Since 1980, the global economy has become increasingly financialized – by all measures, the ratio of debt to GDP has steadily increased. If something cannot go on forever, it will reverse, and there are two ways in which this might do so. One way is the global kumbaya of a debt jubilee, which would collapse human civilization. The other much better way is a de-financialization, such as we have suffered twice before – a painful but necessary return to sound finance and paying cash. As an optimist, I believe this economic root-canal procedure is in our future.
There have been two previous de-financializations that I know of. One came in both Britain and France after the twin speculative bubbles of 1719-20: the Mississippi Company in France and the South Sea Company in Britain. Both bubbles involved an unsavory mixture of stock market speculation and an attempt by a greedy government to “lose” government debt in the maw of a private company, through tapping the almost infinite gullibility of bull market investors.
The de-financialization took different forms in the two countries. In France, the government simply defaulted on the deposits of a bank, Banque Royale, that had taken over the government’s debts and supposedly had the government’s full faith and credit behind it. This was essentially a “Debt Jubilee” applied only to the government’s debts; its result was the ruination of the French middle classes and much of the aristocracy. There was a reason the aristocratic salons of Louis XV’s time were located in Paris apartments and were thoroughly radical and anti-capitalist in their outlook; their participants or their immediate ancestors had been ruined by the 1720 crash and forced to sell their chateaux and lands and live like bourgeois. Thus, France had great difficulty financing its wars with England during the 18th century. The long-term result was the French Revolution, radical like the 1917 Russian Revolution rather than bourgeois like the English Civil War or the American Revolution.
In Britain, there was only a partial default, with losses confined mostly to those who could afford them, but a sharp clamp-down on the stock market’s capital raising ability with the 1720 Bubble Act. There was also a sharp clampdown on the non-metropolitan working- and middle-classes, who were disgruntled in 1714 by being deprived of a Tory government that they had elected with a landslide majority less than a year before – the Riot Act dates from this period, as does the 1723 Black Act. This combination dampened entrepreneurship, but it also reduced the financialization of the economy and made it stabler – the mad new issue boom of 1720 gave way to an almost complete dearth of new stock issues for the next 50 years, while the exciting lotteries and tontines of the pre-1720 period developed over time into the beloved 3% Consols, favored investment of widows and orphans for the next century or more. Finally, after 1760, a new economy emerged, based in the provinces rather than the City of London and with mainly sound canal and industrial companies financed primarily by equity.
There was a certain amount of de-financialization after the market peak of 1873, with deflation for the next two decades and investment re-orienting itself towards industrial sectors in both Britain and the United States. In Britain, Anthony Trollope’s magical cosmopolitan financier Augustus Melmotte goes bankrupt and shoots himself, while in the U.S. the raffish over-leveraged Jay Gould and Jay Cooke are succeeded by the ultra-conservative John D. Rockefeller and J.P. Morgan. However, the next major period of de-financialization, in the United States more than in Britain, was the two decades after 1929.
The 1920s had been a period of striking financialization. Retail investors had widely used margin loans to speculate in the stock market, or short-term mortgages to invest in the Florida land boom. The result was a gigantic asset bubble that would not have been possible under a proper pre-Fed Gold Standard, which necessarily crashed after the market fell in late 1929. More serious was the wave after wave of bank failures that followed, which reduced the U.S. money supply without the Fed really noticing. Banks themselves had not been notably over-leveraged in the 1920s – the typical bank equity ran about a fifth of assets – but the squeeze on money and decline in asset values from 1930 on wiped out the banks’ equity even at that rather generous level.
The de-financialization of the early 1930s lasted right through the late 1950s. The stock market eventually recovered but remained conservatively valued compared with what came before or after. Bank and investment bank rules on leverage were extraordinarily stringent; with no significant public takeover market, major corporations ran with vast amounts of cash, little leverage, and assets in their balance sheet that were often seriously understated because of wartime and post-war inflation. Credit cards did not exist, and personal bank loans required an interview with the bank manager that was beyond most people’s stress tolerance. The government had a lot of debt, but in many years ran surpluses, which together with inflation and robust growth, reduced its relative level. The result was an environment with almost no venture capital, small businesses financed only on a “bootstrap” basis (so, more franchise chains than tech companies) and productivity growth that has never been equaled, before or since.
De-financialization has costs, as the Great Depression famously demonstrated, but it also has great advantages. Inequality declines, because leverage becomes more expensive and difficult to obtain even for the very rich, while asset prices crash. Productivity growth improves, as does innovation, because there are fewer spurious “get-rich-quick” schemes by which the young and ambitious can make money, so they have to do so the hard way (the 18th Century de-financialization led to the Industrial Revolution). Personal finance becomes easier to manage, because debt becomes difficult to obtain, while items that depend on financial availability, such as expensive automobiles, medical services and above all, higher education, become cheaper and of higher quality, because they have to attract the cash buyer. Governments waste less money, because government debt is expensive and damaging to the private sector’s credit availability.
In recent decades, since about 1995, the benefits of de-financialization in the United States have been completely lost. The 1998 Fed-arranged bailout of the hedge fund Long-Term Capital Management was a huge signal that financial incompetents and even fraudsters would be rescued by the Fed and the banking system (the Citigroup bailout in 2008 re-emphasized that message).
Monetary policies since that date, with persistent negative real interest rates, have been designed specifically to avoid de-financialization, because of the losses it would cause to the politically connected. The Fed panicked in 2001-02, when the stock market started dropping from its absurd peaks, and panicked even more in 2008, when apparently respectable but in practice ludicrously greedily managed and over-leveraged financial institutions started to go bust.
Companies have bought back their stock to the extent of wiping out their equity altogether, without regard to the effect this might have in any kind of recession. The government has run persistent and ever-increasing deficits, with its Medicare and Social Security trust funds due to go bankrupt within the next decade or so. Individuals have taken on credit card debt, automobile debt, mortgage debt and above all student loan debt at levels that would have been unthinkable 40 years ago. As a result, bubbles in everything have appeared and productivity growth has gone negative.
Now we need a de-financialization, which the Fed and the politicians will resist, probably for a decade or more. Inflation will not come down from its current 6-7% unless interest rates are forced up to 8% or more, but that is not something the Fed is currently even contemplating. Once the bullet has been bitten, creditors will probably have lost a large portion of their investment, as inflation will have eaten away at capital values, which will make most pension funds and insurance companies unsustainable, as well as many banks. It is difficult to see how this can occur without a partial repeat of the 1930s, although one can hope that the 1930s policy errors of raising taxes and protectionism will be avoided, making the devastation less extreme.
For the survivors, the de-financialized world will nevertheless be very attractive. Innovation will flourish, primarily in areas where capital has not been poured in over recent decades. Personal savings will receive a positive real return, encouraging thrift and good housekeeping and discouraging flashy conspicuous consumption. Companies will seek to provide value to their shareholders through dividends and modest growth of their businesses, avoiding “woke” fashionable destructions of shareholder value, and paying their CEOs no more than is needed to maintain an upper-middle-class lifestyle. Banking will be a quiet business, representing only a modest portion of the economy, with long careers and few risks. Think Thomas Edison combined with Normal Rockwell, and you have it.
It is an attractive final destination. But my goodness, the road we will travel to get there will be a rough one.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)