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“Bezzle and Sardines”
By Jonathan A. Shayne
Paper delivered to The Old Oak Club meeting
Nashville, TN
Feb. 26, 2009
Introduction
Thank you.
The title of my talk today is “Bezzle and Sardines.” The subject will be the current financial crisis and recession or, as some would say, mini-Depression, which I know is on the mind of everyone.
My focus will be on ways to think about and understand what is happening.
If you and I were doctors researching a patient’s illness, we would look at the problem in different ways. We would use stethoscopes, MRI images, and blood tests. Each of these would reveal different aspects of the patient’s physiology.
Tonight, we will be diagnosing our economy, using conceptual tools. Two of the more interesting ones are bezzle and sardines. Let’s get right into bezzle. With a little luck, we will have time to think about sardines at the close. I plan to speak for 30 to 45 minutes.
1. Bezzle
Bezzle is the brain-child of the economist John Kenneth Galbraith, of Harvard. He died three years ago. Galbraith lays out the idea in his book The Great Crash, published in 1954. He writes,
To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful….In depression all this is reversed. Money is watched with a narrow, suspicious eye….Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.
The idea is that, to the extent there is undiscovered embezzlement in the economy, we will feel and act as if we are richer than we are.
As important as actual fraud, actual embezzlement, and the Charles Ponzis and Bernie Madoffs of the world are, the real payoff from Galbraith’s description of “bezzle” comes from realizing that there are other phenomena that are above-board and totally legal, but that have the same effect as embezzlement. Suppose, in happy economic times, you loan me $1,000. Suppose I happen to be someone who is unrealistic and terrible at math. I am not going to be able to pay you back. I do have enough spare change lying around the house to pay the interest for a while, but I can’t repay the principal.
You lent mea thousand dollars to spend. I spend it. You own what you think is a good loan. In fact, you might feel a little wealthier for having made the loan, if you like the interest rate you are getting. Feeling good about yourself for being such a clever lender, you sign a contract to buy a big new house. You feel good, I feel good, and the contractoryou hired feels good, too. None of us will feel good, however, when I have to declare bankruptcy.
This is bezzle in a broader and more honest sense than Galbraith meant it. Honest bezzle is even more pervasive and important than straight-up fraudulent bezzle.
Will the walls fall in if I say that universities that overspend their endowments in good times, because they do not realize that their investments are overvalued, are in effect spending principal without knowing it? Even honest mistakes are a kind of bezzle.
2. Inconstant Constants
Let’s talk about some ratios that we’d normally expect to stay more or less constant, or within certain ranges. In nature, in physics, the speed of light in a vacuum is a constant. In human physiology, body temperature normally varies within something like a degree or so of 98.6 degrees F.
There is an analogy, if an imperfect one, to certain ratios and measurements ineconomics and finance.
10-Year P/E ratio
[ILLUSTRATION 1]
This is a graph of the price/earnings ratio of the U.S. stock market going back to 1881. When you buy a stock, what you want most of all is the underlying earning power of the shares you are buying. The cheaper it is to buy the earning power, the better for you, so a low ratio of price-to-earnings is good for a buyer, and a high one is bad.
The price/earnings ratio is similar to “cost per square foot” in real estate. A low cost is a sign of a good deal, all else equal.
This graph is special because it’s not the price divided by last year’s earnings. Rather, it’s price divided by the average of the last 10 years’ earnings. That comes reasonably close to canceling out the distortions caused by economic cycles.
There is inflation adjustment added in as well. The underlying data come from Robert Shiller, of Yale.
You can see that what we went through was extraordinary.
U.S. Homeownership Rate
[ILLUSTRATION 2]
Here is a graph of the percentage of the U.S. population that owns its own home, 1965 to present. You can see the rise from the 64 or 65% level, all the way to 69% at the peak. With something like 116 million households in the U.S., that is an increase of about five million houses and condominiums. Keep in mind that housing lasts for several decades, and it takes a lot of time to build new dwellings, particularly in areas with tight zoning laws. When you have new entrants streaming into an already-hot market, it is hard to ramp up the supply fast enough, so prices rise even more.
Ratio of Median Home Price to Median Income
[ILLUSTRATION 3]
This shows the median home price divided by the median income, 1965to 2007. I wish it went back further, and forgive that the left axis starts at 20, but you get the idea.
