Summary: Much of the analysis of this great crisis — now clearly the worst since the 1930’s — focuses on minute, even trivial, aspects of the problem. This is natural, as its sweep and magnitude dwarf anything seen during our lifetimes (for most of us, at least). It has affected almost every business, kind of investment, nation — and before the end will probably affect almost every person (except those in the least developed nations).
The simple narrative for a crisis is that which came first must cause what follows. This seems plausible, since post hoc ergo propter hoc is the default reasoning mode of the human mind. Consider dropping colored grains of sand to form a pile. Eventually one will collapse the pile, perhaps a green grain. Is this then a green grain problem? Apparently so to many people.
First this was a subprime mortgage crisis. Then a securitized mortgage crisis. Then a housing crisis. Then a derivative crisis. The crisis drags us forward to an expanding array of problems, with many experts’ eyes fixed backwards on the past. Understandable, as looking forward is quite alarming.
Causes of this crisis
These financial shocks are byproducts of deeper trends, in my opinion. The world has begun a process of regime change, as the foundations of the post-WWII geopolitical order decay. Here are some of the major trends forging a new world. Each of these has played a role in bringing us to this point; some will play an even bigger role forcing events during the next few years.
(a) The transition from a bipolar (or unipolar) world to a multi-polar world.
(b) Entering the transition period to peak oil, as global oil production peaked (not necessarily the peak) in 2005. Since then biofuels have provided most of the growth in liquid fuel consumption. Rapid GDP growth (almost 5%) required high prices to match ex ante demand with flattish liquid fuel production.
(c) The replacement of the US dollar as the reserve currency (by what we do not yet know), after 30 years of foreign borrowing — 30 years of increasing current account deficits.
(d) The exhaustion from overuse of monetary and fiscal policy. Persistently too-low interest rates yielding serial investment bubbles. The long decline to near zero of the marginal elasticity of GDP with respect to debt.
(e) Structural weakness: Funding long-term businesses with “hot” (aka liquid) capital, from the disintermediation of household savings. Money shifted from vehicles where institutions bear the risk (insurance, annuities, CD’s, etc) to direct participation (owning stocks and bonds either directly or through mutual funds). See this post for an explanation.
(f) The Thomas Kuhn-type paradigm crisis in Keynesian economics, by which the world economies have been steered for fifty years. The aggregate debt level of an economy is not a significant variable; attempts to integrate into orthodox theory by radical Keynesians (e.g., Hyman Minsky) were unsuccessful. Sometime after 2000 we reached and broke though the edge of the “operating envelope” of Keynesian theory. We ran like Wile E. Coyote off the cliff and beyond — a few exhilarating years — and now we fall.
How comforting to think that these were Black Swan events! (from Wikipedia):
As formulated by Nassim Nicholas Taleb in his 2007 book The Black Swan … The term black swan comes from the ancient Western conception that ‘All swans are white’. In that context, a black swan was a metaphor for something that could not exist. The 17th Century discovery of black swans in Australia metamorphosed the term to connote that the perceived impossibility actually came to pass. Taleb notes that John Stuart Mill first used the black swan narrative to discuss falsification.
This relieves us of responsibility. Unfortunately, none of these were “black swan” events. All were widely predicted by experts for decades (see here for 2 dozen examples from major institutions and experts). These warnings were made early, allowing us sufficient time to act and prevent this crisis. The world is a large and ponderous vessel, which took generations for its internal weakness to finally capsize it. The failure of the boat to immediate capsize following the warnings was seen as proof that they were false.
This is not a new phenomenon. People’s impatience and short-sightedness are commonplaces in history.
On September 23 his fleet hove in sight, and all came safely to anchor in Pevensey Bay. There was no opposition to the landing. The local fyrd had been called out this year four times already to watch the coast, and having, in true English style, come to the conclusion that the danger was past because it had not yet arrived had gone back to their homes.
Description of William the Conqueror’s arrival, from History of the English Speaking People by Winston S. Churchill. Bold emphasis added.
We are at the stage where the full magnitude of these events has not yet become apparent, even to many experts. Hence the nonsense flooding the media, attributing these great events to the most trivial of causes. Here is a wonderful example (hat tip to Zenpundit):
“Top Theorists Examine Rippling Economic Turbulence“, the PBS Online Newshour, 21 October 2008 — “As the financial sector shifts, so does the reach of the jolt to economic structures around the world. Economist Nassim Nicholas Taleb and his mentor, mathematician Benoit Mandelbrot, speak with Paul Solman about chain reactions and predicting the financial crisis.”
Much of this is correct, of course. As in “Mandelbrot’s key insight came in the ’60s with a study of cotton price surges and plunges, suggesting the world moves in fits and starts, especially the human world.” This is a commonly seen pattern, in both history and the physical sciences (e.g., punctuated equilibrium in evolutionary biology).
But much of this is ”inside baseball”, concentrating on the details of the financial system while ignoring the great changes in the real world — driven by forces far larger than the dynamics of our banking system.
Some of this is just wrong. Myopia can afflict even the greatest experts.
NASSIM NICHOLAS TALEB: Let me tell you why it’s not like before. Look at what’s happening. The world is getting so fragile that a small shortage of oil — small — can lead to the price going from $25 to $150.
PAUL SOLMAN: A barrel.
NASSIM NICHOLAS TALEB: A barrel. A small excess demand in an agricultural product can lead to an explosion in price.
The world “wanted” liquid fuel growth of aprox 2% per year in 2003 – 2007. It got 1.4% per year — 30% less. Almost zero since 2005. (source of oil production #s: BP Energy Review). That is an ex ante shortage of roughly 2 million barrels per day, given oil’s low price elasticity of demand. Sufficient to drive oil prices up quite a bit; hardly a small shortage. this post for details.
This is not academic quibbling about the causes of our crisis. After first aid is successful we must begin serious treatment for our global economic and probably even geopolitical systems. At that point correct diagnosis becomes essential for a cure, and to prevent it reoccurring.
Originally published at Fabius Maximus and reproduced here with the author’s permission.