Reading time: 20 – 33 minutes
The book whose cover is shown on the right was published in 2003 and again in 2004. The author was a credentialed Certified Financial Analyst with 34 years of experience on Wall Street, having lived through 7 bull markets, 7 bear markets, and 5 recessions.
Of course, in hindsight, it is easy to see that Mr. Zucarro was entirely wrong in his forward vision of the market, but for those in the market at the time — literally millions of people — his view of the future seemed entirely reasonable.
"Why It's Different This Time: DOW 30,000 by 2008" by Robert Zuccaro, CFA
I bring this book to your attention, not to make fun of Mr. Zuccaro, but to sympathize with him — his error was simply being human. Like all of us, his vision of the future was based on past experience and the longer this experience, the greater the illusion of certainty caused by this backward vision.
Now, I myself would never have bought Mr. Zuccaro’s book, because I believed equities to be significantly over-priced in 2003, but that is not my point.
Economics is not a science
As children, we learn that a hot stove can burn our fingers and this lesson of experience is as true when we are seventy as when we were five. It remains true because Physics is a science and the relationship between hot stoves and burnt fingers does not change from time to time.
However, economics is not a science in the same sense. Mr. Zuccaro’s 7 bull and 7 bear markets were each distinct one from the next. The variables were all different, the histories were different, and most importantly, the people, sociology, and institutions were different — although they may have had the same names and designations throughout the period.
Wall Street was still in New York, the SEC still ruled the market, the New York Stock Exchange, the Dow Jones Average, Lehman Brothers and Goldman Sachs were all still there throughout this 34 year period.
However, the people were different — some were older, some were just starting their careers. The laws were different, for even the US Constitution was constantly being reinterpreted. There were new leaders among the old, new wars, new international crises, new trading technologies, new economic theories, and — most importantly — the morals, ethics, and customs of the people were gradually changing, for better and for worse.
Interpreting economics: Can you see a pattern in this picture? Can you use this information to deduce a useful rule for action?
Misinterpreting economic events
Humans succeed by learning from experience.
Some experience (like the hot stove-finger example) provide useful, lifelong rules for action.
Other experiences, especially those which involve the behavior of millions of people (like economic crises), are unlikely to ever be repeated in precisely the same way and have so many unknown variables as to defy useful rule-making.
Note: Economists can explain why something happens, or predict (not always correctly) what is likely to happen if such-and-such is done, but their forecasts as to the timing of an economic recovery are usually no better than any one else’s.
Nevertheless, as humans we have an irresistible desire to look for patterns and seek rules that will guide our future behavior and that we can teach our children.
‘Economic experience’ is contained not only in what we observe directly, ourselves, but in books on history, investment success, and economic theory, written by those who profess to have a certain ’scientific detachment’ or record of achievements in weathering past crises and who thereby have earned the respect of others for their expertise and willingness to share their knowledge.
For investors, this ‘persistence of backward vision’ can have unfortunate consequences.
Past crises and economic recovery
Studying economic history is by no means a waste of time. There are many valuable lessons to be learned.
However, the danger lies in trying to derive ‘economic laws’ — a kin to laws of science — from inaccurate, incomplete data, and non-repeating circumstances — which is precisely what we are all prone to do.
"This time is different: Eight centuries of financial folly" by Carmen M. Reinhart and Kenneth Rogoff
What can we learn from past crises? The book, “This Time is Different: Eight Centuries of Financial Folly” by Carmen M, Reinhart and Kenneth Rogoff, seems at first glance to be the antidote to Robert Zuccaro’s book, above.
It certainly is a book that deserves to be in the library of any serious student of capital markets.
The Reinhart & Rogoff’s book does an excellent job of presenting a taxonomy of economic crises, from inflation, monetary debasement of various types, to banking crises and currency panics.
The authors carefully describe the characteristics of various types of crises and their causes.
However, the book does not provide useful guidance for predicting exactly when a crisis will begin, how long it will last, and what the signs will be that it is ending.
There are no rules for economic recovery.
The reason for this is that the triggers for various stages of crisis development are often completely unpredictable and, even in retrospect, implausible.
Wars and other surprises
Who would have thought that the assassination of an Archduke in Sarajevo in 1914 would have led the slaughter of millions of young men in senseless trench warfare in Western Europe, the fall of the British Empire, and the transfer of the center of world finance from London to New York?
The future is full of surprises.
Who, in January 2008, would have predicted the fall of Lehman Brothers in a two weeks period, only nine months later, and the landslide victory of Barack Obama, a politician without any executive experience, mainly known for his Marxist pals and as a community organizer?
