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"Much has been written about panics and mania…. But one thing is certain; that at particular times a great deal of stupid people have a great deal of stupid money. At intervals… the money of these people — the blind capital, as we call it, of the country — is particularly large and craving: it seeks for someone to devour it and there is a 'plethora'; it finds someone and there is a 'speculation'; it is devoured and there is a panic." – Walter Bagehot, "Essay on Edward Gibbon"

The New Model Army

Right up to the second half of July, not only were commodity markets strong, but world equities were still raging ahead in utter denial of the spreading cracks in the credit boom, with both the S&P and the emerging markets' indices making new highs in that time. All this despite the fact that there were elevated sentiment readings: record-high margin longs on the NYSE; record-low mutual fund liquid asset percentage holdings; a major turn in the breadth of the market (that for the NASDAQ has, indeed, since hit new multi-year lows); and volatility indices were climbing with — rather than against — the rise in stocks.

It is now clear that the sense of invincibility displayed by so many players was singularly ill judged. Far from forming a "permanently high plateau," the early summer seems to have marked nothing less than the nose-bleedingly vertiginous pinnacle of what has arguably been the most spectacular mass hysteria in the whole sorry history of financial market manias — namely, the multi-trillion-dollar Ponzi scheme of credit we have created since the collapse of the technology frenzy.

Though there were those who had occasionally sniffed that "irrational exuberance" had begun to appear in any number of asset classes, the majority lacked the crucial insight that the cause of all this mischief was none other than the credit bubble that had continuously been inflating prices everywhere you looked (though, ironically, everywhere the central banks were choosing not to look, at the same time).

The real bubble was in credit: all others — whether in uranium companies, LBO targets, Patek Philippe watches, or Modernist daubings — were ancillary to what the woefully uncomprehending ex-Fed chairman once called a "conundrum," but which was, in reality, all too understandable a phenomenon.

In saying this, we were often haughtily dismissed by institutional investors who could nod in knowing agreement that, say, nickel might be overstretched in the near term, or that oil contangoes made energy indexes a mug's game, but who were still perfectly content to buy yet another pease pottage of dubious, rag-tag credits from their overeager investment bank account managers, each secure in the belief that the statistical hocus pocus that purported to value these baskets afforded him a wide margin of safety.

As the events of the past few weeks have begun to reveal, however, this last presumption has proved just as fatal as all of its many less-than-illustrious predecessors in the perpetration of mathematical hubris. As one hedge fund manager icily told his shell-shocked investors, "[T]he fund was doing well until the market suddenly became inefficient…!"

Such is the unquestioning faith placed by a generation of self-serving technocrats in the alchemical mummery of the "models" by which they market their skills to investors.

A House Divided

Despite the journalistic fixation with the term, "sub-prime," we must not allow ourselves to be misled into thinking that the world is going to go into a tailspin solely because of the travails of the odd hundred-thousand poor fools whose painful desire to make a fast buck flipping condos met a none-too-choosy lender with similarly short-sighted motives.

The plain fact is, however, that the laxity of lending and the euphoric rush of freebasing on risk never limited itself to such a low-rent corner of the world, for far more sophisticated financial operators were also all too eager to don their beads and boaters and to join in the Chuck Prince Charleston, for as long as the band was playing.

So, the whole colorful motley of hedge-fund gunslingers, private-equity barons, bond insurers, CDO traders, and fixed-income investors — the whole out-of-control business of steepling M&As, of vast share buybacks (and hence of main-market equity market performance, as well as emerging market re-rating) — the whole self-aggrandizing swagger of the Bulge Bracket bonus bonanza — all of it — every last red cent of it — has been, in turn, cause and effect of the build-up of the storm system which now threatens to sweep this Big Easy of false prosperity away, leaving little but the matchwood of shattered dreams and disabused expectations in its wake.

Therefore, even if we, personally, have not been knowingly playing the ragged edges of the credit game, the fact that the mighty hurricane which looms above us made its first landfall in the sprawling, plasterboard suburbs of sub-prime is no reason for complacency, for, as is just beginning to be glimpsed, sub-prime is itself no more than a particularly indefensible subset of the far more widespread dangers we all now face.

