'Capitalism goes through recurrent periods of insanity, which it always denies to be the case until after the fact.' So said that astute observer of financial manias, bubbles and crashes, the late economist John Kenneth Galbraith.
We have to go back to October 1929 to find something comparable to what we've been seeing lately on Wall Street. The 'roaring twenties' was the decade of the jazz age, a time of high decadence and excess - of wild parties, opulent mansions and risque fashion - all so vividly captured in the novels of F Scott Fitzgerald.
After a five-year-long stock market boom attended by an orgy of speculation in stocks and all manner of unregulated exotic financial instruments, the US stock market teetered, and then collapsed. On Oct 28, 1929, the Dow fell 22.6 per cent, and then another 12.8 per cent the following day. It continued to trend down for three years, and when it finally bottomed out on July 8, 1932, it was 89 per cent off its September 1929 peak.
The 'Great Crash' as it was called, transformed the financial and economic landscape; from 1929 to 1933, a wave of bank failures swept across America; even brand-name institutions went under. There was a severe credit crunch, which in turn led to business failures; thousands of healthy businesses became rapidly sick and died. Other asset prices crashed. In 1933, almost half of all US mortgages were in default. Unemployment hit 25 per cent. Millions were ruined, some going from stupendous riches to soup-kitchen rags, almost overnight. Many one-time financial heroes morphed into villains - including the president of the New York Stock Exchange, Richard Whitney, who went to jail.
Downward spiral
The downward spiral of the economy is well summed up by Alex Pollock of the American Enterprise Institute: 'Mortgage defaults, tightening credit, reduced demand for houses, foreclosures, falling house prices, greater defaults, failure of lenders, even less credit, further reduced demand, more foreclosures, greater supply of houses for sale, further falling prices, more defaults, failure of more lenders, no credit, further falling prices and frozen markets.'
The world economy was not as globalised then as it is now. Nevertheless, the ripples of the Great Depression were felt around the world. Stock markets, wherever they existed, also tanked. Global deflation ensued.
The world will almost certainly not have to relive the horrors of the 1930s; scary as the current turmoil may be, it is nowhere as bad as it was then. It's also a different world economy today, with many centres of dynamism. However, to anyone who has read about the 1930s, recent events would seem eerily familiar.
The financial world is emerging from yet another episode of excess and insanity. A seven-year-long housing boom in the US has come to an end. Many recent practices - and the psychology that fuelled them - were present in the 1920s too: easy credit; imprudent lending, especially for mortgages; a variety of incomprehensible financial instruments; generous use of leverage; extravagantly paid bankers; a licentious environment in which financial institutions were free to 'innovate', with regulators looking the other way; and psychologically, a widespread conviction that asset prices could go only go up.
The great crash and ensuing depression led to a sea change in economic regulation and management. New regulatory agencies were set up, most importantly, the Securities and Exchange Commission, to regulate stock and bond trading. Also, there was the Federal Housing Administration to kick-start the mortgage market, and the Home Owners Loan Corporation (HOLC) to take defaulted home loans off the books of banks. The Glass-Steagall Act was passed to separate the activities of commercial banks from investment banks.
We are on the threshold of another paradigm shift in economic and financial regulation. Before that, though, there is likely to be (as in the 1930s) a dramatic consolidation in the financial industry - a process which has already started. Stand-alone investment banks like Merrill Lynch, the bankrupt Lehman Brothers and perhaps even Morgan Stanley and Goldman Sachs may come to be recognised as having doubtful business models going forward: there will probably no longer be a market for a lot of the complex securitisation (that, for example, magically turned houses into financial derivatives) undertaken by these institutions and from which they made a lot of money. Many weak banks - and hundreds of them may collapse - will be taken over by stronger institutions; several merger talks are already underway. Insurance companies too, will be broken up. Effectively, that is what will happen to AIG, which now has to sell substantial assets to pay back its US$85 billion loan from the Fed.
Change in mindset
The mindset of central bankers could also change. They will be wary of prolonged periods of easy credit. Policy will move more towards 'leaning against the wind', or as a former Fed chairman William McChesney Martin put it, 'taking away the punchbowl when the party gets going'. Central banks may pay more attention to asset prices and perhaps even target them in monetary policy.
Sweeping regulatory changes might also come; free market ideologies will be thrown out the window under demands from an angry public for more oversight. Mortgage lending standards will be tightened and consumers will have more protection. Many exotic derivatives will be banned; financial institutions will be required to be much more transparent about what they carry on their books. Hedge funds will come under greater scrutiny, as well as credit rating agencies, and executive compensation too. Fundamentally, the prevailing assumption among regulators - that financial institutions know what they are doing - will be questioned.
When the dust settles, the world of high finance will be different and perhaps a little duller. Investment bankers will no longer be the masters of the universe. Many financial heroes of the past - starting with former Fed chairman Alan Greenspan - and a number of bank bosses will be deconstructed. There will be an avalanche of lawsuits against financial institutions. Hollywood will make movies that are set against the financial madness of our time.
Sanity will eventually return to the markets. But if people like Galbraith are right, and if history is any guide, it won't endure.
This article was first published in The Business Times on September 20, 2008.
