The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (45 page)

People were determined to live large and live better than they could afford.They did this by what economists called
smoothing
income. Anticipating higher incomes in the future, young families spent the money right away (e.g., buying bigger houses than they could afford). Nationwide, house sizes grew 30 percent since 1980, said Cornell economist Robert Frank. Even people in their 50s and 60s looked forward to higher incomes or miracles.

Some economists referred to the whole phenomenon as the “democratization of credit.” “Innovation and deregulation have vastly expanded credit availability to virtually all income classes,” said the Fed chief.
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He did not mention his own role in this democratic revolution. He was too modest. He was a Danton and Robespierre put together.The Fed chairman accomplished more than all the nation’s innovators and deregulators put together. Dropping the price of credit below the inflation rate, he offered the entire world something for nothing. Thanks to him, everyman could get himself into financial trouble, not just kings, speculators, and financiers. He made it possible for lending institutions to extend such a long rope of credit to the common man that millions were sure to hang themselves.

We turned to the dead for an opinion. But it was hopeless; the corpses knew even less than we did.They couldn’t even imagine what was happening. Borrow against your house when you don’t have to? Buy a house as an “investment?” Take out “equity?” “Depend on foreigners to balance your budget?”“Live beyond your means and expect Third World wage earners to make up the difference?” The ideas that Americans once took for absurd, they now took for granted.

The baby born when the empire began in 1913 came into the world with nothing. But he owed nothing. Now, he comes into the world owing his share of a huge public debt—one that is growing by more than $1.8 trillion per year.What would the dead say?

WHAT WILL HAPPEN TO AMERICANS’ DEBTS?

“He that dies pays all debts,” said Shakespeare.
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Who pays these debts? And how?

When people cannot pay their debts, they do not pay them. But the debts do not cease to exist.They are merely “paid” by someone else—the creditor. In the case of America’s debts to foreign nations, this can be achieved in three ways: The currency in which the debt is denominated can be devalued against other currencies; the currency can be made less valuable through inflation; or the debt can be repudiated. One of these things—or all of them—is likely to happen.

Repudiation has a long and squalid history. If a man can get away without paying his debts, he will generally figure out why he shouldn’t have to pay them. In public life, the reasons are often very good ones.When a new political regime takes over, why should it be stuck with the bills of the old one? When the Bolsheviks took over Russia in 1917, they made Tsarist bonds worthless.Why should they pay bills that they never agreed to? Why should they honor commitments of one capitalist to another? They didn’t pay. And why, after 1919, should the new German republic have to pay the Kaiser’s bills? France, Britain, and the United States had defeated the Kaiser; let them pay his debts!

The idea of public debt is an attractive nuisance. A father would not have dinner in a fine restaurant and send the bill to his son. Nor would he say to the restaurateur: Hold the bill for my unborn grandson. But such is the state of faith in democracy, that a relatively small group is not only willing to stick its heirs or enemies with costs to which they would never consent—but is happy to do so. Politics is a pernicious and barbarous occupation.

Generally, the public has only the dimmest, most remote idea of the kind of obligations that are being contracted on its behalf. If asked about them directly, many—if not most—would surely object. But who asks? Besides, the unborn don’t vote. And neither do foreigners. Or even out-of-staters.

In America, several states—Michigan, Mississippi, Arkansas, Louisiana, and Florida—totally and permanently repudiated their debts in the panics of the 1840s. In the 1880s, many Southern states repudiated the debts that had been run up by illegitimate carpetbagger governments. But the United States doesn’t have to repudiate. Its debts are denominated in its own currency—the value of which it can control. Having the world’s reserve currency means you can stiff your creditors without ever having to say you’re sorry.

Among the many remarkable stories that appeared in the press in the bubble years, the story of Mr. Asakawa stood out.

