2009 January 25 Sunday
Jeremy Grantham On Popping Financial Bubble

Accomplished money manager Jeremy Grantham muses on why top financial institutions failed to see the popping of the debt and real estate bubble.

I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming.

I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers.

So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored.

More than a few dozen people saw that the US economy was on an unsustainable path and in a housing bubble. See this debt bubble chart starting in 1915 that was published in 2004. Note that the big debt run-up as a percentage of GDP during the 1930s was because of the economic contraction. Whereas today we have a far larger debt as a percentage of GDP even before economic contraction.

Why do CEOs of big banks act in such irresponsible ways when something like a housing bubble is developing? I suspect part of the answer is they are aiming for short term profits and figure the bubble will last longer than it turns out to last. Some bubbles last a long time. The housing bubble is part of a debt bubble that started building in the early 1980s. Here is another graph on the long term trend in US debt. That's an unsustainable trend which has gone on for decades. A lot of people have made a lot of money betting that the trend wouldn't hit the wall and reverse while they held this or that stock or other investment.

Barack Obama uses rhetoric about sacrifice but so far our economy is running on the assumption that foreigners will continue to sacrifice consumption and buy our debt to allow us to live beyond our means. They will not continue to do so. When they stop that'll come on top of the bursting real estate bubble.

What he might have said was that the nations funding the majority of America's public debt -- most notably the Chinese, Japanese and the Saudis -- need to be prepared to sacrifice. They have to fund America's annual trillion-dollar deficits for the foreseeable future. These creditor nations, who already own trillions of dollars of U.S. government debt, are the only entities capable of underwriting the spending that Mr. Obama envisions and that U.S. citizens demand.

These nations, in other words, must never use the money to buy other assets or fund domestic spending initiatives for their own people. When the old Treasury bills mature, they can do nothing with the money except buy new ones. To do otherwise would implode the market for U.S. Treasurys (sending U.S. interest rates much higher) and start a run on the dollar. (If foreign central banks become net sellers of Treasurys, the demand for dollars needed to buy them would plummet.)

In sum, our creditors must give up all hope of accessing the principal, and may be compensated only by the paltry 2%-3% yield our bonds currently deliver.

As absurd as this may appear on the surface, it seems inconceivable to President Obama, or any respected economist for that matter, that our creditors may decline to sign on. Their confidence is derived from the fact that the arrangement has gone on for some time, and that our creditors would be unwilling to face the economic turbulence that would result from an interruption of the status quo.

We have multiple problems that could easily start feeding on each other in a vicious cycle. We have a dumbing and aging population. Those two demographic trends will cause huge problems even without a debt bubble. We also have overpriced real estate and lots of insolvent banks that are walking zombies. We also have an unsustainable trade deficit where we live beyond our means. This deficit keeps driving America ever more deeply in hock to the world. Plus, peak world oil production is on the horizon. Add all these things up and our current financial crisis might just be the opening chapter on far bigger problems.

Update: Back in November 2008 Arnold Kling opined on where our economic trends are taking us: the US government will strip assets from the productive.

My point is that sooner or later the U.S. government is going to have to get serious about stripping the assets of those of us who have tried to live within our means. Sooner or later, the profligate are going to take from the prudent, the grasshopper is going to confiscate the property of the ants.

If you've got wealth, you need to find a haven for it. You don't want to keep it in a banana republic for too long.

That this sounds correct is a very bitter pill indeed.

Update II: John Kemp thinks the US and UK are headed for a debt crisis.

From the 1970s onward, however, the economy has undergone two profound structural shifts. First, the economy as a whole has become much more indebted. Output rose eight times between 1975 and 2007. But the total volume of debt rose a staggering 20 times, more than twice as fast. The total debt-to-GDP ratio surged from 155 percent to 355 percent. Second, almost all this extra debt has come from the private sector. Take a look at Chart 2 (https://customers.reuters.com/d/graphics/USDEBT2.pdf). Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.

Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.

Policymakers were complacent about the build-up of private sector debt because they naively thought that since companies are guided by market forces that the companies were competent to manage the debt.

For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.

