N0 one knows, at year's end, whether there will be global recession in 2008. Or whether Europe and America will enjoy a moderate growth in jobs and incomes. Why this new ignorance?
Up-bubbles in real estate, followed by down-bubbles in real estate, are an old, old story in the economic-history textbooks. Sometimes, these were volatile enough to put the whole economy into a succession of recessions and recoveries.
The mechanism was simple. When housing prices went sour, families became hard-pressed to pay monthly interest owed on the home mortgage.
Therefore, (1) consumer spending on other necessities and luxuries understandably tended to fall after the realty bubble burst. Also, (2) jobs and wages in the building trades dropped when housing prices were dropping.
Modern central banks thought they knew how to 'lean against those winds'. The Bank of England, the US Federal Reserve and the new EU Central Bank would lower their interest rate in the bad times, in order to bring down and offset onerous mortgage payments.
Similarly, when GDP rises so fast as to threaten us with inflation rates above say three per cent, the central banks stepped on their brakes by raising official interest rates. That usually cooled off over-full-employment boom times.
I will add one important remark. My father-in-law, as president of the First National Bank of small town Berlin, Wisconsin - where he was the key lender to local mortgage borrowers - not only had known for a long time those who came to him for mortgage money; he also in all probability knew personally the grandparents of current borrowers.
As a result, when credit conditions and real estate prices were changing, it came as no surprise to him that some debtors would be less hard-pressed than others, who would be in considerable distress.
What is the new element here, differing from the plain-vanilla historic real estate financing ups and downs?
Three words sum it up for me: modern financial engineering. What does this include?
It includes new financial derivatives - 'puts' that reward you when IBM stock or US government 10-year bonds fall in price. And 'calls' that reward you in a leveraged way when your stock or bond is rising in price. It includes all new varieties of collateralised securities that corporations and banks permit themselves to keep off their balance sheets.
Last year, when small banks everywhere placed mortgages on local homes, they sold off, to unknown parties in New York or above the Arctic Circle in Norway, a packet of good and bad mortgages. (A 'bad mortgage' was one granted to a poor family who likely would not be able to keep up its committed monthly payments, unless the housing bubble kept growing.)
America did not send smallpox germs or anthrax abroad. But what it did do, under the deregulation brought about by President Bush's choices for regulators, was to export packets of good (mortgage) cheese, really criminally bad cheese, and in-between cheese. All were given AAA ratings for safety by the three main rating agencies - a really bad and costly joke.
The new few thousand hedge funds were among the suckers to buy these - not with their managers' own money but with their client investors' money.
All 'transparency' was lost. And no one, even in the biggest banks and investment banks, understood that they were over-leveraging (not 2-to-1 or 5-to-1, but maybe even 25-to-1).
Once the real estate bubble came to an end in Florida, New York, Los Angeles and Boston, panic and incipient bankruptcy hit Wall Street, Zurich, London and investors virtually everywhere.
Everyone, from the chief executive officer of Goodman-Sachs to his elevator operators, was hit by surprise.
The central banks did belatedly (!) come to the rescue with huge infusions of new credit cash.
However, icebergs are bigger than what you see on the surface. Neither Governor Alwyn King of the Bank of England nor Chairman Ben Bernanke of the Federal Reserve can today make any accurate estimate of how much bankruptcy is already foreordained.
Future historians will put some of the blame on the Bush-Cheney Republican presidency. Maybe once upon a time a Republican presidency was good for the stock market and for Main Street prosperity. When Calvin Coolidge napped regularly in the White House, the Wall Street boom of the 1920s took place.
Times do change. It was Democrat President Franklin Roosevelt who launched a 20-year bull stock market. After 1960 President John F Kennedy did 'get the country moving again', as he had promised to do in many a pre-election speech.
It would be cruel to blame the Republican Party of Abraham Lincoln for the incompetence of the Bush governmental team.
I helped train at MIT a generation of financial engineers. Early on, in Newsweek columns, I advised both Mid-east sheiks and Norwegian parliamentarians to invest in worldwide portfolios rather than induce inflation at home.
Maybe I should feel like Dr Frankenstein, who created a potentially fabulous creature but, alas, one that turned out to be a monster.
Advanced science can help mankind enormously. It can also create atomic bombs to kill hundreds of thousands of people.
Financial engineering is like that. Under proper regulation and with optimal transparency, it can spread risks efficiently and in that sense reduce intrinsic risk. But sans transparency and lacking understanding of the arithmetic of cancerous leveraging, maybe it introduces into modern finance a new fragility?
My last sentence ends, as it should, with question mark. Time will tell.
The writer is considered one of the founders of modern neo-classical economics and was awarded the Nobel Prize for Economics in 1970
