Crisis? What crisis? Which crisis? Whose crisis?

In the midst of all this panic about a financial meltdown, it is hard to get a sense of how to actually measure if there is a crisis or not. Clearly there are various measures that can be used: the number of houses foreclosed, the number of personal bankruptcies, the number of banks going under, the amount of credit available, the state of the stock market, and so on. While they are all connected in some way, which ones should we be paying most attention to?

Deciding which measures are being used to say there is a crisis is important because that will drive the efforts to resolve it. Clearly what is concerning the political leadership is the state of the financial market, and the current bailout efforts seemed to be aimed at reassuring the banking, insurance, and other financial sectors and propping up the stock market. People are being scared and told that if the stock market declines their retirement savings will go down the tubes.

It is true that there have been fluctuations in the stock market and some recent declines. But whether this is a problem or not depends on whether we know what the “true” level of the stock market should be. If it is declining from an artificially high value to a more realistic one, then there is no crisis, just a return to normalcy.

To get a rough idea of how to see this, you can look at this graph that shows the Gross Domestic Product (GDP), the Consumer Price Index (CPI), and the S&P 500 stock market index since 1970. The GDP is a rough measure of the size of the ‘real’ economy, while the CPI is a rough measure of the rate of inflation.

We see that from around 1970 onwards until now, both the GDP and CPI growth rates have fluctuated around an average annual value of roughly 3.5%. But beginning around 1980, the S&P index started taking off like a rocket, meaning that the size of the ‘virtual’ economy that is measured purely by stock market prices was outstripping the growth of the ‘real’ economy.

This raises the interesting question of what happened after 1980. That was the year that began the great deregulation era, where the corporations and financial institutions markets were steadily freed of the constraints and regulations imposed on them following the Great Depression of 1929. The drive for deregulation started towards the end of the Carter administration, kicked into high gear with Ronald Reagan, and has been on full throttle ever since.

Government regulation was portrayed as this bureaucratic burden that was stifling innovation, so those regulations were removed. The banking and financial sector was delighted because now they could do more things, borrow and lend more money, and take much greater risks than ever before. This was the beginning of the creation of exotic new financial instruments like derivatives, credit default swaps, collateral debt obligations, and securitized mortgages that led to huge debt-based transactions that enabled trillions of dollars to swirl around in an opaque and unregulated manner. All this freely flowing capital drove up stock prices.

There was increased innovation all right, but not all in a good way. The downside of all the dismantling of oversight was not long coming. The massive federal bailout of the savings and loan industry in the late 1980s and the growth and collapse of companies like Enron and WorldCom can be traced to the removal of those regulations that required at least minimally prudent and honest and transparent business practices.

While all those debacles should have been warning signs of underlying problems, the continued rise in the stock market allowed people to ignore the storm clouds. After all, wasn’t the rise in the stock market telling us that we were all getting wealthier, except for those poor saps who lost their jobs in the wake of the collapse of those giant companies?

Below is a graph of the Dow Jones index since its beginning.


Its value on January 2, 1980 was just 786. Like the S&P index, it too started rising rapidly after 1980, reaching a peak of 11,497 on October 1, 1999. It then dropped to 7,592 on July 1, 2002, rose to an even higher peak of 13,896 on July 2, 2007, and ended at 10,831 on October 1 of this year.

The alarmists are pointing to the 3,000 point drop in the last year as a sign of the financial collapse. But if we think the stock market should reflect the value of the ‘real’ economy as measured by the GDP, then it is possible to do a very rough calculation and see what the stock index values should be today based on the growth of the GDP.

If we take the average annual GDP growth rate of 3.5% and add to that the average inflation rate of 3.5% as measured by the CPI, then we can calculate what a 7% growth rate in the Dow, starting with its value in 1980, should give us today. That turns out to be about 5,500, about half today’s value.

If I am more generous and assign a total growth rate of 8%, I still only get a current index value of about 7,200. I need to postulate an astounding rate of 9.5% over the last three decades to get the current value of the Dow index, and would have to ramp it up to 10.5% to get the July 2007 peak value. Such huge growth rates in the real economy over such a long time are, of course, unrealistic.

So is it the case than rather than us currently having “lost” a lot of money, we never should have taken seriously the idea that we had so much money to begin with? Were we living in a dream world of imaginary wealth and living high on borrowed money? Is this financial crisis just telling us that by pumping another trillion dollars we don’t really have into the stock market we are simply postponing the day of reckoning since we are striving to maintain an artificial level of virtual wealth?

