Double Bubble Trouble?

By Sebastian Mallaby
Monday, April 7, 2008

There are two views of the financial crisis. The first is that we face the bursting of a real estate bubble, a product of loose monetary policy, no-doc loans and alphabet-soup financial securities. The second is that we face the bursting of that bubble plus a terrifying long-term one that has been building since the Reagan era. This second bubble is the product of a quarter-century expansion in borrowing, excessive confidence in the dollar and an overblown faith in markets.

The chief partisan of this double-bubble diagnosis is George Soros, hedge-fund manager extraordinaire. His latest book, published electronically last week, predicts the deflation of the second bubble, with chilling implications. You don't have to agree with every part of Soros's argument to embrace his prescription. It's not enough to respond to the real estate bubble in this crisis; the long process of credit expansion must be brought under control.

Between 1950 and 1980, total lending in the United States inched up slowly relative to the size of the economy. Then, in the early 1980s, it took off. Every dollar of capital was "leveraged" aggressively: Private equity wizards loaded firms with debt; hedge funds bought securities on margin; banks lent prodigiously on thin cushions of capital. All this leverage boosted rewards in good times, because a thin capital cushion means fewer shareholders to divvy up the profits. But a thin capital cushion has the opposite consequence when a shock comes. There are fewer shareholders to absorb losses and still repay lenders. Bankruptcy beckons.

Why have Americans gorged on debt? First, because it has been available. The dollar is the world's reserve currency: Holding a dollar-denominated bond or bank deposit has been thought of as the safest way to store savings. So whenever Americans have wanted to borrow more, the world's savers have been happy to provide the capital. As with any bubble, this confidence in the dollar became self-fulfilling. Precisely because the United States was regarded as a safe haven, money flowed into the country at the first sign of trouble, buoying the value of everything from stocks to bonds to real estate.

The second reason Americans gorged on debt was that it didn't seem too risky. Whenever a really big bankruptcy loomed, regulators staged a rescue, cutting the risk of lending to the top players. Without the Fed's intervention, people who lent to Bear Stearns or bought its fancy securities would have been hit with nasty losses. But thanks to the Fed, Bear was the latest in a long line of episodes in which creditors escaped relatively unharmed.

Debt also seemed not to be too risky because financiers had excessive faith in their statistical models. These suggested that their investments would never lose more than a small percentage of their value: Hence a thin capital cushion would suffice. But since its invention in the 1960s, financial economics has overestimated the efficiency of markets and underestimated their tendency to swing viciously. Along with the authorities' successive rescues and savers' confidence in American assets, this error kept the debt party going.

The nightmare is that this long party will be followed by an equally extended hangover. Savers will lose confidence in the United States, preferring to hold euros. Financiers will re-evaluate their models and bring borrowing levels down with a bump. This "deleveraging" will depress the economy, further encouraging savers and financiers to ration credit. The growth-fuelling debt expansion of the past quarter of a century could be followed by a growth-dampening contraction.

If this double-bubble thesis is even partly accurate, the authorities will not be able to protect us from hard times. But what they can do -- in fact, must do -- is guard against policies that inflate the long bubble even further, making the eventual hangover still worse. It is foolhardy to bail out Bear Stearns and pump liquidity into Wall Street without considering what this might do to reinforce the credit culture. Today's necessary rescues must be followed by tomorrow's necessary discipline.

Two reforms stand out as necessary. The complex securities that are traded "over the counter" between banks, hedge funds and other players must be brought wherever possible onto exchanges, because this will reduce the pressure on the Fed to stage rescues. Bear Stearns was not too big to fail; it was, as The Economist has said, too entangled to fail: Its bankruptcy would have stranded holders of billions of dollars of its securities with nobody on the other side of their contracts. When trading moves onto an exchange, the exchange itself guarantees the contract. One impetus to Fed rescues can thus be neutralized.

The second reform involves a lesson from the clever authorities in Spain. Until now, banks have measured their capital cushions by figuring out what their holdings of securities would fetch in the market. This is a formula for bubbles: As markets rise, the value of banks' holdings grows, allowing banks to lend more and drive markets up still further. Spain's central bank broke this cycle by requiring lenders to increase capital cushions during a market upswing. It would be a fitting acknowledgment of America's tarnished preeminence if the world now embraced the Spanish model.

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