Financial crises and Newton's Third Law
"For every action, there is an equal but opposite reaction," is the familiar formulation of Sir Isaac Newton's Third Law of Motion. However, history demonstrates that financial crises frequently meet not with equal but rather disproportionately large policy responses, fueling asset bubbles and thus contributing to even larger crises in future. The 2008-09 global financial crisis is no exception. Recent developments may suggest an even larger crisis may be now unfolding.
Sir Isaac Newton knew a thing or two about physics. In one example of his genius, he demonstrated that the same force that causes things to fall to earth, gravity, also keeps the planets in motion around the sun. How did he manage to figure that out? Like all great scientists, he excelled at the scientific method. For those not familiar, the fundamental precepts of the scientific method are the following:
- Begin with an observation or experience;
- Form a conjecture (or hypothesis);
- Make a specific prediction based on the conjecture;
- Design an experiment to test the conjecture.
If all goes according to plan and the experiment confirms the prediction based on the conjecture, then you have a theory. The scientific method, properly followed, must also allow for others to reproduce the experiment and obtain similar results. However attractive a theory may be at first glance, if it cannot be independently and repeatedly verified in a controlled manner, it cannot properly be called a scientific theory; it remains a conjecture only. In the event that the experiment produces inconsistent results over time, then either the theory needs to be modified or a new conjecture conceived.
It is important to remember that science does not purport to "prove" things in an absolute sense, even though well-established theories are referred to as "laws". Theories—even those achieving "law" status, must be "falsifiable" through experimentation. From time to time, they are.
Many are familiar with the apocryphal story of how Newton came to arrive at his conjecture of a force of universal gravitation operating both on earth and in the heavens: Whilst daydreaming beneath an apple tree, staring up at the sky, an apple fell down on to his head. Thus startled, it seemed in that moment as if the apple had fallen right out of the heavens... Regardless of whether this pretty fable is correct, once Newton had made his conjecture he needed to design an experiment to test his predictions.
Fortunately it was already widely known at what rate of acceleration objects fall to earth; and the work of Johannes Kepler some years before had demonstrated the relationships between the distance of planets to the sun and the speed and size of their orbits. The experiment, as it were, had already been performed, only in separate pieces that no one had thought to combine. All Newton had to do was to put pen to paper and show that the same equation predicted both the rate at which objects fall to earth and Kepler's laws of planetary motion. He was referring to Kepler, among others, when he made his famous, humble claim that his achievement was nothing more than "standing on the shoulders of giants." Indeed. Yet he too was a giant.
It would be over two centuries before Newton's Law of Universal Gravitation would be disproved via the scientific method. Albert Einstein did so with his theories of relativity. Fast forward to today: Apparent discrepancies between the predictions of relativity and the observations taking place in particle accelerators are significant enough that many scientists believe that even the theory of relatively will be shown, in due course, to be inaccurate. The search for truth, at least via the scientific method, is still very much on.
Newton was known for much more, of course. His Third Law of Motion was that for each and every action there is an equal and opposite reaction. While applicable to the natural world, it does not hold with respect to the actions of financial markets and the subsequent reactions of central bankers and other economic officials. Indeed, the reactions of regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, thereby ensuring that future crises become progressively more severe.
Things were looking rather grim for the US economy in mid-1987, soon after Paul Volcker left his job at the helm of the Federal Reserve. The dollar was falling, fast. Inflation and inflation expectations were rising. It was clear that the Fed was going to need to start raising interest rates soon, perhaps sharply. Having successfully broken the back of inflation and supported the dollar in the early 1980s with monetary targeting, double-digit interest rates and the most severe post-WWII recession to date, financial markets were naturally increasingly fearful that the Fed might follow a similar if less severe script again. While the exact trigger will perhaps never be known, this was the fundamental background that led to the great stock market crash of 19 October 1987, on which day the Dow Jones Industrial Average declined by 23%.
