Considering Disaster

Sometimes we forget how bad it can be, and then we howl over minor bad times in the markets. We may be past a mania in residential housing, but we have not really experienced a panic or crash yet. People squeal over how bad the equity market is, but recently we haven’t had anything like the 2000-2002 experience, much less the 1973-1974 or 1929-1932 experience.

Two books come to mind when I think about disaster in a non-fear-mongering way: Manias, Panics, and Crashes, by Charles Kindleberger, and Devil Take the Hindmost, by Edward Chancellor. They take two different approaches to the topic, and those approaches complement each other, giving a fuller picture. Chancellor takes a historical approach, while Kindleberger deals with the structures of financial crises.

From Chancellor, you will see that manias and their subsequent fallout are endemic to Western culture. Someone living a full life over the last 300+ years would see one or two big ones, and numerous small ones. Relatively free societies give people freedom to make mistakes. Given the way that people chase performance, we can all make mistakes as a group, with large booms and busts.

Much as the regulators might want to tame it, they can pretty much only affect what kind of crisis we get, and not whether we get one. Chancellor is somewhat prescient in suggesting that the leverage inherent in derivatives post-LTCM could be the next crisis. This book is the better one if you like the stories, and don’t want to dig into the theories.

But if you like trying to place the manias, panics, and crashes on a common grid, to see their similarities, Kindleberger has written the book for you. In it he draws on a number of common factors:

• Loose monetary policy
• People chase the performance of the speculative asset
• Speculators make fixed commitments buying the speculative asset
• The speculative asset’s price gets bid up to the point where it costs money to hold the positions
• A shock hits the system, a default occurs, or monetary policy starts contracting
• The system unwinds, and the price of the speculative asset falls leading to
• Insolvencies with those that borrowed to finance the assets
• A lender of last resort appears to end the cycle

Summary

I liked them both, but I am an economic history buff, and a bit of a wonk. The benefit of both books is that they will make you more aware of how financial crises come to be, and what the qualitative signs tend to manifest during the boom and bust phases of the overall speculation cycle.

If you are interested in economic history, buy a book, and if you buy it through the links above, I get a small commission. (If you buy anything through Amazon after entering their site by clicking on one of the links above, I get a small commission. That’s my version of the tip jar, and it doesn't raise your cost at all.)

Comments

[MajorTom]

Well said, David!
Gotta love these macro views.

Haven't read those two, yet, though.
Will click on through, to the other side, now.

All The Best!

[Joe]

I am about to follow up as well.
Just in case any interest in the exact opposite, namely the case of
a problem solution (might make above books even more interesting
reading):
Germany's economic recovery after 1945:

www.econlib.org/LIBRARY/Enc/GermanEconom...

it's a couple of lucid web - pages, a case after chaos and disorder,
where everything was started from scratch

[Tom Lindmark]

I've been meaning to read these for some time. Thanks for reminding me and I will certainly click through here so you make a little coin.

[gordon]

The Fed accepting bank's credit card and auto loan debt (as AAA?) comes to mind as "lender of last resort". Why didn't this get any media attention yesterday? Are these the next blowups?

[maverick]

Gordon, do you have a link to a story?

[Tom Lindmark]

Gordon, please direct me to the source of your comment. I need to see the information.

[gordon]

tinyurl.com/4pf7vu

Fed expands auction, accepts wider collateral
By Steve Goldstein, MarketWatch
Last update: 10:51 a.m. EDT May 2, 2008
PrintPrint EmailE-mail Subscribe to RSSRSS DisableDisable Live Quotes
NEW YORK (MarketWatch) -- The Federal Reserve, along with other central banks, said Friday that it was increasing the funding it is providing to banks and announced that, for the first time, it was willing to accept bonds backed by auto loans and credit cards.

[gordon]

There's some good comments to my (above) linked story, like this one:

Sorry to inform you that auto paper is exploding in defaults, you can't find the asset when it does and most of the A-B paper they will accept is really c paper. Most people when they buy a car already have a car loan that is overvalued. So a new car buyer is forced to include old car debt into new loan. LTV's on vehicles at 130% are not uncommon.
They drive off the lot it's at 150%..

This is a bailout of the banks and IB's. This is beyond rediculous!

