Danny's Weblog

The credit crunch has been coming for sixty years

I'm pretty old, so I'm old enough to remember not only things that happened, but also what we were told about them at the time.

For instance, pensions. When the universal pension scheme was introduced in England at the end of WW2, most people welcomed it, but it was fairly obvious that it was being financed in a strange way. That is, current wage-earners were paying for current retirees, and no more than that (actually even less, but that's another issue). In the long run, this only works if the numbers of each group remain stable, or if the wage-earners exceed the retirees. But in this period we had the baby boom. Clearly, unless the population was going to explode, the baby-boom generation would be followed by some sort of reversion to normal fertility rates. And that would break the system. However, the government did not worry because for many years there would be more wage-earners than retirees.

By the time I was old enough to read analyses in the early sixties, the effect was obvious. Simple arithmetic showed that the burden on wage-earners would become stupendous by around 2015. At that time, I was less cynical than I am now, but plenty of people said many cynical things about what the results would be. I formed the opinion that one of the ways that the government would react would be by heavily taxing pension income, and means-testing the recipients of state pensions. I have followed that judgement all my life, and have no pension arrangements whatever.

Why did everyone else not see what I did? Actually, many did: I have often seen it referred to that most baby-boomers believe the pension system will collapse before they can get back what they paid in. But almost everyone took the opposite route: they tried to build up personal savings so that they could survive without a state pension. I think the government will not dare to let pensioners starve, and will continue to provide some sort of pension scheme, but it will have no compunction about seizing assets to pay for this. So I can profit now, while others will be robbed of their life savings to pay for me later. I don't think my behavior in this is any worse than the government's, and much less hypocritical.

But a much bigger reason is what we were being told at the time. We were being told to expect a future in which electric power would be too cheap to measure. We were being told to expect robots capable of carrying out any task, combined (somehow) with full employment. Where is my flying car?

At the same time, we were warned of the risk of nuclear annihilation. Why bother worrying about changing society, or planning, when all of our problems would be swept away, one way or another?

In the fifties and sixties many people relied on company pension schemes. But the swinging sixties left young people no longer expecting to spend their lives with a single employer, and pension schemes ruthlessly punished job-switchers. Also, a string of cases where companies looted their pension schemes were publicized. The best-known case (from the eighties and nineties) is of Robert Maxwell and the Daily Mirror: en.wikipedia.org [http://en.wikipedia.org/wiki/Robert_Maxwell]

Such cases continue to happen, such as (my observation) the way older employees were encouraged to give up long-term jobs at Sears in exchange for apparently more promising jobs at sister companies, only to find that the sister companies were left to wither and the small print of their contracts meant their pension rights disappeared.

So how could people form a nest-egg for their retirement? One way was to buy a house, but there are obvious problems with that. After retirement most people are not eager to go through the turmoil of moving to a smaller, more easily-maintained house, but how else are they to get cash out of the house? Also, as people live longer and require many more years of assisted living, the house would have to be truly palatial, resulting in enormous local tax payments.

And people became aware that there was a speculative boom/bust cycle now in housing. The government kept the house prices high, way above the natural level, by providing tax relief on the mortgage interest, but this resulted in occasional deep falls in prices. (One of the major conclusions from the era of the Wall Street Crash was that it should be specifically forbidden to lend money for the purposes of investment, but that's exactly what the government encourages in the housing market.)

So HMG and the Feds started to offer various schemes to allow people to build portable pensions. Now they never really explained how they were supposed to work. Why exactly should other taxpayers, who maybe have no spare cash for their own pensions, pay higher taxes to subsidize someone to make investments for his own pension? The only undeniable result of these schemes was hugely increased business for the pension companies, plus a new source of investment for various companies on the Stock Exchange.

Still, people were happy. Their money poured into various accounts with a lot of small print, and the investments seemed to prosper (partly because money was pouring into the investments, but oh well).