In the wake of the last year of financial failures and bail-outs this faith in the financial institutions seems, er, dated.

Mish Shedlock responds to John Kemp and argues the US government might not be able to inflate the private sector out of its debt trap.

Clearly GDP needs to rise or debt levels reduced to reach a sustainable path. Kemp argues "widespread bankruptcies are probably socially and politically unacceptable."

While I agree with that statement in theory, practice is another matter. I do not believe government has a realistic choice in an environment of global wage arbitrage, changing consumer attitudes towards debt, and demographics of boomer retirement.

Mish thinks we are going to repeat Japan's deflationary pattern of the 1990s with repeated recessions and little economic growth.

Can we keep having a huge debt-to-GDP ratio or has the damage to the lending institutions become so great that the debtors are going to have an increasingly hard time rolling over their debts?

Share |      By Randall Parker at 2009 January 25 01:26 PM  Economics Credit

Anonymous said at January 25, 2009 3:28 PM:

The Chinese have been signaling for some time that they are sick of this. They have spoken of pegging their money to a basket of currencies instead of to the failing dollar. What if they pull the plug ? My guess -- U.S. standard of living falls 25% to 50%.

One aspect of the Barack presidency that is overlooked is the psychological aspect. The Asians have always viewed the USA as a European-populated country. The Japanese were defeated by whites, not blacks. The Chinese were fought to a standstill in Korea by (mostly) whites. The tech that Asia learned from the West came from whites, not blacks.

Now, the USA has a black face. What will Asians think ? What will they feel ? In Japan, blacks are the people that gang rape schoolgirls. The media covers this up, but whenever you hear of "Jarheads in Okinawa rape girls" it's alway blacks. The Japanese people know this and they hate it.

My guess is that Asians will start to psychologically detach themselves from the USA. The USA will be seen in the same light as Brazil or South Africa. They won't kowtow anymore. They won't buy the debt. They will turn inwards (Japan + China treaty) or turn away from the West.

This is gonna hurt. The USA, in it's multi-racial incarnation, is not a stable place. It requires massive amounts of goodies (cheap toys), food, drink, and drugs to keep the lid on. When this thing blows it's gonna blow sky high.

miles said at January 25, 2009 6:02 PM:

Randall, what do you mean by this exactly:

"My point is that sooner or later the U.S. government is going to have to get serious about stripping the assets of those of us who have tried to live within our means. Sooner or later, the profligate are going to take from the prudent, the grasshopper is going to confiscate the property of the ants.

If you've got wealth, you need to find a haven for it. You don't want to keep it in a banana republic for too long."

Do you mean that if you a guy with a paid-off house and car, the government might tell you that you have to give them up to the less fortunate or something? I know higher taxes are on the way if thats what you mean for the productive who make over 60K a year or whatnot. Hell, I expect that. I also expect higher taxes when retirees tap their 401Ks and IRA's when they retire.

What ideas, worst case scenario, do you think might be contemplated if economically Asia does pull the plug on us?

averros said at January 25, 2009 6:17 PM:

"Sooner or later, the profligate are going to take from the prudent, the grasshopper is going to confiscate the property of the ants."

US was doing that, increasingly, since establishment of the I.R.S.

Actually, one thing we can safely bet on is that rich politicos and their corporate friends will only get richer while the middle class gets taxed to poverty. That, or a rebellion. I'm afraid Americans became domesticated wimps long time ago, so the decay into a banana republic (with nukes but without bananas, Soviet-style) is inevitable.

black sea said at January 25, 2009 11:23 PM:

Lots of people in the real estate sector knew that the pace of development, and the inflated real-estate prices that sustained it, were not going to continue much longer. But if you're an executive in that sector, what do you do? As Michael Lewis has pointed out in the NY Times, so long as other companies are turning a profit, you can't really justify not staying in the game. Your company has a broad range of fixed costs; how do you get away with saying, "We think the market is overheated, and we're just going to sit this thing out until it collapses." Your career will collapse before the market does.