Even in December 2008, after the current crisis had started, most failed to predict that Obama would govern from the far left, pushing the federal debt to $13 trillion in just 17 months with extraordinarily wasteful spending, forcing an unpopular national healthcare program, without bipartisan support and against the wishes of the majority of voters? Even today, as I write this, many millions of Americans refuse to believe the radical nature of the Obama Presidency and this leader’s Marxist inclinations.
Benjamin Roth’s Diary of the Great Depression, reviewed in my last article, shows that throughout the Great Depression, experts were constantly predicting that the bad times had ended, even as early as 1931, only to be shown wrong, time and time again.
Predictions of economic recovery were generally wrong.
Two kinds of crisis
Although Reinhart and Rogoff carefully document a variety of types of financial crises — information that is useful from the point of view of understanding what is going on — I believe that there are only two type of crisis that are really important to be able to distinguish from the point of view of market timing.
Of the various business cycles and economic crises, some are game-changers and most are not.
These are crises that are ‘game-changers’ and those that are not.
Markets of all types, including financial markets, go through cycles of rising and falling prices, which in turn may cause institutions to fail and people to lose jobs and wealth. However, most of these ordinary crises end in an economic recovery in which the fundamental institutions, rules of the market, and beliefs and behavior of market players do not change significantly.
For example, the Crash of 1987, caused presumably by problems with program trading, resulted in a sharp fall in equity values that took two years to recover. However, the market institutions, with some minor rule changes, continued as before. Buybacks still dominated the equity market, there was no radical change in government, New York was still the financial capital of the world, and so forth. This is an example of a crisis that was not a ‘game-changer’.
The fall in equity prices in 2000, in the aftermath of the Dot.com bubble and tied to the buyback movement (See: Case Study of the Crash of 2000), led to a quick economic recovery, some minor shifts in behavior, and the continuity of long-term institutional and societal trends.
In each crisis, economists try to mark the precise beginning and end of the period on charts according to certain definitions for recession or depression, without pointing to any unequivocal signs that would alert future investors as to when, in a current situation, it is indeed safe to commit one’s wealth to the market.
I believe that the problem lies in the fact that some crises are ‘game-changers’ while most are not. In an ordinary crisis, investing for the long-term is not a bad policy — in a ‘game-changer’ crisis, the ‘long-term’ may take much, much longer to kick in than you imagine.
Cyclical capitalist entropy
Since the 19th century, economists have advanced a variety of theories to explain periodic variations in economic activity, which go under the general heading of ‘business cycles’. See Wikipedia for a good overview of this concept.
Economic systems and institutions tend to gradually corrode and become increasingly inefficient and unstable
There is even skepticism as to whether such variations are truly cyclical, or not. (I myself suspect that these ‘cycles’ are an illusion, rather than manifestations of some inner economic clock.)
However, I do believe that there is a type of cyclical activity that afflicts capitalist societies, with periods of unpredictable duration, that I would attribute to the phenomenon of ‘capitalist entropy’.
I use the word ‘entropy’ here not in the strict sense of the physical sciences and the second law of thermodynamics, but rather as a metaphor for the tendency of social systems to become progressively inefficient and corrupted, leading to periodic ‘resets’, resulting in major reorganizations of political, economic, and social institutions — what I call a ‘game change’.
Systemic Deterioration
The hypothesis of capitalist entropy is based on the concept of an ideal, initial Adam-Smith-like society, in which entrepreneurs have a robust moral code that is based on mutual respect, a work ethic that includes the idea of producing something of value at a fair price, solid, conservative market institutions and useful financial products for the current technology, competent and honest government oversight and policing, and a stable political system.
Of course, this pristine, ideal capitalism never has existed, and never will. Even after the most rigorous reforms, this state of perfection cannot be attained. But the concept is useful, anyway.
Over time, this ideal society gradually changes:
The diseases that infect capitalist societies constantly mutate, are slow acting, and gradually weaken the system from new, unexpected angles.
- Ethical and moral deviation: The principles of fairness, honesty, and respect for one’s clients gradually are eroded by avarice and selfish motives. The ‘Agency Problem‘ arises. New, less-worthy philosophies are introduced and taught to young people. Eventually market participants come to believe that, ‘Greed is Good’ and that sharp dealing is a natural and a worthy aspect of capitalism.
- Corruption of the regulators: All societies need a police force to protect the innocent against deviant behavior. However, these regulators are gradually corrupted by the regulated. The rules, designed for one era, do not adapt to technological and social change and are bent by new, mischievous theories.