[R. Mendales]

I'm not sure the crisis is over yet. The problem is that there are other shoes left to drop. As Gordon noted above, auto receivables are vulnerable, and so, increasingly, is commercial real estate. What worries me is that the Fed may already have fired all the ammunition it has.

[Simple Simon]

Always good to see current events put in perspective. We few, we pitiful few are such wind up dolls at times-rushing after this ' rare, valuable butterfly; then that glimmer of gold there "...I can think of a number of securities that are vastly overvalued; yet the mob keeps piling on; ignoring every last bit of historical example that shakes a bony finger "no, no!"

[101010]

Joe-- Thanks for the link regarding Germany's economic recovery post WWII. Very interesting reading!

[Ceviche Fund Partners LP/Dan Jacome]

Both excellent books -- thanks! "When Genius Failed" is another gem that ties in some of the same themes

[fatcat]

gordon, i saw the same stuff...also Jamie Diamon,the hero of the street told a german media that the end is nowhere in sight.I've been short financials for six weeks,getting my ass kicked,wondering why.

I hope i'm wrong ,it won't be good for anyone,but the ripple has got to be coming. The economy stats seem to be cooked,hope i'm wrong.

[101010]

"What worries me is that the Fed may already have fired all the ammunition it has." - R. Mendales

I'm afraid they still have one piece of ammo that they've been firing nonstop, but it's closer to a flamethrower than bullets; they can (and have, and will continue) to print dollars as quick as they can and "loan" them out to commercial and investment banks for next to nothing (because frankly, they're worth even less), using the toxic "AAA" loans as collateral (much of which *IS* worthless)... allowing said loans to also blow up on the Fed's books, thus truly-- sickeningly-- allowing the bankers to privatize profits in boom years, but socialize their losses when the house of cards collapses. By rapidly burning the value of your hard earned dollars (hence the "flamethrower" reference), the *TRUE* value of your labor at your place of work goes down every day.

People (not just directed at you R. Mendales), please do not trust the government's ridiculously contrived low inflation numbers. Inflation is what reflected in the rising costs of living-- you don't need to read a gov't report to see that, just go look at the price at the gas pump, go see how much it costs to buy milk and eggs, and remember how much less these cost 1, 3, 5 and 10 years ago.

Do not think of yourselves as paid in dollars. You cannot eat dollars. You cannot put dollars into your gas tank. Dollars are merely fiat currency, just pieces of paper that can be traded for actual goods. So if you really want to know the *value* of your labor, think of your paycheck as being paid in gallons of fuel, in gallons of milk, and dozens of eggs. If over time for the same pay you can buy less of these items, kindly introduce yourself to your Gov't mandated pay cut... er, I'm sorry... "weak dollar policy" (because that sounds so much nicer, and we can throw in a nice statement about how it'll be easier to export goods... feel better now?)

Here's some hard numbers: I've been religiously tracking my vehicle's fuel consumption, fuel costs, etc. since I bought it in '03, and I only use the same brand of gasoline. Back then, a gallon cost $2.09. Now it costs $4.09. That's almost 100% inflation in 5 years. That's your loose monetary policy. That's Bernanke having the printing presses running non-stop night and day. And that is OUR NATIONAL PAY CUT. That's right: "pay cut". Ask yourself how much of an annual pay cut you would be willing to tolerate? Bernanke seems to believe it should be around 2%. In actuality, it's running around 20%. Think about this: Since oil is priced in $US, and the $US has weakened by about 50% against the Euro, for Euro countries the price of oil is effectively ~33% cheaper than for Americans. I won't go into their higher taxes, etc contributing to their overall more expensive fuel costs... but my point is clear: When the dollar gets weaker, YOU are getting a gov't mandated pay cut.

Expanding a bit on the milk and eggs examples: When industrialized nations are prospering, the prices of eggs and milk actually go DOWN. Prices of all commodities go down. Why? Because of the efficiencies of scale, improved farming techniques, improved distribution, greater competition (which feeds back on itself, bringing about more efficiencies, improvements, etc)... in short, because of Progress. Whereas right now, in the US, we have the opposite situation, so... connect the dots.