It is indeed a testimony to today's utterly Carrollean mentality that the sight of the some of the world's largest banks elbowing each other in the queue to secure penalty rate funding from the central banks has been near-unanimously taken as a positive development and a signal to buy back some of the more beaten-down stocks! With little chance of enjoying anything other than a poor gruel of corporate and economic bad news in coming months, the callow eagerness to go bottom-fishing after such a shallow correction should only serve to confirm the belief that the herd will come a cropper over its unwillingness to admit that hard times lie ahead.

In truth, the whole Grand Guignol presently being performed on Wall Street and in the Square Mile is nothing but a highly dramatized and extremely compressed allegory of the misery a credit inflation serves to inflict on real businesses and real people. While it may be hard to suppress entirely a touch of Schadenfreude at the difficulties now being posed to hedge funds peopled by the sort of individual who had "forgotten" that he had left his $150,000 custom Maserati sitting for months on a London parking meter, a sense of long-overdue comeuppance should not obscure either the wider lessons to be drawn from the crisis, nor hide the fact that the ensuing pain is all too likely to keep bankruptcy lawyers burning the midnight oil far beyond the Hamptons and the Home Counties' hideaways of the fallen Lucifers of leverage.

The Usual Suspects

The common denominator to all these recurring episodes of avoidable madness is nothing other than loose money. This may be fostered deliberately by policy makers; it may be the result of some such historical accident as the conquest of the New World, or the discovery of gold in California or Kalgoorlie; or it may result from the adoption of a financial innovation which economizes on the existing stock of money — possibly by introducing new, highly geared derivative instruments, such as Renaissance fractional reserve banking, options on tulip bulbs, partly paid Mississippi Company shares, New Era margin debt, or today's vastly more powerful implements of Frankenfinance.

Overeasy credit — and the artificially suppressed real, risk-adjusted interest rates it engenders — unfailingly encourages too much investment in too many false projects. Financiers become reckless, investors switch what savings they still make into more speculative, longer-lived vehicles and — showered with the resulting bounty — entrepreneurs are misled, en masse, to see real opportunity where there is only the shimmering mirage given off by hot money.

The resulting surge of new project financings, of increased bank lending and bond issuance, and the enthusiastic provision of venture capital soon gives rise to a marked resurgence of general business activity and to falling levels of unemployment.

Until costs make up their initial lag and begin to rise in proportion to selling prices, the injection of new credit and the stimulation of new investment will also have the effect of boosting accounting profits at both the micro- and at the aggregate levels and will thus appear to justify the mass hysteria that this latest of "New Eras" will, by now, have unleashed.

Sadly, the whole of this gleaming superstructure will be built on sand. For, as Leon Walras once put it, here in Lausanne: "The expansion of … credit does not create [physical] capital, but a new demand for capital and the capital itself remains to be created."

It is in the pervasive semantic confusion over the meaning of the word "capital" that most of the problems arise, for the fact that too many cloakroom tickets have been printed (too much new, unsaved credit has been granted) is likely to mean that a fight breaks out in the foyer after the final curtain falls. Even if fisticuffs do not ensue, the simple fact is that some trusting soul is going to end up going home unprotected against the winter chill.

Thus, the crucial flaw in the development of the boom will lie in the fact that entrepreneurs and their financiers make the mistake of taking an abundance of financial capital (which they themselves have largely created out of thin air) for a correspondingly deep pool of physical capital and labor resources upon which to draw, without altering the prices plugged into their ROI calculations too adversely.

In essence, market interest rates — which are supposed to express the degree of our preference for jam today over jam tomorrow — become scrambled by the credit expansion and are not signaling that savings have been voluntarily increased (less jam today, please) so that a greater pool of resources lies available for redeployment into new investment projects (more jam tomorrow, thank you).

Thus, the timetable for the delivery of sufficient consumer goods to meet income earners' sequential demands will be thrown awry. Lower rates may well allow promoters access to finance, but they do nothing to ensure that they will be able to turn it into the physical capital they need to carry out their plans — at least not without putting themselves dangerously at odds with the desires of the very consumers they think they are serving.

Long time-scale investment rises, yet no one voluntarily saves any more. To the contrary, given the increase in money incomes that all that extra business activity will bring about, taken in combination with the prevailingly low-interest-rate environment, saving may well go down, both proportionately and absolutely. This is especially the case if people are gulled into believing that the asset price appreciation that is a likely accompaniment to these conditions has somehow made them effortlessly wealthier.