Michael Lewitt of Hegemony Capital Management (a hedge fund) gives his perspective. Given his position as a market insider, trading in the very kinds of things that are at the heart of the current mess, his critiques carry particular weight. He concludes that:

There is a point when free enterprise tips over into a degree of economic and social inequality that is politically unacceptable, and the United States has reached that point. HCM is well aware that its views on this topic genuinely anger many of its readers, but this is an issue that must be addressed as an essential component of any program that will return confidence to the financial system. Free market economic policies, in particular tax policies, have led to the creation of an American oligarchy whose wealth and power is excessive. While not as pernicious as the oligarchy that rose from the ruins of the Soviet Union and now lords over Russia and spends its money garishly over the world, an American oligarchy has unduly benefitted from ill-advised tax and economic policies and must be reigned in as a sign to Main Street that the game will no longer be rigged against it. (my italics)

His analysis of the causes of the current situation is similar to what I have been saying:

Financial busts are preceded by financial bubbles. The current bust was preceded by a debt bubble whose unique manifestations were debt securitization and credit derivatives. Underlying these novel debt structures were the human emotions of greed and fear that led to abuses by even the most sophisticated individuals and most highly respected institutions in the market. While these human attributes are the most difficult to legislate, their ability to wreak havoc is clear evidence that they must be regulated in a thoughtful way.
. . .
The profits that Wall Street generated over the past few years were not the result of some new-found genius in the executive suites, but were merely the product of adding unprecedented amounts of leverage to balance sheets.

He points out that all the current panic talk is being driven by short-term thinking.

It is a certainty that America, and then the rest of the world behind it, is going to experience a severe recession the likes of which it hasn’t seen for decades. . . One of the problems plaguing America is that we have become so frightened of short-term pain that we are willing to risk incalculable long-term suffering. Any plan that treats the symptom (the loss of confidence) and not the disease (the underlying problems that caused the loss of confidence) will not solve the real problem.
. . .
Despite the cries of pain from the credit markets, HCM has never believed that the world would spin off its axis if a deal is not rushed to completion in the next few days. A bad deal would be worse than no deal at all. (my italics)
. . .
In order to be successful, the Paulson Plan needs to be followed up by comprehensive regulatory reform that accomplishes the goals of convincing the public that the financial system will be fairer in the future than it has been in the past (i.e. that the gains will be spread more equitably and that failure will not be rewarded) and that strong steps will be taken to prevent the oversights that led to the current instability from being repeated.

He also points out that the heads of these financial institutions, while asking for the taxpayers to bail them out, are brazen in their demands, acting like they are doing us a favor by taking our money! And Paulson and Bernanke go along with that.

While trying to help rebuild confidence in American capitalism, Mssrs. Paulson and Bernanke tried to convince Congress that bank executives would prevent their institutions from participating in the bailout if it meant that their compensation would be capped. One would think, as the financial system teeters on the brink of collapse, that the Secretary of the Treasury and the Chairman of the Federal Reserve could make a more persuasive argument than one that poses the likelihood that corporate executives would knowingly violate their fiduciary duty and refuse to participate in a plan to rescue the financial system because it might limit their compensation.

Meanwhile, Pam Martens, who worked on Wall Street for 21 years, reads the fine print in the bailout plan and discovers what Wall Street hopes to win from it. It is an inside job in which the Treasury, the Fed, and Wall Street are using their agents in Congress to pick our pockets.

The more I think about it, the more this bailout plan looks like a swindle. I hope the members of the House of Representatives defeat it in its current form and instead demand a full and careful examination of the problem and what is needed to solve it.

POST SCRIPT: The Vice-Presidential debate

Well, the debate went pretty much as I expected. Sarah Palin was fairly coherent in her answers most of the time though I thought she overdid the folksy, down-home manner. By the way, did you know that she and John McCain are mavericks? And that Palin likes to talk about energy issues whatever the question?

Those who are not political junkies may have been surprised by the solid performance by Joe Biden, who has been pretty much ignored so far in the media coverage, overshadowed by the other three candidates. This may explain why early polls suggest that he ‘won’ the debate, though declaring winners and losers for such events is a largely meaningless exercise.