The United States economy has been so strong for so long, people all over the world have come to accept the imperial currency. By 2005, no one had more of it than poor Mr. Asakawa in Tokyo. The man controlled the biggest stash of U.S. paper in the world. His life had come to imitate a popular joke. “A man who owes his banker $100,000 can’t sleep at night,” the joke begins. “But when a man owes his banker $1 million, it’s the banker who can’t sleep.” Mr. Asakawa is the central bank’s banker. At the end of 2004, he held an estimated $700 billion worth of U.S. dollar-denominated paper assets in his vault at the Finance Ministry. Beside his bed was a blue plastic monitoring device that would go off like an alarm clock when the dollar fell out of a given trading channel. Mr. Asakawa, needless to say, did not often sleep soundly.

A relatively modest drop in the dollar’s value would mean huge losses to Japan’s central bank and other dollar holders. But what could Mr. Asakawa do? His infernal alarm alerted him to drops in the dollar/yen exchange rate. But he merely aggravated himself and his wife. He could do nothing about it. The Asians owned so many U.S. dollar assets that any attempt to sell would cause the very thing they most worried about—a drop in the value of their single biggest asset.

We understood why Mr. Asakawa would be alarmed. What bothered us was why no one else seemed to be. With as much as $100 trillion of the world’s wealth denominated in dollars, how did the world watch so complacently as the value of its main asset was marked down? In 2002, the dollar went down against the euro by 10 percent. Then 20 percent. And then 30 percent. When Warren Buffett began putting his money in euros, he could buy one for just 86 cents. By early 2005, the euro cost nearly $1.36. In Europe, the dollar had lost about 40 percent of its purchasing power.

14

Still Turning Japanese

The most successful economy of the twentieth century was the United States of America.The second was probably Japan. It rose from the bombed-out ruins of World war II to become a worldwide export powerhouse, dominating the auto and electronic equipment industries.

But at the end of 2008, stock prices in Japan had fallen to more than a quarter-century low. Investors in Japanese stocks made nothing in 26 years.

As if the poor Japanese investor hadn’t had misery enough! He’s been, beaten up for the last 18 years. He was whacked when Japan, Inc., went bust in 1990. He was smacked when stocks fell 70-90 percent during the ’90s. He was racked with pain when property collapsed to as little as one-tenth its late ’80s value. He was starved for yield when the Japanese Central Bank dropped its policy rate to zero and kept it there for 6 years. He was tortured over an entire decade as his government wasted $1 trillion trying to force him to spend and invest. And he was hung by his thumbs in four separate recessions.You’d think Mr. Market would have the grace not to kick him when he was down.

When the sun rose on 2008, the typical Japanese was still in a fetal position, with his head down and his wallet closed up tightly. But along came the sell-off of 2008—and he got the boot again.The Nikkei fell another 50 percent.The Japanese investor who bought stocks in 1982 when he was 35 years old was now 61 . . . and his stocks were not worth a penny more! And now he gets the news that the Japanese economy is once again in recession. Today, we feel his pain—not so much because we sympathize with the Nipponese themselves, but because now we are Japanese too.

When people approach retirement, something happens to them: They become risk averse. A young man—with 60 years of life expectation—will do the damnedest things. He’ll drink a half bottle of good scotch and drive down a mountain road as if he thought he was making a moonshine run. Or, he’ll jump out of a perfectly good airplane. Or enlist in the army just when war has been announced.

An older man has less to lose, but like a shipwrecked sailor down to his last pack of cigarettes, he guards it carefully. He won’t cross against the light and won’t even have a cup of coffee before going to bed for fear it will disturb his sleep.

Imagine what happens to an economy when millions of people grow old at the same time. Well, you don’t have to imagine. You have only to look at what has happened in Japan since 1989.

Biology and actuary science converge at around 50 years of age.They soften up a man’s brain and his stomach, and turn him from a dynamic risk taker into a fretful old coot who won’t part with a penny without a court order.

