October 24, 2008
THE (RE)EDUCATION OF THE MASSES
Seeing the world as chaos, devoid of rules or logic when the capital and commodity markets go into a tailspin and the economic outlook is grim is a potent temptation. But it's a mistake to think that order has run off the rails.
The problem has been hubris—an excess of hubris. The comeuppance is now upon us, and the process of a return to modesty, humility and a healthy respect for risk in money management is in full swing. This comes as a great shock to many investors. But to say this is something new is to ignore history.
Financial calamity is always lurking. As Kindleberger put it, financial crisis is a "hardy perennial." Sometimes it's kept at bay for years, even decades, but eventually the beast returns. Painful as this recurring truth is for those who must live through it and watch hard-earned savings wither, there can be no other path.
Don't misunderstand. The pursuit of progress in economics and portfolio management must continue, and will continue. We're not doomed to sit on our hands and let the financial gods do what they will with us. We can and will advance the cause of intelligence on these fronts. Indeed, we've learned much over the past 100 years. Yet greed and fear are immune to knowledge and wisdom, much as the common cold is resistant to the miracle that is medical science.
But the system—the economy, the markets—impose their own discipline when self-restraint has given way, as it invariably does at some point. Imagine an alternative universe where companies and economies grow to the sky, risk is always rewarded. At some point in this fairy tale world everyone would be a day trader, working out of 80,000-square-foot homes and driving SUVs plush with surround-sound audio and widescreen TVs.
Such a world, as enticing as it may seem on a personal level, would--must eventually collapse of its own bloated excess. Someone has to run the farms, build the bridges and figure out how to build small, more efficient computer chips. Having plumbers and bus drivers, in short, comes in handy on a regular basis.
The discipline that takes leave at times is returned by force in the form of economic and financial turmoil. Stability is inherently unstable, Hyman Minsky famously warned. The inevitable instability isn't pretty, nor is it desirable per se, but ultimately it's necessary to keep us from turning into the financial equivalents of overweight blimps a la the animated movie WALL-E.
One might imagine that the pummeling of investors in the 2000-2002 collapse of the tech bubble would have reacquainted Wall Street and the world generally with the principles of humility and an appreciation of risk. For a time, the lesson was learned (relearned actually), but it was fleeting. This time, however, the lesson will be learned anew, and one day forgotten.
We're all guilty in some degree of ignoring the excess that preceded the correction that now bites us. We're all guilty in some degree of looking back at "history," as defined by 5 or 10 or even 30 years and concluding that risk never looks uglier than this, or that. We're all guilty in some degree of failing to look back over much longer periods of history, at the experiences of different countries, and considering how bad it can really get and what that implies for risk management. We're all guilty in some degree of assuming that a correction would be fairly brief and that it would create a buying opportunity by next Thursday, and that juicy rewards would flow within weeks, or months or certainly within a year. We're all guilty of assuming that the massive rise of debt, the non-stop spending by consumers, and the general embrace of the more-is-better paragon would be a costless affair.
Yes, some of us were warning of the dangers for some time. What's more, some have studied the past deeply in an effort to understand the full range of possibilities in the money game. GMO's Jeremy Grantham is one example. But such warnings generally fell on deaf ears. That's no great mystery. Optimism comes easily to the human mind. Meanwhile, preparing for the apocalypse--or just thinking about it--is always easy to postpone, like bringing out the garbage or cleaning up after the dog.
We've all been disabused of these and other short-sighted and historically shallow notions. Few of us have ever seen anything like what we're experiencing now. Few were expecting the risk blowback that now afflicts the planet. But the future is rushing toward us, and it's a future with a lot less finance in the economy. For some time now there has been too much finance in the world. It was naïve to think that the industry, and all its excess, could keep growing indefinitely. But that has stopped, and the process will continue reversing in a big way for a long time. The future will deliver few mutual funds, fewer ETFs, fewer hedge funds, fewer over-sized egos in money management, to name but a few examples.
It's all very painful, of course, partly because the biggest bull market of all was the explosion skyward in expectations. The hardest task is coming to terms with a future that looks radically different from the past. But rest assured, the pain too will be fleeting. When the last man has sold; when it looks like nothing could go possibly right again; when darkness appears infinite; that's when the rebound will commence in earnest. It'll arise quietly, mysteriously, and almost no one will see it in the beginning. But it will come. Meantime, we're all booked for a lengthy session in the Economics Re-education 101.
Posted by jp at October 24, 2008 10:25 AM
it is instructive to recall some psychology theory in which they proved that humans over-anticipate both pain and pleasure, prior to the event - try to be more even-minded and avoid both highs and lows
so it goes
Posted by: franko at October 24, 2008 2:30 PM