John Kenneth Galbraith, renowned economist and author of the bestselling The Great Crash, 1929, died in 2006, and so he never saw the crash of 2008. But he would not have been surprised.
I just finished reading his A Short History of Financial Euphoria: Financial Genius is Before the Fall, a treatise on bubbles and busts of history, starting with the Dutch Tulip Bubble of 1637 and ending with the crash of 1987. The book was written in 1989, but the message is still timely today. Galbraith draws out the common factors of all financial bubbles; all will seem eerily familiar to the financial refugees of 2008.
These common factors are:
- Extreme brevity of financial memory. Although the bursting of the dot-com bubble happened only seven years earlier, the most similar recent crisis in my mind was the demise of Long Term Capital Management in 1998. But who remembered that after the dot-com bubble? (For a refresher, I highly recommend the 2000 Nova documentary Trillion Dollar Bet.)
- The specious association of money with intelligence. We have a tendency to think that people who have made a lot of money must be intelligent, and vice-versa. Surely people who can understand CDOs must be blindingly brilliant and deserve the million dollar pay packages they were earning. This association is so deep that for most of us, it is an unthinking assumption. For instance, we might ask about people who invested with Madoff, "How could smart people be so dumb?" when we should be asking: "How could rich people be so dumb?" This factor is the source of the book’s subtitle: Financial Genius is Before the Fall.
- The thought that there is something new in the world. By chopping and dicing mortgage risk in different ways, and parceling it off to unknown counterparties (think AIG), financial regulators were persuaded by banks that the overall risk of the system had been reduced. But it wasn’t. In many cases, it wasn’t even redistributed, with banks that had sold bad assets on to investors finding that they still were at risk because they also lent the funds which the investors used to buy the assets in the first place. As Galbraith says, "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."
We All Did It
Galbraith also has something to say about who is to blame for the 2008 credit crunch:
We are to blame. Everyone who indulged in the rush to buy into an accelerating housing market by taking out a loan which they could never pay back. People who used their homes as ATMs, using seemingly endless home equity to finance vacations to the Caribbean. Foundations, Charities, and Funds-of-funds blithely intrusting their money to the likes of Bernie Madoff. Even investors who bought speculative stocks at inflated prices at the start of 2008 despite the stratospheric valuations.
Unless you took your money out of the market in 2007 or 2006, and used it to pay down your debt, you were part of the euphoria which led to the crash. With luck, we will all learn this expensive lesson, and be able to remember it long enough not to be part of the next euphoric episode.
History shows that most of us will forget all too soon (if we learn in the first place.) Nevertheless, we have the power, and the ability, not to be "most people."
Tom Konrad, Ph.D.