The Depression

A clear message from books written in another era.

75 years on

It's hard to believe that the following passage was written in 1931:

"Prosperity was assisted, too, by ... stimulants to purchasing, each of which mortgaged the future but kept the factories roaring while it was being injected ... People were getting to consider it old-fashioned to limit their purchases to the amount of their cash balance; the thing to do was to 'exercise their credit' ... 15% of all retail sales were on an instalment basis ...It was fun while it lasted." - Only Yesterday, an informal history of the 1920's, F.L.Allen.

The 'stimulants to purchasing' of the 1920s were modest by comparison with our own times.

At the hint of a tailing off in economic activity governments are now certain to inject more demand, and the reliability of this intervention encourages business to use credit to the maximum of its ability. Companies adjust for safety-nets put there to protect them from economic downturns by taking bigger risks.

Few policymakers understand enough economics to realise that stimulating demand to protect jobs forces companies into taking more risks. In an environment skewed by government intervention, a cautiously managed firm quickly withers and falls victim to takeover by an aggressive one. The fittest business is the one which treads closest to the limit of safety without overstepping it; so move the limit and the fittest configuration for business must follow.

Towards financial sophistication

In our current environment most major successful businesses have extended themselves 'off balance-sheet', and into things like the derivatives markets. Here - under the disguise of clever financial management - they have underwritten financial contracts for fantastic amounts of money to generate small profits on large but improbable risks.

These derivatives are very like insurance, only the risk that is being insured is not a fire or a flood, but the equally low risk financial equivalent - something like "the yield on 10 year US Treasury bonds, less the yield on 5 year Japanese government bonds, divided by the yen/dollar exchange rate will not exceed x before the end of 2009". Modern derivatives are frequently very confusing, but in the end unlikely to go wrong.

But eventually they do. Procter and Gamble - a large cleaning products manufacturer - famously found out what can happen when their $200m borrowings were 'insured' by derivatives to save $7.5m over 5 years. When the impossible happened their small saving turned into a loss - effectively an insurance claim against them - of $157m.

Yet derivatives remain popular because for every Proctor and Gamble there are 50 smaller winners for whom the risk pays off, resulting in what amounts to financial insurance profits being generated apparently out of nowhere – from 'off' the balance sheet.

And in these lucky companies profits rise, their shares follow, and the brilliance of their financial management leads them to take over those companies more circumspect than themselves. So the derivative habit is perpetuated and companies start to rely for their profits on being lucky in financial insurance markets - rather than being good at doing something commercial.

You can see the evidence of this switching to financial activities in the leading companies in the stock-market, both in the growing dominance by totally financial businesses and in the increasing financial operations of manifestly industrial companies.

Banks - for example - have done particularly well. Government stimulation works by using the central bank to distribute large sums to a handful of giant financial organizations at a real interest rate of less than zero. This generous supply of cheap money is then disseminated through the network of financial products from complex derivatives to the humble mortgage, and as it trickles down it puts money in the hands of people to buy what they would otherwise have not bought. In its way it is a magnificent machine, but it isn't very safe in a crisis.

The web of undertakings

The problem is that it all rests on confidence in promises. Simple property can be owned only once. But once the habit grows of saying "you own a right", then soon everything is enmeshed in a web of undertakings, all defined in complex legal language which is dimly understood - even by the people who wrote it.

A typical London property is owned by the freeholder, who may lease it long term to a leaseholder. The leaseholder is mortgaged by a AA+ retail bank, which has packaged up 1000 similar loans into a mortgage backed security [MBS], which has been sold to raise funds to be recycled into the same profitable mortgage market. The MBS was channelled through an investment bank and had its currency switched on the foreign exchange derivatives markets to make it marketable abroad; the foreign exchange risk was merged into a default swap on an inferior rating at BB-. The rump was bought by a pension fund, but is so boring that it has been used to underwrite call options to squeeze an additional 5 basis points for what looks like a tiny risk.

The people who do these deals are clever, well paid, and work for big organisations of the type which can borrow money at exceptional terms from the waterfall of credit pouring from the modern central bank. You cannot help but admire their ingenuity and success.

But the structural weakness in their operation is that it relies on a belief rather than a property. Both sides depend on the confidence that it is more in the interest of the counterparty to behave honourably than to dispute a detailed clause in legal drafting which may have been written 7 or 8 years ago. It is when this confidence in each other breaks that the world witnesses a credit squeeze, and at that time a great many organisations dependent on credit are destroyed.

In 1954 J.K.Galbraith had this to say about the financial instruments of the time just before the Great Depression:-

"One of the paradoxes of speculation in securities is that the loans that underwrite it are among the safest of all investments. They are protected by stocks which under all ordinary circumstances are instantly saleable, and by a cash margin as well....A few firms made this decision: instead of trying to produce goods with its manifold headaches and inconveniences, they confined themselves to financing speculation...This was, possibly, the most profitable arbitrage operation of all time." The Great Crash

When that web of credit failed in 1930 Robert Smitley - writing in 1933 in the pit of the Great Depression - described the mad scramble to convert those promises back into property. He wrote this :-

"It is impossible for the mob mind to grasp the complexity of this credit liquidation. They cannot see the picture wherein about 700 billion dollars of credit is trying to be turned into about 5 billion dollars of money."