Of itself, this is enough to introduce a debilitating degree of abrasiveness into the system for, while credit can serve well enough as a fuel, it turns out to be a poor lubricant. Effective (though not always imagined) managerial horizons are now foreshortened (in executive speak, there is little "visibility') even as plans have become more grandiose. To paraphrase von Clausewitz: Everything is very simple in an inflationary boom, but the simplest thing is difficult. These difficulties accumulate and produce a friction that no man can imagine exactly who has not seen inflation.

Let Them Eat Cake

But this is only an interim stage, for the inevitable consequence is that final goods prices will begin to rise, narrowing the gap — and finally overtaking — the gain in prices being paid for investment and intermediate goods.

Once this happens, the seeds of disaster, sown by the credit expansion, will begin to germinate, for this is the point at which the less-specific (or, if you prefer, the more-versatile) "factors" (people, machinery, land, and raw materials) will be bid away from work on the longer-horizon, slower-amortizing undertakings — or, just as calamitously, from the later processing of their output somewhere amid their convoluted progression from mine and machine shop to the mall. Instead, they will be enticed away into now-more-lucrative activities directly seeking to fulfill the desires of the crush of would-be consumers, eagerly cluttering up the high street and haunting the estate agents' offices.

After seventy years of Keynesian indoctrination, this crucial point — that too much consumption, rather than too little, is the most likely cause of an economy-wide cardiac arrest — has become harder to grasp than it should be. In truth, there is not that much difference in the mechanism at work (even if the ramifications are here less momentous) when horizontal, rather than vertical, competition arises — when people decide they will buy sneakers, not sandals; or a Lexus, not a Lotus. The winner thrives and can pay more for its inputs: the loser cannot respond as its revenues are shrinking fast. Think "Betamax."

Perhaps the reason that this makes intuitive sense is that is founded in microeconomics — in truth, the only viable subset of the modern canon. Once we move up to macroeconomics, however, the ludicrous convention exists that a homogeneous slug of new consumption demand instantly and automatically prods owners of a similarly monotonous block of capital into taking the action appropriate to meet it. This leads straight to a belief that while competition for resources across a given slice through the productive structure is a commonplace, a similar contest up and down it must be decisively ruled out.

Yet, if we start from the other end, we can perhaps illustrate how this stultifying disharmony between investment and consumption may sometimes spring up by taking the case of a nation at war, or by looking at the brutal, peacetime industrialization pursued by Europe's red- and brown-shirts in the 1930s.

The popular fallacy persists that these acts of violent mass coercion served as the only effective remedy to the Depression which had plagued that dark decade — a misperception that confuses a process of genuine recovery with the bare truth that the whole workforce had at last found employment — whether as the ultimate exhaustive consumers who peopled the state's vast, conscript-slave armies, or as the factory hands busy hammering out, not goods for their own enjoyment, but the tools of destruction (the "bads") with which their brothers and sweethearts in the front line would be fitted.

The truth is that all this "investment" was, in fact, crowding out the satisfaction of the individual's everyday wants. Flags may have waved and anthems bravely blared, but the workers' lot was to endure the enforced penury of an unrelenting toil, their only real reward one of shortages, queues, and rationing, while being browbeaten into sinking the unusable surplus of their earnings into war bonds — a singularly inapt vehicle for preserving their wealth in such an inflationary milieu.

Though a deal less extreme in its choice of means, it must be recognized that there is little a priori economic difference between this particular tyranny and the much more commonly practiced attempt to deny the free expression of the individual's choice in disposing of his income — the so-called "forced saving" — which takes place under the conditions of an investment-led credit expansion.

This may, indeed, be much the more efficient method precisely because it does not need the overseer's whip or the threat of the gulag to effect it (as the rather milder, collectivist planners of today's China have long since worked out). The fact that the worker at first colludes in his own expropriation may appear at the outset as the main strength of this approach, but, once the deception is rumbled, this misguided voluntarism rapidly degenerates into a critical failing if he should at last decide that he'd actually like to taste some of the pie he's been slaving over in the collective kitchen.

