January 3, 2018
Four very expensive words: “This time it’s different”Posted in Irish Times · 331 comments ·
Much of today’s economic and financial discourse revolves around the impact of new technology on our lives, as if this were something new. It’s not. The repetitive economic cycle is also as old as the hills, as is speculation.
If you doubt this think about the Book of Genesis. Remember when the Pharaoh awoke, petrified by a dream? He dreamed that he had seen seven cows, “attractive and plump”, feeding by the Nile. But soon these beasts were followed by seven skinny, ugly cows which proceeded to eat the fat cows.
Terrified, the Pharaoh called for Joseph, who explained that the dreams represented the fact that seven years of plenty tends to be followed by seven years of famine. The cows represented the good times followed by the bad times. Joseph urged the Pharaoh to set aside food in the good times, to feed the Egyptians when things turned down.
There in Genesis is Joseph, the first truly prudent finance minister, explaining a seven-year economic cycle, the type of which we are all well used to in the western world. Due to having economic cycles, we also have people who are willing to speculate on the future trend of these cycles, or on new technology that will affect the trend.
Historically, because humans are social animals and we tend to behave like a herd, religious leaders have regarded anything that has driven the herd or the flock to extremes as highly dangerous.
Speculation is one such danger, and for centuries speculation was forbidden in religious teaching precisely because of what it did to human nature. Speculation fuelled greed and fear, both of which are inherently destabilising.
As a result, St Thomas Aquinas preached about the “just price”, whereby a “good man” shouldn’t knowingly sell anything for more than it’s worth. Under no circumstance should he lend money for interest to anyone else to bet on the cycle.
For St Augustine, speculation – which he termed “appetitus divitiarum infinitus”, or the unlimited lust for gain – was among the deadliest of the seven deadly sins. But humans love financial speculation.
The word “speculation” comes from the Latin “speculari” which means to be on the look-out for trouble. Even the Roman forum had a corner reserved for the speculari. These lads (and lassies) have long dominated markets, manipulating human nature and undermining rationality in pursuit of riches.
New technology always attracts new speculators because of its ability to influence the trend of the economy. When money is cheap, the incentive to borrow, to drive up prices, and sell on to the next guy (pocketing the difference) is always with us.
Think about what is happening with Bitcoin. The price of the cryptocurrency is rocketing based on the notion that it will ultimately replace money as we know it. This may or may not happen. But Bitcoin’s price has risen by 1,525% this year alone.
Or consider speculation on the share prices of technology companies, some of which have yet to make a profit but are valued at billions of euro. Some will end up delivering but many won’t. Amazon’s share price is up 55% this year; that of its Chinese equivalent, Alibaba, is up 99%.
Once speculative mania takes hold, all sorts of people who normally remain aloof from these episodes are tempted to get involved on the promise of quick riches.
We’ve witnessed, through the ages, mass speculation in technologies; canals, railways, electricity companies, cars, radios, and, most recently, the dotcom boom and crash. All these technologies changed the world, but fortunes were made and lost betting on precisely how, when, and in what form the change would take place.
There is a huge difference between speculating and investing. The speculator typically starts with a little money and hopes to make a lot, quickly. The investor, in contrast, starts with a lot of money and hopes to make a little, more slowly.
All boom-and-bust cycles tend to follow similar paths and are always, as now, underpinned initially by low interest rates and cheap credit. The most expensive four words of all are: “This time it’s different”.
To understand the credit cycle better we must reject classical economics, which takes the irrational human out of the equation, and recognise the importance of the human propensity to panic, indulge in herd behaviour, and believe our own propaganda.
From euphoria to panic
Credit booms go in stages. Punters oscillate from optimism and euphoria to depression and panic – a journey that can only lead to the destruction of wealth. Most people are what is known in financial markets as “momentum investors”, those who follow the crowd, buoyed up by the excitement of it all, rather than “value investors”, who are constantly asking themselves whether prices are reflecting real value or something else.
The predominance of momentum investors has the effect of amplifying the high and low points of cycles. It is this sort of behaviour that leads to bubbles and can also push the economy out-of-kilter for long periods. It is simply not true, as classical economics contends, that the self-interested economy naturally rights itself and finds equilibrium.
In fact, the opposite is the case. The self-interest of banks, market players, and leveraged speculators can produce long inflationary periods or leave us stuck in stretches of unemployment and deficient demand. We know this in Ireland too well.
Panics can also be sparked by relatively trivial events, and the financial system can move very quickly from a position of rude health to one of fragility. The great American economist, Hyman Minsky, identified five stages of a credit crisis: displacement, boom, euphoria, profit-taking, and panic.
At the beginning, something real happens to disrupt the old order. This can be a monetary event, such as quantitative easing, or an innovation, such as the internet, Amazon, or Uber.
For example, since 2008, central banks have pumped trillions of dollars into the financial system. This was the displacement moment. As interest rates fell, those with money decided to punt – and, as ever, asset prices rose as more people speculated.
In the years up to 2014, the US stock market posted double-digit gains consistently. This kind of boom leads to gearing, as banks fall over themselves to get involved. This process drives prices ever higher. Balance sheets play tricks on both lenders and borrowers. But success breeds a healthy disregard for the chances of failure.
During the euphoric stage, leverage amplifies prices, and people, who are emboldened by previous gains, drive up the prices of more and more esoteric assets. A favourite of mine is the Bloomberg Wine & Cheese Index which measures the prices of posh cheese and wine. It is up 34% this year.
The giddiness in the euphoric period is also reflected by people investing in places they can hardly locate on the map. In the past 12 months, the stock market of Vietnam rose by 43%, driven largely by Americans.
We then move towards the profit-taking period, as some savvy players take these lofty levels as a signal to cash in their chips. A prescient few take profits.
We are already seeing this in the US stock market, which has run out of steam and is now trading side-ways. Typically, this begins the process of unravelling. When the herd realises that prices are falling, everyone rushes for the door, in panic. The edifice collapses, fortunes are lost, and we start again.
The five-stage cycle can take time to play out, and it never runs exactly the same as in previous cycles. But the five stages remain a handy model for analysis. You might want to speculate what stage the Dublin commercial property market is at.
The essence of a credit cycle is a build-up of debt combined with old-fashioned human nature fuelling humanity’s pathological optimism as we end-up believing our own propaganda.
As today’s financial markets go ever higher, and the gap between valuation and prices becomes more and more stretched, it would seem injudicious to ignore the repeated warnings from history and overlook our capacity for individual and collective self-delusion.
As we venture into the New Year, leaving the Christmas period behind, maybe it’s time to go back to the Bible and scripture to get a clearer sense of the future.