A man over 50 doesn’t want to wait a quarter of a century for stocks to come back to where he bought them. Rather than take the chance, he typically shifts his portfolio from capital gains to income. His risk tolerance also shifts, from return on investment to return of investment; and his savings strategy drifts, too, from just-in-time to just-in-case.

Amos Tversky, a Stanford University psychologist, found that people would rather not lose money than make it.This confirmed something that did not need confirmation, a self-evident insight from the economics profession known as the
marginal utility
hypothesis. As people get more and more of something—whatever it is—each additional unit is of less and less value. (In the case of calories, information, and heroin—after a certain point, additions are not only worthless, they are less than worthless.) An extra dollar means less to a billionaire than it does to a pauper.This is another way of saying that the loss of an additional dollar is of lesser consequence than the loss of a man’s last dollar.This is obvious when it is reduced to the extreme situation—where a man only has a single dollar. If he loses it, he will go hungry. But if a billionaire fails to make an additional dollar, it will not even be noticed. This means that a speculation with 50/50 odds is inherently senseless—but people make worse speculations all the time.

Tversky also noticed what he called the
prospect theory
—that investors are more ready to gamble with “house money” than their own. Investors took the fall of the Nasdaq and the decline of the Dow with good grace. But in 2009, they are nearly a decade older—closer to retirement age—and taking losses, not just of house money, but of real money: savings that were intended to cosset gray heads and wrinkled brows.

That these marginal, 60-something investors would panic out of stocks seemed a foregone conclusion.And panic out of houses, too. And out of the habit of consumption!

When Americans begin saving like the Japanese, should it surprise us if the U.S. economy also turns a little Japanese?

Who would have believed it? Japan’s problem was that its people did not consume enough. America’s problem was just the opposite. We were too good at it.We consumed with our eyes shut.We were the best consumers in the entire world.When it came to buying things we don’t need with money we didn’t have—no other nation came close.

If only consumption could make you rich! But during the bubble, who wanted to hear it? There was no point to telling your neighbor that rising house prices wouldn’t make him rich.You might as well have told him that his wife was fat; he probably already noticed and wouldn’t appreciate the observation in any case.

Besides, who was going to believe he was getting poorer when his house was rising at 20 percent per year? And then, when it all began to fall apart, even seasoned hacks seemed to have no idea what was going on. Neither pundits, ministers plenipotentiary, nor Wall Street pros pre-penitentiary had an explanation.
Barron’s
is a financial weekly published since 1921. You’d think in all that time they’d get a little idea of how things worked. Nope. The best advice they could give to President-Elect Obama was the same program that didn’t work in Japan: Protect the dinosaurs . . . and spend more public money.

But the crisis that began in the summer of 2007 was not a typical business cycle recession.The idealized business cycle downturn came about after an economy “overheated.” Labor rates rose and the cost of living went up. This consumer price inflation forced the central bank to raise rates, causing the economy to “cool off ” again.

This was different. Centered in America and Britain, it was a credit cycle recession. Investors all over the planet were taking a beating. Mr. Market had taken a cudgel to stocks, property, consumer spending, and the economy—just as he did in Japan during the “Lost Decade.” People were afraid to lend and afraid to borrow; they worried that the money would be knocked senseless before it found its way home.

This time, the economy did not overheat . . . nor did labor rates go up. And when the bubble popped, the pin was not higher lending rates. This bust was caused by too much credit, not by too little. It is what economist Richard Koo calls a “balance sheet recession” a la Japan in the ’90s.
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That is, it is a time when businesses, investors, and householders realize that if they don’t cut back they could go broke.

And unlike the more typical recession, this was a slump the feds couldn’t control and couldn’t cure. They could offer easier credit; but more debt was just what both lenders and borrowers were most afraid of. The feds could offer more props, more handouts, and more public spending, too, just like Japan. But all they were doing was retarding the correction. Mistakes of the bubble era needed to be fixed. Balance sheets needed to be brought back into balance.There was no way around it. Japan proved it.