The Panic of 2008
on October 11th, 2008 at 8:11 am
This week, financial markets truly succumbed to The Panic. The US Dow Jones and S&P500 Indices lost 21%; Australia’s All Ordinaries fell 16%. “Buy and Hold” gave way to “Get Out At All Costs”.
When we look back with the eyes of history, the ninth day of the tenth month of 2008 will be the Black Thursday on which the world’s biggest ever speculative bubble finally burst.
The Stock Market Crash of 2008
Friday’s wild gyrations on Wall Street–which saw the Dow down as much as 700 points and up as much as 140, before closing down 128 points for another 1.5% loss on the day–are aftershocks from a financial earthquake driven by tectonic shifts that have a long, long way to go.
The US markets are down 21% for this week alone, and 45% from their peak; the Australian market has fallen 16% this week, and 42% from its peak. The only other stock market crash that compares with this is, of course, 1929.
Comparing the Crash of 2008--thus far--to 1929
The fall in 1929 itself was much more sudden–the fall from the market peak of 381 to Black Tuesday’s plunge to 230 points took just over a month, versus over a year this time. But the long grind to the bottom in the 1930s took three years (and the market didn’t revisit its 1929 peak until 1957). We may well face as long a wait before a new world financial order is established.
If we can gain our senses this time, we may be able to establish a financial system that serves capitalism rather than subverts it. We need, as Hyman Minsky argued, a good financial society in which the tendency of markets to indulge in speculative behavior is constrained.
It is obvious now that this will not be a deregulated market. But can it merely be a regulated one? Will regulations alone–bans on short selling, “Chinese Walls” between investment and merchant banking, quantitative regulation of lenders, etc.–be enough?
Clearly they were not this time round. That is the world constructed after the Great Depression (and its political aftermath, the Second World War) when Keynes ruled economics. It fell apart over time because, as Minsky put it, “stability is destabilizing”. A period of economic tranquility ushered in by drastic reductions in debt levels and firm regulation of financial markets leads us to forget the tragedies of The Bust, and to believe that markets are inherently stable.
This delusion was aided and abetted by the economics profession, which reacted to Keynes’s arguments about the inherent instability of markets like an immune system repelling a virus
Economics dreamt up such absurd notions as the “Efficient Markets Hypothesis” (which assumes that markets accurately predict future earnings and value shares on that basis), the Modigliani-Miller Hypothesis (that the most rational funding model for firms is 100% debt if interest payments are tax-deductible), and Rational Expectations (markets are always in long run general equilibrium, and government is impotent to affect real economic activity), and even invented asset market valuation concepts (such as the Black-Scholes Options Pricing Model) that were integral to the development of the derivatives market, the most destabilising force of all in modern capitalism.
Capitalism will survive this crisis, as it survived 1929; and it will be reformed, as was the sober post-WWII system after its profligate predecessor of the Roaring Twenties. But with speculation on assets still a potential path to individual riches–and with a drastically lower level of gearing, as the Great Depression level of debt unwound from its 215% of GDP peak in 1932 to a mere 45% at the start of 1945–the seeds for today’s repeat of the tragedy of speculation were sown.
We need instead to consider redesigning the financial system so that the currently inherent profitability of leveraged speculation on asset prices (when debt levels are low) is constrained.
I propose three such reforms, in full knowledge that they have Buckley’s of being implemented now–but hopefully they will be considered more seriously when this crisis reaches its second or third birthday.
These are:
- To redefine shares so that, as do corporate bonds, they have a defined expiry date at which time the issuing company repurchases them at their issue price;
- To impose “caveat emptor” on mortgage agreements, so that the lender’s security is limited if poor credit evaluations were done of the borrower’s capacity to meet the payment commitments in the contract (this will be further explained below); and
- To base house price valuations on a multiple of the imputed yearly rental of a property, rather than its potential resale price.
The intention of the first redefinition of capital assets (this is much more than a mere reform) is to put some effective ceiling on how high a share price can be expected to go, and to therefore force valuations to be based more on soberly estimated future earnings (of the sort Warren Buffett now does) than on the prospects of selling a share to a Greater Fool–which is the real basis of modern-day valuations.