[ILLUSTRATION 4 IS EXTRA AND CAN BE SKIPPED]
Personal Savings Rate
[ILLUSTRATION 5]
When the value of your house and your stocks are both going up, and when it is so easy to borrow against them, you are getting richer, on paper, without having to put aside much in your hard-earned savings.
Here is a graph of the personal savings rate, as computed by the Bureau of Economic Analysis at the U.S. Department of Commerce. The rate used to be 8% or more, but notice that it actually went negative in the past few years. Not only were households not saving any of their income, in aggregate. They were actually borrowing and, through this borrowing, spending even more than they made.
This is self-induced bezzle, caused by easy credit, and trusting too much in the price signals that the market was sending regarding the values of houses and stocks.
When you see “constants” go ballistic like this, you have to ask, after checking the math: has something fundamental changed, or is this just a bubble? People usually resist the idea that there is a bubble. Some academic economists have what I would call a kind of scholastic,medieval belief that because bubbles do not exist in their theories, they must not exist in fact. Spotting a bubble is much easier if you have read the history of past ones, and how otherwise very smart people, including Isaac Newton during the South Sea Bubble of the early 18th century, have fallen into them.
3. Deleveraging
Let us continue our tour of revealing concepts with the idea of deleverage.
To illustrate it, I am going to use some figures published a few weeks ago by Jeremy Grantham, who is a serious student of financial history, and one of the founders of GMO, a large investment management firm in Boston.
Two years ago, before the crisis hit, the total value of all domestic private wealth in the U.S.was $50 trillion.
Against those private assets was total private, non-governmental debt, of $25 trillion. Take $25 trillion of debt against $50 trillion in assets, and you have a 50% leverage ratio.
I have seen other estimates, and Grantham did not footnote his sources, but his numbers are at least in the ballpark, and approximation is fine for this illustration.
Now the value of private assets has gone down. The stock market is down 50% from the peak as I write, and housing prices and commercial real estate prices are, or will be, down by about a third. So overall, let’s say that the $50 trillion in assets is now down to $30 trillion.
The debt, of course, at $25 trillion, didn’t budge. So now instead of a 50% leverage ratio, we are up to 83%. $25 trillion in debt against $30 trillion in assets is much more leveraged than $25 trillion against $50 trillion.
And as you may have concluded from the prior graphs, the evidence is that today’s asset prices are probably much more reflective of long-term economic reality than the prices of two years ago. Not because they are lower, but because they represent valuation metrics that are closer to long-term averages.
On top of that, we have all concluded that borrowing 50% was probably too much. Maybe a better number is 40%.
To get down to a 40% leverage ratio tomorrow, the $25 trillion in debt needs to become $12 million. In other words, the outstanding debt needs to be cut by about half. This gives you a sense of how huge the problem is, and why even a trillion or two of deficit spending will only soften the blow.
How can we fix this? There are three realistic ways to deal with the problem of deleveraging. We can write the debt off, but some banks will then wind up insolvent; our central bank can print vast amounts of new money, but that risks inflation and, down the road, even a run on the dollar; or we can just mope around for years as asset values rise, slowly but naturally.
Deleveraging, in size, is devastating. Only the more serious students of the economy seem to be able to wrap their heads around it. I am not sure that I fully understand its implications, but it is clearly happening now, to an important degree.
As Cole Porter might have put it:
It’s destructive
It’s depressing
It’s deleverage!
4. Spirals
It is useful to think of both inflation and deflation as spirals.
We can start with inflation, because that is easier. If the government prints more money faster than the real economy expands, there will be inflation. The number of cars produced, hours billed by lawyers, or baseball cards printed tends to go up gradually as the population grows and our productive capacity expands, but if the supply of money goes up at a faster rate than that, there will be inflation as sellers figure out that there is more and more money that can go into buying what they are offering.
The spiral starts when the public catches on. We notice that the dollars in our wallet are depreciating. If the rate is rapid, we decide that we are not comfortable holding dollars. We rush to spend the money quickly. We might as well spend it now, because it won’t be worth much in a year. We reduce the amount of money sitting idly in our wallets, and in economic terms, the velocity of money increases.
Of course, with people accelerating their spending in response to inflation, this makes the inflation problem only worse. And with the prices of goods and services going up, workers will ask for higher wages, and the government will likely need to print even more money to keep up with its expenditures.
The behavior of businesses and consumers is not static. Once inflationary psychology takes hold, it tends to feed on itself.
