Those of my readers who have been paying attention to the financial news over the last couple of weeks may have noticed a certain weakening of the ebullient smile Wall Street likes to paste on the world. Pundits and financiers who were announcing vast profits and crowing over new stock market records a month ago are adopting a noticeably different style as they try to explain why many billions of dollars invested in hedge funds and the like aren’t there any more. The baroque financial architecture of yet another economic new era has turned out to consist mostly of bubbles rather less tiny than the ones that Don Ho used to sing about, and the results, to put things charitably, have not been good.
The carnage began with mortgage companies, not so long ago the darlings of the financial press. Eighty-odd of them have imploded in the last few months as they discovered that if you loan money to people who can’t pay it back – who’d have thought? – they can’t pay it back. Next it was the turn of hedge funds that speculated in mortgage debt, with two Bear Sterns funds leading the rush to insolvency. In the last few days, problems have surfaced in the commercial paper market, as it turned out that several firms in that end of the financial industry also have a good deal of dubious mortgage debt on their books, and in quant funds –funds that speculate in stocks using computer programs – that got slammed to the mat when the stock market didn’t behave the way their models said it would.
Meanwhile, other sectors of the credit market are looking nervously over their shoulders at their own equivalents of what the mortgage industry has uncharitably but accurately termed “toxic waste” – huge volumes of loans made with little attention to their prospects for repayment, and then offloaded onto buyers around the world whose greed for an extra percentage point of interest kept them from noticing that gamblers don’t always win their bets. Short term credit tightened up so drastically last week that central banks around the world had to dump more than $200 billion into financial markets to stave off a credit panic. Where this is going is anyone’s guess, but at this point the chance of a serious recession is hard to dismiss.
All this is interesting enough in its own right. As J.K.Galbraith pointed out in his wry classic The Great Crash 1929 – required reading for anybody interested in the vagaries of economics, not to mention the funniest work of serious economic history ever written – economic panics offer an unequaled glimpse at the gaping chasm between expectation and reality that opens up when people think they can get something for nothing. It also has real implications for the future of industrial society, since resources flushed down the ratholes of subprime mortgages, speculative hedge funds, and the like will not be available to deal with the pressing needs of an oil-dependent civilization slowly discovering that it’s already on the far side of Hubbert’s peak. All these are relevant, but the spectacle of empty air opening up beneath yesterday’s speculative boom also does a fine job of pointing out one of the most pervasive bad habits of contemporary thought.
The subprime mortgage mess is a good place to start. For many years it’s been customary in the banking industry to justify giving mortgages to people who wouldn’t normally qualify for a home loan by charging them a higher interest rate than usual. The extra income from the interest compensated the bank for the losses from those borrowers who defaulted on their loans. So far, so good, but this extra fillip of interest attracted money from outside the banking industry, and banks found that they could package mortgages into “collateralized debt obligations” – CDOs, for short – and sell them for cash, offloading risk while pocketing the proceeds of the sales.
In a time of record low interest rates, the return on subprime CDOs looked good, so long as you didn’t think too hard about the risk of default. Banks soon figured out how to hide that risk even further by slicing up packages of mortgages into multiple “tranches” that, at least on paper, had different levels of risk. The process was pushed further along when companies bought tranches of different CDOs and reassembled them into new CDOs, with their own multiple tranches, which could then be bought and reassembled ad infinitum.
Beneath all these bells and whistles, though, was the same pool of mortgage loans to people who couldn’t qualify for an ordinary mortgage – a pool that became increasingly risky as profits from the CDO market lured banks and mortgage companies into handing out mortgages with less and less attention to the borrowers’ ability to pay. The bottom of the barrel was reached with what were called NINJA loans – no income, no job or assets – which combined a hefty interest rate on paper with a fair certainty that not one cent of the interest or principal would ever be repaid.
In effect, the idea of risk had evaporated from the minds of the speculators. It’s understandable that banks and mortgage companies would stop worrying about risk once they learned to package their mortgages and sell them to other people. It’s less understandable that people who wanted to buy houses, to live in or (more and more often as the boom went on) to sell at a profit in a few months, lost track of the fact that if things went wrong they could be left with debts far beyond their ability to pay. It’s still less understandable that investors around the world would lose track of the fact that a high interest rate that never gets paid isn’t actually worth anything at all.