The intention of the second, which may look paradoxical, is to impose the risk of reckless lending on the lender. Note that a sale of a house by the lender is called a MortgagEE sale–where the suffix indicates that the BUYER is selling the house. The borrower, on the other hand, is known as the MortgagOR–where the suffix indicates that the borrower is the SELLER.
What’s going on? Simple: in a mortgage contract, the lender BUYS a promise by the borrower to provide a stream of payments in the future in return for a sum of money now. The lender is the buyer.
What if the lender didn’t properly check the capacity of the borrower to meet this commitment? If we imposed the old Common Law principle of caveat emptor–”Buyer Beware”–the consequences would fall on the buyer. At the moment, lenders avoid the consequences of poor research into a borrower’s capacity to meet the payments by getting absolute security over the asset the borrower subsequently purchased with the lender’s payment.
Were caveat emptor imposed by the courts, I think that lenders would be rather less willing to indulge in the frenzy of irresponsible lending that has marked the end of this long speculative bubble.
The intention of the third reform is to base lending for house purchases on the income-generating capacity of the asset being bought, rather than as now on the resale price potential. If a multiple of, for example, ten times annual imputed rental income were the basis of valuation, then it would be more than possible for a landlord to borrow money to buy a property, and rent that property out at a profit.
This would establish a firm link between the valuation of a house, its rental income, and the maximum loan one could secure to buy it. It would forge a link between an assets valuation and its income earning potential–a link that is so fragile in today’s speculation driven market. It would also establish a class of wealthy agents–landlords–who have vested interest in keeping house prices and loan levels low.
With such reforms, there is at least some prospect that I will not have a successor writing of the follies of the Stock Market and Housing Market Bubbles of 2060. Without them or similarly effective structural alterations, with merely regulations as were imposed after the Great Depression, we will be here again some time in the future.
All that is, of course, for the future. The immediate problem is what to do now, if, as so many more expect than once did, this market crash is the prelude to the world’s second Great Depression.
i believe that we need a new tax system which does not tax income, saving or enterprise, but raises all public revenue through the rental of land and finite resources (i am not referring to the existing land tax). No loopholes to avoid this form of tax or site-rental are possible – you cannot hide a piece of land in a tax haven.
Cancel GST, payroll, stamp duty and all other taxes. Get rid of the whole tax collecting/policing system with its huge cost of compliance.
local governments already collect rates and we have an excellent system of land valuation already in place in australia. Revenue collected in this way is returned to the community, not to the deep pockets of developers/speculators with the existing system of huge concessions and subsidies for property investors.
This system is very well etablished and proven to work. before you criticise, please have a look at http://www.taxreform.com.au http://www.prosper.org.au http://www.progress.org
boma, I expect that real estate prices will fall for at least 2 years but probably longer, and will then be fairly stable for a long time. So locking the money away shouldn’t be a problem. What has surprised me is how rapidly everything is moving, which means we’ll be soon be seeing 1-2% a month price decrease.
http://www.youtube.com/watch?v=oZFt46aQyQ8
this is a highly simplistic comical video from apparently 2006 that ‘predicts’ a major crash
Bullturnedbear said,
One guy suggested that all debts will need to be forgiven. Dream on! Don’t forget that someone lent that money in the first place and they want it back.
That was me. I don’t know which part of “the debt can never be repaid” you don’t understand.
The debt, and the interest on it, can only ever be repaid by creating more wealth/money out of thin air. That creation is called economic growth,
Economic growth is dead. We have finally run up against the LIMITS TO GROWTH wall that was predicted in 1970, from here on the production of oil will go down hill, soon followed by gas, and soon followed by coal.
There is no way we can have any growth with declining energy availability.
Therefore the debts can never be repaid.
So we either forgive them, or repossess everything and throw everyone out on the streets.
You work it out…..
Great to engage Mike.
Debts forgiven as in jubilee is very different to debts not being repaid. The debts will not be forgiven.
I agree with you strenuously that there will not be further growth from this point. No! The lender will take what they can. Both the borrower and the lender will suffer heavy loss.