If your incomes have remained relatively the same since '03, you have effectively taken a 50% pay cut. That's a fact. Fortunately, my income has gone up almost the same amount that the dollar has gone down... and let me tell you, ANY extra money I have I immediately convert out of the dollar-- I work TOO DAMN HARD to make these little pieces of paper, only to have the cronies at the Fed determine that the value of my labor last week is worth less this week, and even less in the next. Screw that.

There have been many, many success stories for many countries throughout history, but know this: No country has ever achieved (or maintained) prosperity through the devaluation of its own currency.

Full disclosure: I own FXA and accumulate more any chance I get, particularly for its 6.77% interest rate. I'm holding off on buying more FXC although I hold substantial positions in both. I also very seriously doubt that this post is going to affect forex trades on the Aus$, so please refrain from any notion of me "pumping" anything. But for those of you wondering how I am diversifying away from our ever more worthless US$, there ya go. (I own a bit of GLD, but at these prices feel that we are still in bubble territory, despite the small *pop* down. I also know that gold is far too easily manipulated by government entities, so I have trouble picking a fair price. Hence, FXA.)

[mkreisel]

Not everything is going up in prices: housing has gotten a lot cheaper during the last 2 years; electronics are getting cheaper all the time; apparels, furnitures, automobiles remain cheap.

We all know that food and energy are going up, but that has been talked about ad nauseum.

Two things that have experienced huge inflation during the past decade seem to be moderating: healthcare and education. The charts of UNH and WLP should tell you a lot about the future of insurance premiums; and elite universities such as Stanford have begun to offer FREE education for families earning less than 100K.

[101010]

mkreisel-- Yes, and how often do you buy a house? What about electronics? Are you buying a new TV or cell phone every two weeks? Healthcare, education-- yep, are you perpetually ill or a regular student?

Didn't think so. But you sure as heck need to buy fuel for your car, and food to fuel you and your family.

"Inflation" moderating for those items you mentioned is moot for 90% of the population 90% of the time. Everybody buys gasoline-- and gasoline has doubled in 5 yrs. Same with food. Think about it.

[mkreisel]

Houses are the single largest purchase most people ever makes. A single house ($200000 median) is worth 60000 gallons of gasoline at current price, more than most people will ever burn during their life times. In fact, Americans drive on average 1000 miles a month, which translates to about 50 gallons on average. So that's 600 gallons a year, and at most 40000 gallons for life.

Food, despite recent sharp rises, is still dirt cheap. We are a family of 4 and we live in California, we enjoy eating out very often, and we spend no more than $1000 a month on food. In fact, our grocery bills amount to only to half that amount, with the remaining $500 going to restaurant tabs. If we get more frugal and cut back on that, we can get away with $600 a month.

Education inflation is scary because we eventually need to send our kids to schools. Right now, it costs $100000 in tuition just to get one child through the undergraduate program from elite schools (Stanford), even the second rate University of Colorado will demand $50000 for the same thing. If the tuition inflation continues as in the past 3 decades, very few will be able to get their degrees without incurring huge debts.

Healthcare is the single most expensive item in this country. One night hospital stay costs anywhere from $1000-$3000. If you are unlucky enough to cancer (leading cause of death in the US), one year trial of Avastin costs at least $300000. So insurance is a must. But if you have to buy insurance on your own, you need to pay at least $1000 month for a family of 4, on top of $5000 deductibles and severely reduced choice of doctors and hospitals.

101010, I'm sorry to say that you just have no idea about what the real life is, what's expensive and what's not!

[icandoitdon]

there is a world of difference between an asset and an expense. food and gasoline are examples of pure expenses that have no future value because the value of each is immediately consumed. the cost of insurance might be another. a car is a bit of each....it is a depreciating asset with a short life-cycle. similarly consumer electronics with an even shorter life-cycle.

an asset has future value that can ultimately be monetized. education and housing are two of them. education produces higher future income (notwithstanding those taxi-driving lawyers out there who made the wrong career choice) and is as much investment as expense because its return last a lifetime. it is the appreciating charateristic of houses that permit many or even most people to "trade up," hence increasing their standard of living. it can ultimatley be monetized when the kids move out and people downsize.

as for food being "dirt cheap" but health care being the "single most expensive thing" in this country, i don't mean to be unsympathetic, but it seems to be that anyone who spends $1,000 a month on food, half of which is for restaurants shouldn't complain about the cost of health care insurance, which at least offers protection against financial disaster in the event of serious illness.