A friend of mine who's an architect told me about a conversation he had with a couple of real estate developers. He told them that he couldn't understand the condo market in Atlanta, since, for the level of output to make sense, practically every single person moving to Atlanta would have to buy a condo, and Atlanta is overwhelmingly a city of single-family homes. The two developers acknowledged that there was no way that all these condos could be sold at a profit, but none of their own money was at stake, and they would be financially divorced from these projects long before it became obvious that there was no money to be made there.

Multiply those circumstances and attitudes by several thousand, and I guess you have a real estate crisis.

Kenelm Digby said at January 26, 2009 4:07 AM:

At root, the recent trend to those two weasel word misnomers 'globalism' and 'neo-liberalism' must be blamed together with their two greatest cheerleaders those two pieces of used toilet-paper 'The Economist' magazine and the 'Wall Street Journal' which advocated those policies so viciously and duped a lot of stupid, vain politicians into enacted those policies (you see politicians are generally white trash with ego problems and law degrees who wish to seem 'clever' as well as 'powerful', the way to appear 'clever' is to read 'The Economist' and actually be unwise enough to enact the policies advocated by the silly bastards who write that shit).
The current debacle is the inevitable result of paper fiat money, 'free-trade' commanded by supra-national diktat with nations that the USA could never hope to compete with ona level playing field, hence the piles of paper wealth end up in China - and the danger is that the paper will actually be exposed for the con it is.
The 'clever' fuckers at the 'The Economist' love to castigate trasde policies in the 18th century when money actually had an intrinsic value in itself and debtor nations were pauperized by actual draining of specie.
In fact, those 18th century 'mercantilists' had much more of a clue or a brain td lumps of hook-worm infested excrement at 'The Economist'.

Wolf-Dog said at January 26, 2009 5:22 AM:

Historic charts of the trade deficit of the United States can be found here (middle of the page):


During the last 10 years, an average of $500 billion per year is transferred to foreigners (during the last few years it is more than $700 billion per year.) This is the amount by which Americans are getting impoverished every year. It is clear that ultimately the U.S. will have to stop this and start local jobs to manufacture whatever is needed. The prices that we pay to purchase the imported foreign goods, are only slightly cheaper than what the price would have been if the goods were produced here, because even though the actual labor cost in Asian countries is low, the wholesale importers are making are making a huge profit by marking up the price, so that the ordinary American is still paying a price that is not much lower than what we can produce here. Thus within a few years, it is almost certain that by necessity, the trade deficit will be balanced.

Bunkered said at January 26, 2009 10:14 AM:

miles and averroes,
Discussions about looting 401 K plans have been in progress:


Hide your money if you can. And buy precious metals like brass and lead...

geezerette said at January 26, 2009 1:28 PM:

How does one 'hide' money? There is always a paper trail and always income tax to pay on IRAs and 401Ks, so how does one liquidate and hide this money? I am retired and have lived very in order to save for my retirement years and I retired with no debt and I still have no debt. I was smart enough to go to cash in early July so
my retirement funds (my only wealth) lost only about 3%. How does one not leave a paper trail?

Randall Parker said at January 26, 2009 8:32 PM:


Depends on who or what you are trying to hide the money from and what trade-offs you want to make.

One way to hide money: take it abroad to a good place for bank secrecy (assuming some exist), buy stock in a company (preferably foreign) that earns no dividends (so no taxable income) that you think has great long term growth prospects, and leave the info at that bank where you did the transaction. You have to make guesses about long term stability and quality of investment.

But there are less extreme approaches. Keep in mind that capital gains tax is a transaction tax. Buy to hold for a long time and you can avoid lots of taxes. Buy a foreign company and you can avoid a big surge in US taxes. Though in theory the government could start taxing ownership of assets other than land assets.

It really comes down to how to hold your assets. That depends on how much you know about investing, how much you have to work with, how much risk you can afford, and how much energy you want to put into it.

Alastair said at January 27, 2009 12:33 PM:

The following book (which I bought before Christmas and am reading) pretty much predicts the whole mess - from over 5 years ago.

Some of the stuff is uncanny in that it feels like it was written yesterday.

The Dollar Crisis
Richard Duncan

Richard Duncan's a financial analyst who (like Roubini) seemed to see it all a long time ago and was also ignored. Very depressing.


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