The biblical model of Jubilee didn’t work then and it won’t work now.
If anyone out there is in debt (even your home loan). Get out now. When the global companies start falling and the CDS risk starts unwinding (or some other unknown trigger) the crunch on main street will be much harder than the crunch on the share market. When the lenders/depositors panic, everything gets liquidated and surprise surprise there are no buyers. Houses are very illiquid and will suffer unprecedented falls in value. Because of Australia’s obsession with home ownership the falls will be even greater.
Ever heard of REVOLUTION?
Steve,
the basic cause of the housing bubble not addressed by you and your fan club is TAX.
Tax is the root of all financial and political evil.
The Great Depression was made infinetley worse by the high levels of taxation compounding other economic mismanagement such as credit restriction etc. Hoover raised tax from 25% to 60% to cope with expanding government deficits, only to cause further economic contraction resulting in a further drop in tax revenue. Roosevelt continued this policy, and it was a major factor in the 1937 recession. During WW2, marginal tax rate reached 90%. Obama is going to bring in top marginal tax rates of 60%+ – those who don’t learn from history—.(www.financialsense.com)
The high rates of marginal tax rates that kick in at relatively low income rates ensure that Australia will have a tax avoidance obsession, and that “negative gearing’ will be pursued by all and sundry. I personally know of nurses who have several ‘negatively geared’ properties that are under water, but because of the “tax deductablity of interest and maintenance”, have delayed the inevitable day of reckoning, “because property always comes good”- ho hum. In the meantime, their savings, garnered often from excess overtime go down the financial drain – no wonder Aussie banks are so ‘stable’and profitable.(thanks Kevie) Removal of the capital gain excemption for any short term investment would discourage all forms of tax driven speculative investments, and lowering marginal tax rates combined with abolition of all tax deductions (which only distort rational economic decisions – ie.’no free lunches’)would eliminate the perceived need for tax driven investments. Lower tax rates result in higher economic activity and lower tax avoidance which results in higher tax receipts. Legislate for a permanent budget surplus, so politicians can’t steal from future generations, and problem solved.
In a country where 40% of families pay no net tax (recent report in The Australian) and 20%+ are on pensions, and free Medicare and unfunded government pensions remain a future growing liability, a more rational tax system, which is fair reasonable, transparent, adequate and low cost to administer and results in more productive investments than “McMansions” is long overdue.
PS anyone who doesn’t believe that climate change is a serious risk to human existance, that at least needs serious insurance cover, is a complete—— AND, Failure to deal with the Peak Oil(Energy)challenge will result in the Great Great Great Depression.
Cheers, Gary
Gary said,
Steve,
the basic cause of the housing bubble not addressed by you and your fan club is TAX.
No it isn’t. It’s greed.
It doesn’t matter how good people have it, they want more.
In the case of housing, they want more bathrooms, more toilets, more living rooms, more and bigger TVs, more and bigger refrigerators, swimming pools, airconditioning, bigger McMansions….
It’s called living beyond your means.
I have almost finished (and am living in) a 145 m2 house I designed with one bathroom and one toilet. It’s an environmental award winning house. We virtually own it outright, and it costs nothing to run, our last power bill was $29.55, and $25 of that was ambulance levy.
The economy can collapse as far as we are concerned, we saw this coming a long time ago.
So when I mention forgiving debts, I’m not at all concerned about ours.
I built the house for $95,000 BTW. It’s all solar powered, all costs included.
So much for Carbon trading costing the earth!
I should have added that we live so cheaply, I have given up work (I’m 56) and haven’t paid any taxes for at least seven years. My wife who is a Nurse works two or sometimes three days a week (more to do with staff shortages than our need or want for more money!)
One other factor rarely mentioned is the Current Account Deficit. For many years now the CAD has exceeded, economic “growth” and this means we have been earning less and making up for this by borrowing from other countries. The banks have been helping this process by creative distribution of the interest payment burden amongst home buyers and speculators not to mention people who have been “sucked into” other Ponzi type geared “investment” schemes on the advice of “financial advisors”.
