carried this mistake into the world of finance
• as more and more loans with a high risk of default were made from the late 1990s to the summer of 2007, the shared level of credit risk increased throughout the global financial system
• ballooning credit risk can be thought of as ecomonic poison
• in theory, those risk pollutants have been diluted in the oceanic vastness of the world’s debt markets
• thanks to the magic of securitization, they are made nontoxic and so pose no systemic risk
• in reality, credit pollutants pose the same kind of threat to our economy as chemical toxins do to our environment
• like their chemical counterparts, they tend to concentrate in the weakest and most vulnerable parts of the financial system
• that’s where the toxic effects show up first
• the subprime mortgage market collapse is essentially the Love Canal of our ongoing risk-pollution disaster
• more and more risk pollution is rising to the surface
• credit continues to contract
• FIRE economy depends on the free flow of credit
• will experience its first near-death experience since the sector rose to power in the early 1980s
• FIRE economy will be in need of $12 trillion by time prices reverted to mean
  
• all asset hyperinflations revert to the mean
• we can expect housing prices to decline roughly 38 percent from their peak as they return to something closer to the historical rate of monetary inflation
• if rate of decline stabilizes at between 6 and 7 percent each year, the correction has about six years to go before things stabilize
• Where will that money be found?
• "Bubbles are to the industries that host them what clear-cutting is to forest management. After several years of recession, the affected industry will eventually grow back, but slowly"
• housing bubble has left us in dire shape
• worse than after the technology-stock bubble
• Federal Reserve Funds Rate was 6 percent
• dollar was at a multi-decade peak
• federal government was running a surplus
• tax rates were relatively high
• made reflation relatively painless
• i.e. interest-rate cuts, dollar depreciation, increased government spending, and tax cuts
• now:
• Funds Rate is only 4.5 percent
• dollar is at multi-decade lows
• federal budget is in deficit
• tax cuts are still in effect
• chronic trade deficit, the sudden depreciation of our currency, and the lack of foreign buyers willing to purchase its debt will require the United States government to print new money simply to fund its own operations and pay its 22 million employees
• economy in serious trouble
• new bubble needed to keep the economy from slipping into a depression
• new bubble
• criteria
  
• the industry in any given bubble must support hundreds or thousands of separate firms
  
• financed by not billions but trillions of dollars in new securities
  
• Wall Street will create and sell those
• this sector of the economy must already be formed and growing even as the previous bubble deflates
• like housing in the late 1990s
• legislation guaranteeing favorable tax treatment for those investing in that sector, along with other protections and advantages for investors, should already be in place or under review
• finally, the industry must be popular, its name on the lips of government policymakers and journalists
• should be familiar to those who watch television news or read newspapers.
• candidates
• number of plausible candidates, but only a few meet all the criteria
• health care
  
• must expand to meet the needs of the aging baby boomers
• but there is as yet no enabling government legislation to make way for a health-care bubble
• pharmaceutical industry
• can hyperinflate only if the Food and Drug Administration was gutted of its power
• second technology boom, under the rubric “Web 2.0”
• based on improvements to existing technology rather than any new discovery.
• biotech
  
• will not inflate, as it requires too much specialized intelligence
• alternative energy: only industry that fits the bill
• is already being branded by the media
  
• Al Gore, joining Kleiner, Perkins, Caulfield & Byers
• "providing a massive dose of Nobel Prize–winning credibility that will be most useful when its first alternative-energy investments are taken public before a credulous mob"
• candidates for the 2008 presidential election invoking “energy security” in their stump speeches and on their websites
• legislation: Energy Policy Act of 2005
• authorizes $200 million annually for clean-coal initiatives, repeals the current 160-acre cap on coal leases, offers subsidies for wind energy and other alternative-energy producers, and promises $50 million annually, over the life of the bill, for a biomass grant program
• loan guarantees for “innovative technologies”
• boom in infrastructure will support alternative-energy bubble
• alternative energy and the improvement of our infrastructure are both necessary for our national well-being
• therein lies the danger: hyperinflations, in the long run, are always destructive
• estimate of $20 trillion in speculative wealth will be created
  
• gross market value of all enterprises needed to develop hydroelectric power, geothermal energy, nuclear energy, wind farms, solar power, and hydrogen-powered fuel-cell technology—and the infrastructure to support it—is somewhere between $2 trillion and $4 trillion
• assuming the bubble can get started, the hyperinflated fictitious value could add another $12 trillion
• In a hyperinflation, infrastructure upgrades will accelerate, with plenty of opportunity for big government contractors fleeing the declining market in Iraq
• thus, we can expect to see the creation of another $8 trillion in fictitious value
• That money that inevitably will be employed to increase share prices rather than to deliver “energy security.”