Europeans, Japanese, and even rose-colored glasses-wearing Americans are suffering from what has been described as an optimism deficit. This rather unthreatening phrase should not be mistaken for an insignificant economic problem.
Optimism fuels all sort of important economic activities, such as entrepreneurship, saving for the future, and social cohesion. It may in fact be the most fundamental immediate challenge facing the developed world today. But with pre-election political gridlock setting in, our leaders are big on rhetoric and short on concrete actionable ideas that can restore confidence.
There is one idea, however, that I believe could make a significant impact on restoring optimism, but before getting to that a brief personal backstory.
I lived in San Francisco and worked in tech during dot-com bubble and bust a decade ago, and it taught me a lot of lessons. But perhaps the most important one didn't come until several years afterwards. Having been away from California for a few years since the bust, I moved back in 2003. To my disbelief, I began noticing similarities between the still-nascent housing bubble and the one for which I had recently had a front-row vantage. The tech bubble seemed too fresh in my mind for the kind of speculation on housing that was taking place. While the assets were different (tech stocks vs. real estate), the underlying psychology was eerily familiar.
I did not have the foresight of Michael Burry, Steve Eisman, and the founders of garage startup hedge fund Cornwall Capital to cash in on this observation. Instead, I simply ignored peer pressure and pesky real estate salespeople who warned me that if I didn't purchase a home now I would be priced out of the market forever. Another memorable ribbing from that era was the "you're throwing your money down the drain" by renting year-after-year. When the 2008 financial crisis hit, it made the Tech Bubble look like a small financial radar blip.
Witnessing two significant financial crashes in such close proximity to each other left an indelible lesson, which was to never underestimate how quickly a large number of people can forget a traumatic financial event.
This month marks the four-year anniversary from what was arguably the canary in the coal mine moment, the July 2007 collapse of two Bear Stearns hedge funds, both of which were heavily invested in mortgage securities. Bear Stearns itself blew up approximately nine months later, and it would take until September 2008 for the crisis to reach its nadir with the simultaneous implosion of Lehman Brothers, AIG, Merrill Lynch, and a bevy of other financial firms.
The case of Citigroup (NYSE:C) bears special mention. Its collapse and bailout marked the third time in the last quarter-century that the firm needed to be rescued by the government (the other two instances being the 1982 Latin America debt crisis and the late 1980s bust in commercial real estate, which sparked the S&L crisis). Yes, that's right, about once every eight years on average Citibank blows up and needs a taxpayer-funded bailout.
While Rogoff and Reinhart caution against the following type of thinking, I suspect that this time is different from 2003-04. I don't believe as many people have forgotten the financial crisis as did the dot-com bust, and not just because the 2008 crisis was much more spectacular in its magnitude. There are two big differences between then and now:
- Protracted high unemployment, which in the U.S. is at 9.2%, and in places like Spain is over 20%.
- The sovereign debt crisis that is hitting not just European countries such as Greece but is also hammering away at confidence in the U.S. with daily headlines about nearing the debt ceiling.
A sense of widespread and growing economic unease can be seen in recent polling data: A New York Times/CBS News poll finds that 39 percent of respondents believe “the current economic downturn is part of a long-term permanent decline and the economy will never fully recover.” (in October, only 28 percent of people believed the U.S. economy was in permanent decline -- marking an 11-point increase between now and then) The survey is only one of a recent spate indicating widespread distress over the state of the economy. On June 8, a CNN poll found that 48 percent of Americans believe another Great Depression is either very likely or somewhat likely.
The 2008 financial crisis was a severe blow to economic confidence and optimism, by far the biggest since the Great Depression. The most important and personal asset for the vast majority is housing, which lost one-third of its value from the peak and recently began a double dip. This combined with high unemployment and the suffocation of too much debt is at the heart of the current economic unease.
A New York Times/CBS News poll finds that 39 percent of respondents believe “the current economic downturn is part of a long-term permanent decline and the economy will never fully recover.” (in October, only 28 percent of people believed the U.S. economy was in permanent decline -- marking an 11-point increase between now and then)
The survey is only one of a recent spate indicating widespread distress over the state of the economy. On June 8, a CNN poll found that 48 percent of Americans believe another Great Depression is either very likely or somewhat likely.
What Did Taxpayers Receive in Exchange for Bailing-out Banks?
The fundamental instability of the financial system was laid bare for all to see during the 2008 crisis. The public also got a glimpse of just how dangerous Too Big to Fail financial institutions are as governments around the world rushed to bailout megabanks and firms like AIG with taxpayer money. What did taxpayers get in exchange? As much as Paul Volcker, Adair Turner, Sheila Bair, and other well-meaning and respected technocrats would like us to believe that Dodd-Frank, Basel III, etc. repaired the foundational cracks, the ongoing sovereign debt crisis casts serious doubts on these claims.
Today, people aren't wondering whether the next proverbial shoe will drop. People are instead bracing for when the next economic tsunami will make landfall. Will it be this week with Greece, the end of this month with the U.S. debt ceiling, or sometime around the next major elections, when historically (and peculiarly) financial crisis seem to appear? The exact timing is uncertain, but there is broad understanding that another major financial crisis will strike, and perhaps soon.
This sense of pending chaos has left many people in a state of economic paralysis and dealt a collective blow to confidence and optimism. As Austin Powers would put it, we've lost our economic mojo.
A Key to Fixing Our Optimism Deficit
A big key to restoring economic optimism is the establishment of a sturdy foundation for the financial system. Our current system is opaque and not well understood by the general public or many experts, such as macro economists, almost all of whom failed to see the crisis coming. Apocalyptic terms are often employed when discussing it, and a fear that it may come crashing down at any moment feeds existential worry and creates a drag on productive economic activity. For example, concern of another crash inhibits lending and investment, reduces entrepreneurial risk taking, and may be responsible for the stockpiling of cash we're seeing at many large corporations, like Apple (NASDAQ:AAPL), which is sitting on approximately $60 billion.
How best to provide the financial system with a rock-solid foundation? Is simply restoring Glass-Steagall enough? I don't think so. The most far-reaching, comprehensive and achievable plan is the one outlined by Professor Laurence Kotlikoff, which he calls Limited-Purpose Banking. I believe that title may in fact do a disservice to his well thought through ideas, which go far beyond banking and include insurance and other areas of the financial system (e.g., regulatory consolidation of the 120 government agencies currently charged with supervising various elements of the financial system).
Kotlikoff has written a book on his ideas, Jimmy Stewart Is Dead: Ending the World's Ongoing Financial Plague With Limited Purpose Banking (the Stewart reference is to the thespian's role as community banker George Bailey in It's a Wonderful Life). You can listen to an excellent talk he gave at the London School of Economics here. His proposal has generated bi-partisan political, regulatory and intellectual support around the world. Mervyn King of the Bank of England has been one of its foremost champions.
Without going into all the technical details, Limited-Purpose Banking basically removes leverage from the financial system and makes the entire system more like mutual funds, which did not collapse or suffer from fraud during the recent financial crisis. Here are some of the promises of Limited-Purpose Banking:
In short, we’ll have a financial system that’s honest and that we can trust. The financial plague will be cured, once and for all.
To bring back economic optimism we must build a new, more stable foundation for economic activity. This foundation can be created with a new financial system like the one proposed by Kotlikoff, who is quite optimistic about the likelihood that his ideas will ultimately be implemented. It may take one more financial crisis and bailout of the banks to get the public and politicians on board with this type of reform, but I agree with Kotlikoff that something along the lines of the reforms he's outlined will happen eventually.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.