We and the US have been operating the world’s first cargo cult. We would not need “growth” to repay the debt we just need to be much less greedy. We also need to be be organised by the government in such a way that we can “trade” on the global interface and not just buy on credit. We need free trade not free cargo. Our line of credit is collapsing leaving us with a $700billion debt and all the oposition leader could comment on tonight was that he was concerned that the goverment would kill the (fiscal) surplus.
Also beware our quoted unemployment level of aroung (4.5%) it is a lie and pollies say this is “historicaly low”! This is for a very short “historical” period as back in the 1960′s unemployment was at a low of 2% real or 1% using the current shambolic metric. If this unused labour was being and had been used, we would have a much smoother future with little debt but now the “Greater Depression” looms.
We have been bludging on other countries (the Americans would say “mooching”).
Now read this….. sorry to ruin your day!
On July 30 Hans Redeker, head of foreign exchange strategy at BNP
Paribas, Europe’s biggest investment bank, predicted: “The Aussie is
going down, big time.”
Back then – it already seems like a long time ago – the Australian
dollar was sitting majestically at 97 cents to the US dollar, which
was taking a battering. But the Aussie did, indeed, go down, big
time. Within three months it had crashed by 33 per cent to US65.5
cents. Now Redeker has issued another warning to Australia. We’ll get
to that. But first, let’s look at his track record.
December 2006: Redeker predicted a sharp recession in the United
States, saying the condition of its housing market was worse than the
experts were stating and the flow-on effects would be much worse than
predicted. That was almost two years ago. He was right.
January 2008: He predicted the Aussie dollar was facing two years of
decline, and expected to see it fall to 66 cents. He was right. He
also predicted a rise in financial market volatility, higher
inflation worldwide, higher interest rates in Asia, weakening demand
for Australia’s minerals exports from China, and a weaker sharemarket
in China, all of which would drive down the Australian dollar. Since
then, the Shanghai sharemarket has crashed 50 per cent from its peak.
October 2008: Two weeks ago Redeker repeated his claim that abundant
foreign money had been available to Australia and too much of it had
been spent on real estate, creating a speculative bubble: “The easy
money went straight into real estate ?c Australia will now have to
generate 4 per cent of GDP to meet payments to foreign holders of its
assets. This is twice as high as the burden faced by the US.”
After the Australian Reserve Bank slashed key interest rates by 1 per
cent, Redeker also told London’s Telegraph that he was concerned
about what the Australian Government may do: “Yes, Australia has a
fiscal surplus, but that does not offer as much protection as people
think. If the Government boosts spending further, the current account
deficit will spiral out of control.”
And what has the Rudd Government just done? Boost spending.
There was certainly no discussion of the current account deficit
spinning out of control, or Australia’s excessive debt, when the
Prime Minister, Kevin Rudd, launched his $10 billion economic
stimulus package last week, nor any from the Opposition Leader,
Malcolm Turnbull, who offered in-principle bipartisan support. It
gets worse. Redeker continued: “There is a risk, however remote, that
Australia could face some of the foreign funding difficulties we have
seen in Iceland.”
Iceland! Iceland was the most leveraged economy in the developed
world when it became the first economy to be bankrupted by the credit
crisis. You do not want to be mentioned in the same sentence as
Iceland unless the discussion is fishing or blondes.
After quoting Redeker, the Telegraph’s global business columnist,
Ambrose Evans-Pritchard, weighed in with his own commentary: “The
immediate problem for Australia’s banks is that they gorged on
offshore US dollar markets to fund expansion because the interest
costs were lower. They were playing on a huge scale with leverage.
European banks face much the same problem as dollar liabilities come
back to haunt, but Australian lenders have pushed their luck even
further.”
Gabriel Stein, of Lombard Street Research, weighed in with this,
after noting that Australian household debt had reached 177 per cent
of gross domestic product, almost a world record: “It is amazing that
in the midst of the biggest commodity boom ever seen they have still
been unable to get a current account surplus. They have been living
beyond their means for 10 years. What worries me is that productivity
growth has been very low: they have been coasting after their reforms
in the 1990s.”