What was really surprising was the way Palin was flirting with me.

Sarah, give me a call and let’s get together for coffee sometime.


  1. Anonymous says

    Hi Mano,

    I am totally convinced now that this is a scam, however I’m quite surprised at the lack of people focusing on the issue of non-reviewable section of this bill.

    “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”

    Just reading this sets off every alarm bell in my head. Should someone not be asking Paulson “Why must this be in the bill? What does this do to help restore the “confidence in the market”? What assurances does the public have that you won’t abuse this money and power?”

    I would love to hear absolutely any good reasons why this should be in there?

  2. Alex says

    I completely agree with the previous commenter. There is no reason that such a provision was necessary in the bill, unless Paulson is going to need it further down the line.

    On a different note, Sarah was clearly flirting with ME!

  3. Ravi S. says

    Hi Mano,

    Since I’ve been reading your blog for a while, but I’ve never actually left a comment, let me introduce myself. I was a student of yours in 2001-2002 for P121-22. I’m currently a graduate student at Duke and work on CDF at Fermilab in Chicago. I used to work for Corbin.

    I have a couple of friends on Wall Street working in … credit default swaps (just entered the company two years ago). I had a conversation with one of them yesterday and he called it the biggest creation of fake currency in history.

    As you probably know, credit default swaps are effectively “insurance” on loans, except that anyone can buy them with no requirement to own the loan the CDS is for, effectively enabling them to be used as a gambling tool. You also know that the corporate climate of Wall Street during prosperous times encourages underwriters of CDS to be as aggressive as possible, as that lowers the cost of the insurance. These assumptions aren’t questioned when purchasing a policy; it is assumed the company underwriting the policy did their homework. To this effect, a company would often underwrite a CDS, then turn around and purchase a CDS from another company willing to provide the insurance at a lower cost (with a more aggressive set of assumptions). Since no company actually has the resources to pay out the CDS policy on all the failing loans, this sets up a daisy chain of failing companies.

    Any money (like the 700 billion) injected into the market will be used to sell worthless loans to the fed. The problem is that this is not enough to invalidate the overly aggressive assumptions about CDS that were made in better times. The daisy chain of CDS calls will still continue and the banks will continue to fail. The estimates I’ve heard about how much money it would take to fix the issue this way range in the ~10 trillion range, which seems reasonable given the 63 trillion of CDS policies currently held by companies across the world. The 700 billion will be gone in a few months.

    Seeing an inevitable failure of this bailout plan to help in the long term, an alternative plan has been suggested by some. Based on a very similar proposal by Bo Lundgren (deputy financial advisor during the very similar Sweden 1992 crisis), it suggests using government money to setup a bank to loan out money to businesses that are following sound business practices (in this case, not investing in CDS). Leveraging of 8:1 is very reasonable, even in difficult times, so a 700 billion pool of capital could easily inject 5.6 trillion into the economy, with a much better recovery rate than the bailout proposal that was just passed. This money would go to normal businesses to pay workers, balance inventory, etc., all the normal things businesses use loans for. By law it would be forbidden to be used for speculation or paying down of existing liabilities due to CDS. The current banks will fail (painful but necessary), but the rest of the economy will stay strong. It also has the upside of avoiding moral hazard for these big financial giants and their executives.

    I have talked to my (very liberal) democratic congressman, and he has talked to some of the heavyweight economists about it who speak of it positively. Although political will is currently lacking, there’s a chance that this proposal could be put into place by a new administration.

    Oh, and there’s a really nice article here about the rise of Wall Street in the american corporate culture since the 1980 Reagan revolution. Seems to coincide with the turning point that you mention quite well.

    Also, I don’t know if you’ve read “The Shock Doctrine” by Naomi Klein, a google search of your blog didn’t turn anything up. It a very interesting (and horrifying) book about how certain ideologies (especially capitalism) push through ideas onto an unsuspecting public in times of crisis under the guise of prompt and necessary action. It changes the way you look at crisis, and I would definitely recommend it.

    Cheers, Ravi

  4. says


    Nice to hear from you! The kind of plan you speak of is what should have have been debated, along with other plans, instead of Congress being steamrolled.

    I have heard of “The Shock Doctrine” and listened to many interviews with Klein but have not actually read the book, which is why I have not mentioned it on my blog. But what I have heard seems to me to be sensible.

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