The View From 1776

Collectivism in the Federal government since the 1930s New Deal is paralleled by the emergence in financial markets of giant, multi-national financial institutions.  Both reflect the detached, numbers only, view of socialistic regulators who deal in large abstractions called “the economy” and “the workers.”

As Stalin is reputed to have said, one death is a tragedy; a million deaths is just a statistic.  Make it big enough, and it can be made to seem in the best interests of society.

Stalin’s detachment applies to the process of pooling thousands of individual debts – home mortgage loans, automobile notes, etc. – into a single large debt package.  Implicit is the idea that, even when a whole class of debt is highly risky, putting enough of them together will somehow mitigate the riskiness of any one of the components.  Risks of default may be high in any one of the underlying pooled obligations, but aggregating enough of them into a single statistical vehicle presumably cancels the risk of individual components.

Macroeconomics is the Keynesian thesis that specific prices and wage rates don’t matter, that it is sufficient to look only at averages of prices and wages for the whole economy.  And, in that picture, the ultimate determinant of employment and economic activity is Federal deficit spending, the perennial Democratic Party “solution” to every economic slowdown.  Closely allied is the theory that the Federal Reserve can control inflation and the level of economic activity by fiddling with interest rates.

In contrast, traditional economics looks to the free market to readjust interest rates, prices and wages that have become too high in individual companies and segments of individual industries, fully aware that average wages and average prices are meaningless in re-establishing economic equilibrium.  History repeatedly demonstrates that individual people and enterprises are far better at judging prices and wages than any elite group of economists or state-planners.

The 1920-21 recession was as severe as the start of the Depression in 1929-30.  With little government interference, the 1920-21 recession was ended in less than a year via the historical processes of lowering wage rates and materials prices until businesses could again produce goods at a profit.  It is to be noted that there were many thousands of different adjustments of prices and wages, varying from industry to industry and from company to company.

In baleful contrast, the macroeconomic approach of Presidents Herbert Hoover and Franklin Roosevelt pressured businesses to keep wages up, with the result that production costs remained too high for businesses to resume profitable production.  Unemployment remained in excess of 15% for ten years.

The appearance in 1936 of John Maynard Keynes’s General Theory of Employment, Interest, and Money made macroeconomic theory orthodoxy among the socialist intelligentsia in Franklin Roosevelt’s administrations.  Since then, three generations of students have been taught that Keynesian macroeconomics is the appropriate analytical tool to understand the dynamics of our economy.  Those students, since the 1980s, have transformed banking and investment analysis into a numbers-only abstraction of averages that disregards underlying risks in the individual transactions that now are rolled up into huge pools of securitized debt. 

Bankers historically were schooled to judge first and foremost the personal character of their borrowers, then to determine whether the requested loans could reasonably be repaid from cash flow of the business. Banking and investment since the 1980s has been increasingly divorced from knowledge of the underlying assets and increasingly focused on law-of-large-numbers abstractions in which the underlying economic reality is out of sight.

In the commercial real estate field, for example, as recently as the 1970s, institutions financing office buildings, shopping centers, apartments, industrial warehouses, and hotels were staffed with people who had lived through one or more economic recessions, people who therefore were keenly aware of potential risks in property locations and property types.  Prudential Insurance Company, then the largest real estate lender, had more than 60 offices in every part of the country with loan officers who knew every detail of their territories and details of every investment. 

By the early 1980s, hyperinflation created by President Johnson’s Great Society deluge of welfare entitlements spending had wrecked the balance sheets of S & Ls and insurance companies.  S & L depositors withdrew their savings from 4.5% savings deposits, and insurance company policy holders borrowed full cash values of their policies at the contractual 5% rates, both groups reinvesting in short term money funds that were paying interest rates around 12% to 14% per annum.

This started the rapid agglomeration of financial institutions, changing S & Ls from local institutions that knew their territories into giant organizations lending nationwide.  They were staffed mostly by young people in their 20s who had never lived through down markets.  And those inexperienced lending officers were asked to lend in much larger individual deals, at a fast pace.

The same scenario was repeated in insurance companies, investment banks, and commercial banks.

Most of the young people taking jobs in those huge financial organizations were schooled in computer analysis and creation of abstract financing techniques, which meant that too many of them never left their offices and knew little or nothing about the underlying business or real estate projects they were financing.

The diffusion of the Keynesian macroeconomic mindset thus set the stage for recent unraveling of complex, computer-constructed investment vehicles in which it is impossible to determine the real economic bases of the millions of individual transactions comprising them.

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