Figure 1: A falling dollar was part of the fundamental background to the 1987 crash
Index March 1973 = 100
Source: Federal Reserve, GoldMoney Research
Alan Greenspan, a veteran of US economic policy-making circles but a neophyte at the Fed, sensed correctly that an emergency easing of interest rates and other liquidity-enhancing measures would help to restore confidence in the equity market and prevent a possible recession. Sure enough, equity markets bounced sharply in the following days and continued to climb steadily in the following months. It was most certainly a baptism by fire for Greenspan and one which, no doubt, taught him at least one important lesson: If done quickly and communicated properly to the financial markets, emergency Fed policy actions can provide swift and dramatic support for asset prices. But what of the consequences?
While Greenspan might consider this his first, great success, was the Fed's policy reaction to the 1987 crash proportionate or even appropriate? Was it "an equal but opposite reaction" which merely temporarily stabilized financial markets or did it, in fact, implicitly expand the Fed's regulatory role to managing equity prices? Indeed, one could argue that this was merely the first of a series of progressively larger "Greenspan Puts" which the Fed would provide to the financial markets during the 18 years that the so-called "Maestro" was in charge of monetary policy and, let's not forget, bank regulation.
Having received a shot in the arm from the abrupt easing of monetary conditions in late 1987 and combined with the lagged effects of a much weaker dollar, US CPI rose to over 5% y/y in early 1989 and the Fed raised rates in response, eventually tipping the economy into a recession. One aspect of the 1990-92 recession that received much comment and analysis was the "double-dip". Whereas the initial phase of the recession looked like a fairly typical business investment and inventory cycle, the second phase was characterized by a general "credit-crunch" that constrained growth in most areas of the economy. What was the cause of this credit-crunch? Why, the long-forgotten Savings and Loan crisis.
The American dream of homeownership, although associated with the US economy's capitalist traditions, is apparently something that cannot be achieved without ever-growing government regulation and subsidies. Politicians just love finding ways to assist their constituents with home purchases. In some cases, there is so much government "help" available that homeowners end up owning homes they can't afford. In the 1980s, Congress decided that, in order to help make housing more affordable, it would ease certain regulations previously restricting the lending activities of Savings and Loans. Credit would thereby become more widely available to a range of borrowers who previously might not have qualified. Importantly, this included risky commercial lending.
Seeking higher returns, some S&Ls broadened their lending activities, expanding their balance sheets and focusing more and more on the riskiest, most lucrative opportunities. As S&Ls were financed primarily by deposits, they needed to offer more attractive deposit rates to expand. But because all deposits were insured in equal measure by the FSLIC (the Savings and Loan equivalent of the FDIC), depositors would shop around, seeking out the best rates. Deposits therefore flowed from the more conservative to the riskiest institutions offering the highest rates on deposits—fully insured, of course. Some of the most aggressive S&Ls went on a shopping spree, snapping up their more conservative counterparts and deploying their newly-acquired deposits into the latest, greatest, high-risk, high-return ventures.
The results were predictable. By the late 1980s, a huge portion of the S&L industry was insolvent. The recession of 1990-91, made a bad situation worse. FSLIC funds were rapidly depleted. But a federal guarantee is supposed to be just that, a guarantee, so Congress put together a bailout package for the industry. A new federal agency, the Resolution Trust Corporation (RTC), issued bonds fully backed by the US Treasury and used the proceeds to make insolvent S&L depositors whole.
All of this took a while, however, and as the bad assets of the S&Ls were being worked off, the economy entered part II of the "double dip" and the credit-crunch intensified. The Fed, however, knew what to do. By taking the Fed funds rate all the way down to 3%, real interest rates were effectively zero for the first time since the 1970s. The Fed then held them there for nearly two years, finally raising them when it was absolutely clear that the economy was recovering strongly and the credit-crunch was over in early 1994.
The Fed's hiking cycle was abruptly aborted, however, when Mexico plunged into crisis in 1995. There was a scramble to shore up Mexico and Latin American debtors generally, the effort led by the so-called 'Committee to Save the World', comprised of Treasury Secretary Robert Rubin, his Deputy Secretary Larry Summers, and Fed Chairman Greenspan himself. One of the measures taken, not surprisingly, was for the Fed to reverse a recent interest rate hike. The stock market responded favorably and, by 1996, Fed officials were concerned that a bubble might be forming in the equity market.