The spiral works in the opposite direction with deflation. Normally, it is only an academic concern, but these days, it is a real threat. Once we, as consumers, notice that prices are starting to fall, we have no problem keeping cash in our wallets, or in a bank account that pays no interest. After all, the money is getting more valuable every day. We postpone purchases, on the assumption that we will get more for our money next year. Of course that panics businesses into cutting prices in order to keep the doors open.
In a situation like this, if prices are dropping fast enough, even zero percent rates on loans will not persuade us to buy an asset today. This assumes that we feel good enough about our jobs to spend in the first place.
The deflationary spiral constitutes what economists call a “liquidity trap.”
I quoted Cole Porter a minute ago, but here, an Elvis song, tweaked a little, works best:
We’re caught in a liquidity trap
We can’t walk out
Because we leveraged too much, baby
5. The Paradox of Thrift
The paradox of thrift is a close cousin of the deflationary spiral. Credit for this idea goes to John Maynard Keynes, the great British economist who died in 1946, and who is best-known for advocating deficit spending during depressions. According to Keynes, what makes sense individually can be disastrous societally. In a time like the present, it makes sense for individuals to cut back their spending. In fact, since we were, on average, spending too much and saving too little, it is a virtue for us each to get our spending back in line with income. However, your spending was my income! So as you cut your spending, I am forced to cut mine, and so on down the line. This is the paradox of thrift.
- Plato and Aristotle
[ILLUSTRATION 6]
This is a familiar painting by Raphael, from the early 16th Century. It is known as“The School of Athens.”
Notice all the great Greek philosophers, including Xeno and Heraclitus. At the center are Plato and Aristotle.
The painting gets to the fundamental philosophical debate that recurs in all fields. [ILLUSTRATION 7, DETAIL OF SAME PAINTING] Plato is the idealist, pointing up. He argues that ideas are more important than what we see around us, and that reality is best understood as a sort of imperfect expression of timeless ideas. Over the door to Plato’s Academy were the words, “Let no one enter who has not studied geometry.” Aristotle, on the other hand, points down. He argues that we should study things around us, as they are.
You may have deduced from the charts and ratios I have shown you that, in matters relating to the economy and markets, I think Plato usually has the better argument. What we see around us can be very deceiving. Times looked good, but measurement showed imbalances that had to reverse, in time.
In thinking about how bubbles form, it is important to remember that most people are Aristotelians. They are looking at the world around them and taking it at, more or less, face value. Only through mathematics and, more generally, thought, can one see that the underlying reality is very different from the apparent one.
Look at the sky and the earth. If you trust your senses, you will be absolutely certain that the earth is still, and the sun is moving. Thought and mathematics tell us the opposite, and are correct.
7. A Brief History of Financial Time
Let me sneak in a few words on how the bubble formed,for context.
From one point of view, the current crisis is just the breaking of a classic bubble. People lent and invested in bonds, real estate and businesses too sloppily. This has happened before in countries around the world, across centuries. The present episode will not be the last.
I would argue that parties like this can be understood as starting in a way that is, effectively, random. Once they get started, however, they reinforce themselves. When housing prices were rising, almost anyone who was having trouble making payments from income could just sell the house to repay the loan. There was little perceived downside to the homeowner or the lender. The low default rate attracted more lending, which made prices go up more, which attracted more buyers, which raised prices, which lowered default rates further, which increased lending, and so on. The stories in other asset classes, including complicated ones such as collateralized debt obligations, were, at core, the same.
People follow trends because it is far easier to figure out where prices have been than where they are going. There is an informational asymmetry, you could say, between the past and the future. Faced with uncertainty about the future, we tend to look at what our neighbors are doing. We tend to take history and project it forward. It is a crude method. It works in most areas of life, but in finance, it fosters disaster.
Let me supplement the very general picture I have just given with some of thespecifics that characterize this cycle.
You have already seen figures on how the values of houses and stocks rose during the boom.
Another characteristic was looseness in lending. I think everyone is aware that, during the past few years, some of the people who got home mortgages were un-creditworthy. Many lenders were willing to make loans without income verification, and of course, much of this lending was sold off in bundles of securities to investors around the world. Buyers of mortgage-backed securities tended to rely on credit assessments by the rating agencies Moodys and Standard & Poor’s. Some of the securities were very complex and the agencies did a poor job rating them. Almost no onetook the possibility of a housing bubble seriously enough.