In all such examples, an underlying sense of aggregate impatience — of "time preference," in the jargon — has at last reasserted itself and shaken off the initial distortions of the credit injection to determine, once more, the relative prices of cash (or goods) today and the promise of cash (or goods) tomorrow.

It is at this critical juncture that — absent a further intervention to re-energize it by injecting yet more producers' credit into the system so that higher-end firms may once again enjoy a transient lag between the rise in input costs and selling prices — the great ocean roller of the boom is likely to topple over and crash as it races over the reefs of its own internal contradictions.

Thrown a Curve

Assuming that no fresh influx of funds does appear, this may also be the point where the dreaded omen of a negative yield curve may appear. Short-term money rates will soar as hard-pressed businessmen find themselves embroiled in a bidding war for the factors they so urgently need to complete the transformation of their wares to saleable final goods — factors whose reward their own internal cash flow has suddenly become too meager to encompass.

Another feature of the aggravated need for working capital may be that some of those caught out by this uncoiling of the inflationary tangle will choose to finance a store of unsold inventory, or to extend further credit to a customer by way of shifting it off their own books and temporarily avoiding scrutiny. Unwilling, just yet, to admit defeat and to clear it out at whatever disappointingly lowly price the market will currently bear, they have thus become no more than leveraged speculators on a resumed rise in that inventory's price.

In sum, anxious to salvage anything they can from the wreckage of their plans, the swelling ranks of struggling producers will be willing to pay interest not merely up to the level of their expected profit, as before, but even up to the full extent of their (soon to be foregone) depreciation allowances as well — a phenomenon Hayek termed: "investment that raises the demand for capital."

Whatever specific form it takes, the inescapable denouement to this drama is that the fatal divide between entrained investment and the ex ante desire to save will come to reveal the utterly false premises on which the boom was launched.

As costs rise and revenues fall at the multitude of firms undergoing this excruciating dislocation, they will begin by freezing all discretionary spending — especially that earmarked for new capital outlays (note that this will reduce macro measures of profits, as well as pressuring genuine micro ones, by lowering the total of revenues not matched by the same-period booking of costs in the tally). Next, outside business services deemed "non-essential" will be curtailed and, finally, redundancy notices will be issued to the workforce.

The first of these countermeasures will tend to focus much of the pain up into the higher-goods sectors. Here, revenues derive much more from expenditures made by their fellow businessmen below the line rather than above it, the type of spending which is much the more deferrable of the two. Moreover, those bearing the brunt typically turn out the most narrowly specific range of products, goods themselves often requiring the most specialized equipment to make. These are therefore the types of companies least likely to find any alternate outlet, once orders fail to be renewed or start being canceled by their regular clientele.

Whatever the specific trigger for the turn, once we have reached the point where the investment boom cracks, we find it typically takes the form of a cascade of failure and retrenchment spreading downwards — not upwards — from the capital goods manufacturers to the High Street.

Since, in a modern economy, business spending dwarfs the total of final, "retail" outlays, in contrast to popular belief, the intensity of the end-consumer's penchant for spending is far from being a leading sign of distress, for it is only now, when the malign influence of rising unemployment makes itself felt that boom-swollen incomes shrink and the tinkle of cash registers begins to fade.

The recession has now truly arrived, though not, you will note, from any lack of "effective demand," but rather due to a surfeit of defective — that is, mutually incompatible — demand.

In saying this, we should not lose sight of the fact that each bust has its own idiosyncrasies that diverge in some fashion or other from this bald stereotype. For example, in our current performance of the tragedy, though the classic top-down avalanche of failure is still likely to make its appearance among the "real" industries as the entrepreneurial disruption spreads in the wake of the credit shock, the twist to the familiar plot is that, this time, Dame Finance may well be the first to succumb to the trauma of her many self-inflicted wounds.

Modern "finance" is, of course, itself an industry of significant scale; accounting for over one sixth of US gross output. It is the one, to boot, which is being most seriously discommoded at present, largely as a result of its own egregious behavior during the boom. Indeed, as a business that has undergone a period of remarkable hypertrophy — whether we look at growth in assets, traded volumes, securities in issuance, derivative contracts outstanding, floor space, payrolls, or pay packets! — a protracted suspension of the present asset inflation cannot fail to reveal a degree of collective managerial error among bankers, brokers, and fund managers on a scale likely to dwarf the puny travails of the overambitious steel magnates or disappointed copper miners who may be staring nervously down the same barrel of restriction as the one now threatening their larger creditors.