The global financial world is watching the Australian dollar because
it holds a key to the great unanswered question of this uncertain
era: will the global market punish a currency for its declining
interest yield? Or will it reward a currency because of the soundness
of its economy? Central banks are acutely interested in the answer.
Evans-Pritchard thinks the early signs are hopeful that the answer is
the good one, that nations will be rewarded for having sound
economies. But he does not believe Australia can escape the
consequences of excess: “Australia has allowed its net foreign
liabilities to reach 60 per cent of GDP during a decade-long boom,
twice the level of the US. The country will, in effect, have to pay 4
per cent of GDP in the form of rents to foreign asset-holders as the
bill for such extravagance falls due.”
The bill is falling due. Earlier in the year Australians travelling
in Europe would have paid about $1.50 for every euro spent. Today
they need $2.10. The Aussie dollar is weak again, despite all the
luck of the China boom. This raises a number of awkward questions.
Did the lucky country became the greedy country? Did it fail to
sufficiently embark on a program of nation-building during the
resources boom?
Was most of the bonus redistributed as tax cuts, which were spent
chasing bigger mortgages, bigger homes, new cars and general
consumption, stimulating short-term economic growth but not enough on
long-term productivity and higher savings? During 17 years of
unbroken economic expansion and a 10-year commodities boom, it took a
lot of people, borrowing a lot of money, taking a lot of unproductive
risk, to get to where we are today: a nation with excessive debt and
excessive vulnerability to external circumstances barely within our
control.
http://www.smh.com.au/news/opinion/paul-sheehan/greed-a-deadly-sin-for-the-economy/2008/10/19/1224351052160.html?page=fullpage#contentSwap1
I don’t see how your three proposals would stop a tulip bubble. You seem to assume that shares and real estate are the only assets that hyperinflate, but if these were removed then others would come to the fore. The art market which is in an absurd bubble at the moment is a prime candidate.
It seems to me that a better option would be to allow the RBA to increase the rate of CGT or the time it has to be held for a discount for particular assets types. By applying CGT increases to particular assets the RBA could deflate an individual asset bubble without clobbering the entire economy like they do with interest rates.
The asset bubble resulted because real estate prices went too high. Other things being equal, the cost of real estate is inversely proportional to the land tax. So when land taxes are high, (e.g. 7% of valuation) then real estate will be cheap. Ergo, no bubbles.
The government prints the money, (M0) but after that, the various forms of money (M1, M2, M3) are in the hands of private enterprise. The government has recently found it necessary to guarantee M1 so that business transactions can be made without suitcases of cash. I suggest the government should issue online M0 (zero interest) or online M1 (interest say 4%) accounts. Access could be through the ATM network. Then (with appropriate safeguards) remove the guarantee to APRA overseen institutions.
Do not confuse capitalism with free enterprise (aka lassaiz faire).
Once upon a time, free enterprise was a man with a horse and cart. Then came capitalism exemplified as a goods train. The modern version of free enterprise is a truckie.
Technology turned free enterprise into capitalism. Now the wheel has turned, and capitalism is in the process of being supplanted by small free enterprise businesses.
I support the Henry George suggestion that government income should mostly be derived from land tax. To supplement that income I would add the rental income from natural monopolies (e.g. Airports, mineral wealth, electromagnetic spectrum, transport corridors). The income from those monopolies would directly flow to government, while various “teams” would quote for their management.
To summarize:
1) Capitalism (stock market) is withering away as did feudalism before it.
2) Consequently,there are far fewer places to invest money, because most large corporations have no place in the economy of the future.
3) Banks should be cut free from government guarantees. Instead the government should offer guaranteed M0/M1 accounts to everyone.
4) Government should legislate to derive it’s income from land & monopoly taxes, and most of that money returned to the people as negative income tax. (not as free hospitals & schools). Since each child would get a negative income of about $12,000, some of that money could be given to the parents as a cheque that could be cashable at any school.
Much of the above is inevitable (e.g. that is why the stock market is collapsing).
Government will probably enact legislation in a vain attempt to protect the big corporations (because the big corporations pay taxes and hire unionists and PAYE taxpayers).
Governments generally do not like small businesses, because it is so hard to tax them.