Faulty Judgment at Inflection Points in History
Today the economy and the capital markets are faced with the long-term buildup of public and private credit. Moreover, promises to tax and spend future income may even be the greater influence. How we got here is more a story of what has happened to our culture than it is one of a particular central bank or government policy.
Combined, our private and public liabilities are multiples of the income of the United States, and the situation is no different in Europe. The change to a system wherein liabilities could pile up without eliciting much concern happened so slowly that few noticed any change, yet a time traveler from a century ago would not recognize the financial or governmental institutions of today.
Interestingly, a citizen of the Roman Empire would see certain parallels: His empire spared the aristocracy from taxation, and protected it in credit crises. The treasury of the Roman Republic flooded its economy with 50 tonnes of freshly minted silver denarii annually at its peak, driving up real estate prices. Yet the cost of living remained subdued with free bread and entertainment.
Often long-term trends such as this work in the background, like the Coriolis force giving birth to a tropical storm which then builds into a hurricane. Save for the 1970s, the system of fiat currency has been spectacularly successful: Recessions have been tame and short, while the cost has been tolerable inflation during expansions. Ironically, tapping into the people’s credit and spending power through Keynesian fiscal policy and aggressive central banking builds up more Coriolis force, but dampens the perception of risk in the near – term.
The credit crisis of 2008 may be remembered as a gentle rain, with downpours in certain small regions. Or what we feel may be bands of moisture preceding a category five deluge, or a reminder that the next season might be worse. There is a huge difference between forecasting the weather and being prepared for inevitable dangers. The former is almost impossible to do; the latter ought to be easy. But, as the victims of Katrina in 2005 would attest, not having known of such loss of life since the 1928 Okeechobee Hurricane bred complacency.
It is almost impossible for humans to be concerned with what in retrospect seems so logical a course of action when the benefit from doing so is actually the denial of some short-term pleasure. Shoring up levees is a costly and constant necessity. Even simply leaving town for a few days is inconvenient. Before advance warning and flood insurance was available, folks simply did not build in the flood plain.
The timing or eventuality of financial calamity is unable to be forecast. At best it might be like a hurricane warning: The tempest may strike here, it may hit there, it may be downgraded to a tropical storm, or it may go elsewhere entirely. But that doesn’t mean one should whistle through the graveyard. Man has developed ways, though crude, to help those who dare to live in dangerous regions.
The capital markets are the nerve center for all things economic. They flash signals of future events, sometimes warning of danger, sometimes transmitting aggregate foolishness: a mirror to our psyche. But many times the commentary from the experts is dead wrong when longstanding trends give way.
Humans are especially prone to faulty judgment at points of inflection, that is, when a trend is reversing. This is particularly so when what is to come is well outside the realm of expectations. At such points, there is a minority of market participants who are sensitive that the change is occurring. Members of this group, like Dickens’ signal-man, have glimmers of the change to come. It is not necessary that they completely understand what is occurring. In fact even completely bogus input could yield the proper result to those acting upon the new information.
On the other hand, the majority are so hardwired to the established direction they will insist that the reams of information put in place during the historical trend prove they are in the know. Another way to think about inflection points being invisible to the majority is to draw an analogy to how fish might view swimming in a pond that is surrounded by the first winter cold front capable of freezing it. They live in the dimension of water, and cannot know what the air is doing unless they are among the few who might be jumping.
Similarly, humans have an inherent difficulty with factors existing in another dimension, for these can remain unapparent to observers even sometime after an inflection occurs. In 2007, banking CEOs were saying their institutions were sound and some even had their boards of directors authorize massive share repurchases to defend against slight drops in valuation. Charge-off ratios and delinquencies were manageable. But depositor funds, leveraged near 20-to-1, had been invested in mortgages secured by real estate whose value had skyrocketed; a slight drop might wipe out the thin coverage inherent in loan-to-value ratios and the banks’ capital ratios. To many banks it did.
[Editor’s note: This passage is reprinted from William W. Baker’s book, Endless Money: The Moral Hazards of Socialism, with the permission of John Wiley & Sons, Inc (©2010). You can get your own copy here.]