As one of the prime beneficiaries of this latest episode of inflationary wealth transfer, finance has done far more than simply channel cheap funds to real business. Rather, its own spending decisions have come to loom overlarge in the consciousness of all too many others — whether superstar architects, IT salesmen, business travel facilitators, yacht brokers, or Savile Row tailors — meaning that the smoke rising over the Valhalla of value-at-risk will prove a portent of much hardship ahead for all those who have thus far helped lighten the bulging pockets of the financiers in their turn.

Sifting Through the Rubble

How long will the downturn last? That's very hard to say, but it must be noted that — as Hayek confessed in later life — our modern interventionist state and its favored floating currency regime does allow the authorities much leeway to "smooth" (in truth, to disguise) the amplitude of the cycle, but only at the expense of stretching its wavelength and embedding its errors more deeply into the system.

As this particular boom teeters on the abyss of readjustment, the first impulse will be to continue to try to reinvigorate the dropsical financial network, which has been the first casualty of the crisis. After all, next to financing the predatory organs of the state, central bankers principally exist to underwrite their local cartel of perpetrators of that imperfect fraud we call fractional reserve banking.

Here, one suspects, they might face a more difficult task than is widely supposed at present. For while the use of open market operations, discount windows, and special facilities can help overcome a bout of illiquidity (a state that arises when maturing liabilities are of much shorter tenor than are the fundamentally sound assets that correspond to them), the problem of insolvency (when the worth of those assets falls well below that of the said liabilities) is far more intractable.

Sadly, it is the latter case that seems to be the more pertinent as we attempt to pick a path through the soaring massifs of highly compromised, pseudo-AAA debt. These mountains of unsound finance, you may be aware, were originally nothing but swamplands of unsaleable junk before the wondrous metamorphosis occurred when the presumed (but, it transpires, the drastically underpriced) residual risk was crammed into those improvised explosive devices of extreme leverage so favored by players themselves geared up to the eyeballs and funded, at root, by yet more leverage — that of last resort which is the modern banking system.

The degree of twisted ingenuity involved in all this infernal repackaging means that putting Humpty Dumpty back, intact, on his wall may well prove beyond the ken of all the king's horses and all the king's men, even if they do respond to the crescendo of political exhortations to "use all the available tools" — presumably that "technology we call the printing press" — perhaps by taking the "unconventional actions" (monetizing promiscuously first and asking questions later) previously arrogated to their box of tricks in the wake of the last fiasco.

As officialdom struggles to overcome the banking crisis, per se, thoughts will already be turning to other measures targeted at the real economy. For instance, the otherwise impeccable counsel of Bill Gross at PIMCO has been for Leviathan to prepare to mop up the mess and to send the bill later to the thrifty and prudent for the privilege of bailing out their greedier or less-foresighted neighbors.

Then, as already advocated in an intellectually dire FT op-ed penned by Martin Wolf, attempts will be made to foster sheer, mindless spending somewhere around the globe in a virulent pandemic of Keynesianism, spearheaded, perhaps, by those in charge of the trillions of dollars of forex reserves piled up in the centralized coffers of the Asian exporters and major energy producers.

If their export markets dry up along with the wellsprings of their consumers' credit, their governments will doubtless cajole the people into buying more of their own output as an offset. To the extent such goods themselves contain a high level of imports — and trade deficits thus threaten to replace the current surpluses — those same reserves, they will reckon, can readily be run down in order to pay the bill. And if the home currency weakens along the way? All well and good, from their typically mercantilist perspective.

Though this may indeed provide a breathing space if carried out with sufficient "in the long run, we're all dead" resolve, we shudder to think of the time a few years hence, when the Last Emperor is found naked and shivering in the half-finished halls of his jerry-built Forbidden City, as China's ramshackle scaffolding of bad debt, needlessly duplicated industries, rudimentary accounting, and pervasive corruption is no longer shrouded in the bright silks of oriental propaganda and occidental wishful thinking — and the wash of hot money consequently turns from swelling flood to roaring ebb.