But what is the *long-term* picture for such investments? Recent history is full of cases where fund managers have made serious blunders in administering a fund, eg Long Term Capital Management (a name which became highly ironic, but which actually did not even reflect their stated modus operandi): en.wikipedia.org [http://en.wikipedia.org/wiki/Long-Term_Capital_Management]

A particularly interesting element in LTCM's case was that after its collapse, its holdings were liquidated making a small *profit*. In other words, even operations which were sound in some sense were vulnerable to speculation. Unfortunately, society took the wrong message from this. It seems to have decided that financial institutions deserved to be bailed out when things go wrong. Society would have been much safer if it had decided to execute LTCM's directors and major investors.

But now we had a situation where millions of individuals with no experience were expected to administer their own pension plan. Not only is it quite possible to pick stocks which go bad – for instance, by misunderstanding the correlation between various holdings so that what appears to be a balanced portfolio is actually highly vulnerable – not only are stock markets subject to long troughs, so that an entire generation of retirees are forced to sell off most of their holdings in the first few years – not only are government-controlled inflation indexes well known to ignore medical and nursing expenses vital to retirees – but simply having too many transactions kills the small investor. Transaction costs are minimal for investment funds themselves, because they know the system and have a strong negotiating position. But individuals see a fee of 2% of the buy and an 0.5% per-annum fee and think that's not much. Well, 0.5% per annum profit is about what the *best* strategies get, long-term, beyond inflation, for the small investor. And a single 2% fee can blow several years of compound interest. And a lot of investors get suckered into even *higher* fees, as well as exposing themselves to intensive marketing to churn their accounts. "Intelligent" pensions are about as good a deal as "long-term capital management".

So people start thinking about housing as an investment again: not just buying your own house, but investing in various more complicated ways. Governments like this because they really have only three strategies: increase taxes, borrow and start wars. (Kind of like the joke about the guy who starts a new job and his predecessor hands him three envelopes.) The beauty of inflating house prices, from the government's point of view, is that it can hand out money to people and the people who will have to *borrow* that money are people in the *future*.

What do I mean by that? In order to hand out more money, the government gives money to banks. But the banks then have to *lend* it to people. This works best if people are *forced* to borrow it. But if the government forces up house prices, by offering tax breaks and reducing the supply by zoning etc, people who *already* have houses are insulated. Those people can easily get loans based on this artificially inflated value, and spend the money on real-granite countertops and Harley-Davidsons and investments in government securities, and the people who will really pay the price for all of this are those people's children, who will be forced to buy houses because rental prices are pushed up by the house prices, so it will still make financial sense to choose to buy instead of rent.

All of this was clear to me 30 years ago, when I sold a house I'd owned for a year, and observed that I made more money than I'd earned that entire year in my job (even after transaction costs).

Well, maybe a lot of people had the same thoughts. But they didn't react by putting any pressure on the governing class. They just figured the situation wouldn't change anytime soon.

Cut to 2003. The US government, for reasons best known to itself, wanted to have a war in Iraq. It didn't want to finance it by raising taxes, because then the people might finally start putting two and two together, and it was lying about the real cost of the war. But it really needed a *lot* of money, so it borrowed the money. It flooded the international market with US securities.

But the supply of credit is not infinite (despite the Chinese government's apparent attempt to demonstrate it). All over the world, sources of credit started to dry up. Housing finance rates, which had been very low for a long time, started to creep up. Young people began to despair of ever entering the housing market and began to resign themselves to sharing housing and living with their parents and siblings. The supply of willing buyers dried up and houses became unsaleable. And people who had been encouraged to buy a house on the assumption that its price would rise enough to pay off a balloon mortgage found that someone else had made a big bet that *they* were going to lose.

Well, you know I'm talking about the credit crunch, which has left most financial institutions which invested – in whatever overcomplicated way – in the housing market completely exposed to fully-leveraged losses. But it's not some big surprise, and the banks who made bets that it would never happen are not the real architects of this disaster. The people who are most guilty, and are least likely to be punished, are generations of politicians of all parties who conspired to convince everyone that "Social Security is the third rail" and anyone who dared to propose the reforms that would be necessary would be destroyed.

And the Bush regime, but you probably guessed I'd say that.

And all of this is happening even *before* the baby boomers start to retire. Now *that* is going to be the real third rail. And we're all going to have to pee on it.

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