Still, the same myopia has appeared on cue in every previous speculative frenzy, too. Purchasers of subprime toxic waste can now join the long line of self-deluded gulls that reaches from the people in 1999 who bought stock in fly-by-night dotcom firms, all the way back to the people in 17th century Holland who spent hundreds of guilders buying single tulip bulbs on the assumption that they’d be able to sell them for even more in a few weeks. It’s an affliction endemic to market capitalism throughout its history, but it became pandemic in the last years of the 20th century and remains so today – and not just in the world of economic speculation.
It’s worth suggesting, in fact, that blindness to risk has become one of the most widespread mental habits in contemporary society. Plenty of examples could be cited, but one discussed many times in this blog – peak oil – belongs high on the list. All through the controversies about how much petroleum the world still has, how rapidly it’s being depleted, and whether or not it can be replaced by some other set of energy resources, one constant theme has been the refusal of most people outside the extreme “doomer” end of the peak community to notice that industrial civilization could end up in deep trouble if things go badly.
Those who argue that the world still contains ample supplies of oil that just haven’t been found yet, like those who insist that innovation will take care of the problem by pulling some currently unknown technological rabbit out of a hat just in time, tend to respond to such questions as “but what if you’re wrong?” in the same tone of irritated superiority as a Wall Street financier might have done a few months ago if asked what would happen if subprime defaults got out of hand. There’s an oddly incantatory quality to this nothing-can-go-wrong rhetoric, as though it will all work out fine just as long as everybody agrees it will.
As the long and sordid history of economic crises shows all too well, though, optimism is not always justified, and things that seem too good to be true generally are. Right now the world economy is reeling and shuddering because a great many otherwise intelligent people jumped to the conclusion that nothing could go wrong with a new set of moneymaking schemes that promised something for nothing. The similarities between this bit of delusion and the even more widespread faith that humanity can pump infinite amounts of cheap energy out of a finite planet leaves me wondering if the exponential expansion of industrial society over the last two centuries or so might be seen, in a certain sense, as the biggest speculative bubble of them all.
Speculative bubbles, after all, always launch themselves from a basis of fact. It was true in the 1990s that huge new fortunes were made on the Internet, and investments in computer firms during those years paid off spectacularly. It was true earlier in the present decade that a lot of Americans wanted homes of their own, and low interest rates and abundant capital from overseas made it possible for that desire to be met. Equally, it was true that the exploitation of coal, oil, and natural gas by way of an ever more sophisticated suite of technologies enabled the industrial societies of the West to enjoy the great-grandmother of all economic booms.
Just as every speculative binge eventually trips itself up on its own excessive optimism, in turn, industrial society ignored the well-timed warnings of oncoming resource depletion in the 1970s. The small but steady declines in oil production that have taken place over the last two years, despite sky-high oil prices and a flurry of well-drilling that has driven rig costs to record levels, may just turn out to be the equivalent of the rising default rates in subprime mortgages that started today’s economic landslide on its way. At the moment, industrial civilization is poised somewhere in the same period of eerie calm between the beginning of decline and the arrival of panic that comes late in the history of every speculative binge. In the example now unwinding around us, that period of calm ended a few weeks ago when Bear Sterns admitted that two of its billion-dollar hedge funds were no longer worth a cent. What will end the equivalent period in the trajectory of our civilization is still anybody’s guess, and it may still be years in the future.
Whenever it comes, though, the central problem that will have to be faced then is the same problem that banks, mortgage companies, and the global economy are having to face right now. By ignoring the reality of risk, the money managers of the last few years left themselves with very few options once the economic situation changed in a way they hadn’t anticipated. In the same way, by ignoring the possibility that we may be running out of cheap abundant energy, modern industrial civilization could well be backing itself into a corner. Without preparations in place, or even a sense of what the options might be, we could all find ourselves desperately scrabbling around for a Plan B when the illusion of endless energy supplies pops around us like a bubble – speculative or otherwise.