It was around this time that Greenspan uttered his infamous 'irrational exuberance' comment before Congress. This spooked the equity market somewhat, as it was unusual for a Fed Chairman to speak officially of market valuations at all, much less in a way with potentially negative implications. Greenspan later backpedalled, however, and the stock market kept right on rising, as indeed it would do, notwithstanding the occasional correction, into the great dotcom-inspired valuation crescendo of 1999-2000.
Figure 2: Real interest rates were effectively zero in 1992-93
Source: Federal Reserve, GoldMoney Research
When that great equity bubble finally burst, the Fed responded aggressively and, yet again, disproportionately. There is now general agreement that the origins of the 2003-08 boom and bust in housing and credit generally can be traced back to the highly accommodative Fed policy implemented in the wake of the dotcom bust in 2001-2003. By late 2003 there was clear evidence that the US housing market was surging due in part to homeowners extracting record amounts of equity from their homes, thereby stimulating the broader economy. However, amidst relatively low consumer price inflation, the Fed determined—incorrectly we now know—that interest rates should rise only slowly notwithstanding the large surge in housing and other asset prices.
With the Fed moving slowly and predictably, risk premia for essentially all assets plummeted. Greenspan referred to the "conundrum" of low term premia for bonds. But low credit spreads and low implied volatilities for nearly all assets were clear evidence of inappropriately loose Fed policy all the way into 2007. By the time the subprime crisis hit in mid-2007, the economic damage had been done. There had been vast overconsumption at home and over-investment abroad resulting collectively in perhaps the most monumental global misallocation of resources in history. There was no avoiding the crash; the new challenge quickly became how to prevent a complete collapse of the financial system. At this point, the crisis acquired an overt political dimension as taxpayers were asked, in various direct and indirect ways, to bail out those institutions at risk of insolvency and default.
In retrospect, the entire S&L debacle, from its origins in regulatory changes and government guarantees, through the risky lending boom, bust, credit crunch and fiscal and monetary bailout can be seen as a precursor to the far larger global credit bubble and bust of 2003-2009: Just replace the S&Ls with Fannie/Freddie and the international shadow banking system. But there is no need to change the massive moral hazard perpetrated by economic officials, including of course the Fed, and the reckless financial firms who played essentially the same role in both episodes.
Those surprised by the aggressive post-2008 efforts by the Fed and other central banks and regulatory bodies in the US and abroad to expand their power over the financial system and the economy in general have not been paying attention to history: For every market action there is a disproportionate economic and monetary policy reaction which increases the moral hazard of the system. History may not repeat but it certainly rhymes.
Figure 3: See the pattern? For every crisis there is a bailout (S&P500 index)
Source: Bloomberg, GoldMoney Research
Today, there are ample signs that another such boom cycle, the result of the disproportionate policy response to 2008-09, is nearing its conclusion. There is no way to know just how the bust will play out, but play out in some form it will. Investors sensing this danger should be unusually conservative in their investment posture. As history demonstrates so clearly, this should include an allocation to physical gold. Rather than be perceived as a speculative, alternative asset, gold should thus play a central role in a conservative portfolio.
1. Several triggers for "Black Monday" have been proposed in a number of papers. One relatively recent study was prepared by Federal Reserve staff and listed rising global interest rates, a weaker dollar and rising US trade deficit as potential fundamental, macroeconomic causes and a proposed corporate tax change, listed options expiry and large redemptions from a prominent mutual fund group as potential immediate triggers. See A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response by Mark Carlson, Federal Reserve Board of Governors Finance and Economic Discussion Series, 2006. http://www.federalreserve.gov/pubs/feds/2007/200713/200713pap.pdf
2. A reasonably complete timeline of the key events leading up to the S&L crisis is provided by the FDIC at http://www.fdic.gov/bank/historical/s&l/
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