However, even if the consumption-biased GDP aggregates do start to look better, as a result of a mass exercise of "bail out and build," don't forget that as the upswing gathered force, the cycle manifested itself in what we called a "lengthening" of the productive structure — in the undertaking of investments increasingly removed from the immediate provision of consumer goods, and especially of consumer staples.

A crushing asymmetry has come to bear here, as a result. This lies in the fact that it is far easier to achieve such a lengthening — to use easy money and expensive shares to build plant, lay pipelines, and fill the factory with banks of shiny, new, specialized machinery — than it ever is to shorten it again: to retool the assembly line for a different (more exhaustively consumable) use; to bring a different ore out of the same mineshaft; to break the equipment profitably up for scrap — when the premise on which these bold steps were taken proves to be a mere falsehood spun amid the intoxicating mood of financial incontinence.

Since the quantity of capital, likely to be stranded when the tide of fortune goes out, will be both so large and so immobile, there will subsequently be little, if any, enthusiasm for an outright dismantling of that capacity. In the West, an expedient bankruptcy filing can both lift the burden of heavy dividend and interest payments and break now-insupportable labor covenants while leaving capacity intact: in the East, the central state will prevent liquidation just as effectively by other means. Neither will do much to speed the process of readjustment.

As a consequence, there will probably ensue a long period of submarginal economic returns to be endured in any such overbuilt business as its capital slowly dissolves amid a gnawing corrosion of high-grading, undermaintenance, and neglected depreciation.

Doubtless, too, some Broken Window-befuddled idiot will pipe up that it has all been worth it — that we wouldn't have all these factories, all these international trading hubs, and technology parks if it weren't for the bubble, but that's a little like trying to comfort yourself for your loss by saying you wouldn't have all those near-pristine Italian suits hanging in the wardrobe if you'd known you were going to put on that much weight right after you bought them.

However rose-tinted the perspective, the fact remains that much precious capital has been needlessly wasted during the boom and since the accumulation of productive capital is the only means by which we can ever improve our general standard of living, that loss cannot fail to be a meaningful one, even if its consequence can only be conditionally reckoned by way of a counterfactual narrative.

Under a more rational financial system, this regathering of strength would generally be accompanied by the higher real interest rates which are consonant with the reduced level of real capital now available and the next upswing would therefore begin on a sounder foundation, if to a timetable more considered than your average vote grubber might wish. In practice, therefore, such political intemperance will mean that official interest rates are likely to be held too low, for too long, all over again — at the cost of encouraging another two-act drama of inappropriate optimism and crushing disappointment a few years down the line.

East of Eden

In trying to visualize what the economic landscape will look like after this hurricane of deleverage has finally dissipated itself, we suggest you draw the lesson from sub-prime and start by looking for the corporate, financial, and sovereign equivalents of those who took out (as well as those who looked like geniuses for extending) larger and larger chunks of "NINJA" loans ("No Income, No Job or Assets"), even as the ship was visibly heading for the rocks. Among these will be found the most likely casualties of the bust.

Another hurdle we will have to overcome arose because, as Bagehot (again) put it,

The good times too of high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while, and long before discovery the worst and most adroit deceivers are geographically or legally beyond the reach of punishment. But the harm they have done diffuses harm, for it weakens credit still farther.

As we have just drawn the curtain down on the most lavish exhibition of mass credulity ever experienced, we can well imagine that the scandal sheets will soon be running extra editions in order to fit in all the coming revelations of "ingenious mendacity." Just as we did after the tech-telecom bubble, we can also wearily expect that what seemed at the time to have been a Gilded Age of corporate profitability will be rendered a good deal less extraordinary, once the accounts have been properly recast, in an era of temporarily greater rigor in such matters.

But that's as it should be. Prodigious amounts of capital were wasted in the boom and much of what was spent as income in the good times clearly included a large element of that squandered capital. The chief vices of the upswing — fraud, foolishness, and frippery — were terribly costly to sustain and — as they give way for a while to their opposite virtues of scrupulousness, skepticism, and sobriety — our records will have to be amended to reflect that fact.

At least it will give us something to do until we figure out where next to hitch up the engine of inflation. At which point we can once again cast off the hair shirts, put on our gladrags, and throw another wild, exuberant, but ultimately destructive, orgy of high living and hot money — and devil take the hindmost!