- Increasingly risky behavior: In the pursuit of profit and gain, entrepreneurs gradually slip the traces of prudence and commonsense, adopting increasingly risky behavior. The economic witch doctors proclaim a New Era and modern theories of risk mitigation, with the idea, ‘It is different this time’.
- A drift towards socialism: Concepts of individual self-reliance and small government are gradually (or sometimes abruptly) replaced by notions of dependence upon a supposed all-powerful, ‘wise’ government that promotes ‘fairness’ and redistribution of wealth. In return, taxes and regulation increase, government becomes ever more corrupt, and the seeds of inflation and political instability are planted.
The demon of socialism and drift towards repressive, big government is a constant threat to capitalist societies.
- The invention of new financial products and techniques: Our hypothetical initial ideal capitalist society is based on a certain set of technologies. Over time, new ‘better’ systems and techniques are introduced with seemingly irrefutable advantages and ardent promotors. However, these new products contain flaws — unexpected defects that were not foreseen by their inventors and that are not guarded against by the old regulatory system.
- Institutional entropy: The organizations of capitalist systems — the exchanges, clearinghouses, banks, brokers, and issuers — gradually become larger, more complex and, less transparent. In the process, markets become more inefficient and regulators less able to control or even understand inappropriate behavior.
Some examples of ’game-changers’
Game-changing capitalist cycles are relatively rare and each is quite different from the others. I can identify only four ‘game-changing’ cycles that I lived through, one of which occurred when I was a child:
Life on the streets of NYC in 1935, under Franklin Delano Roosevelt.
- The Great Depression (US): Touched off by the stock market crash of 1929, this ‘game-changing’ period lasted throughout the Hoover, Roosevelt, and Truman administrations, emerging into a new reformed capitalist system in the Eisenhower administration. The old systems were swept away by a long period of deflation, World War II and the Korea War, and careful, bipartisan financial reforms under the guidance of the Pecora Commission. I was only a child during most of this period, but got my first job with a reformed Citibank in 1956. (See: The Decline of Citicorp: Some banks are too complex to manage.) See also: FDR and workers’ capitalism.
Burn, Baby, Burn. The Watts riots in Los Angeles in 1965. 34 people died; 1,032 were hurt; 3,952 went to jail. This is what is mean by 'blood in the streets'.
- The Johnson-Nixon-Ford-Carter Years (US): The good times brought on by the Eisenhower administration ended with the assassination of John F. Kennedy and the inauguration of Lyndon Baines Johnson. LBJ mired the country in a seemingly purposeless war in Vietnam (most Americans weren’t quite sure what the war was about), while carrying on a socialist ‘War of Poverty’ that increased the size of government and regulatory interference and that (together with war spending) laid the basis for stagflation in the following three administrations. Regulatory changes included ERISA and the reform of mutual fund marketing techniques. The 1973 Oil Embargo led to the delinking of the dollar from gold and weaknesses in major bank stability, due to careless efforts to recycle petrodollars. This was a period of ‘blood in the streets’, characterized by race riots, anti-war demonstrations, and anarchism, inspired by communist radicals such as the Weather Underground, the training ground of Bill Ayers and Bernadine Dohm, friends of a future US President, Barack Obama . This ‘game-changing period’ ended with the election of Ronald Reagan. See: LBJ’s Great Society.
Jânio Quadros was known for banning bikinis in Copacabana, ordering public employees to wear strange uniforms, and admiration for Che Guevara
- The Quadros-Goulart Years 1961-1964 (Brazil): This was a crisis caused by a flawed political system that allowed a losing candidate for President to become Vice President and resulted in a radical leftist, Goulart, becoming President of the largest country in South America. On the eve of April 1, 1964, João Goulart, backed by the Soviet Union, attempted a coup d’etat but was deposed by the military that favored democracy. While trying to sort out how to get democracy back on track, the military oversaw the country for a period of fifteen years, introducing major economic reforms in the capital markets and engineering ‘The Brazilian Economic Miracle”. This is an example of a ‘game changer’ that was caused not by a flaw in the capitalist system, but rather in the political structure that contained it. The triggering event for this crisis was the sudden, unexpected resignation of a popularly elected President, Jânio Quadros on August 25, 1961, while his Vice President was on a trip to Communist China. The reasons for his resignation are not entirely clear to this day. See: Prelude to the Revolution of 1964.
Jakarta riot, May 14, 1998. Racist extremists targeted Indonesians of Chinese descent.
- The Habibie-Abdurrahman Wahid-Megawati Sukarnoputri Years 1998-2004 (Indonesia): In the last quarter of 1997, Indonesia suffered a severe currency crisis when the country’s Central Bank ceased to protect the Rupiah-Dollar rate. Since most corporations in Indonesia had unhedged debt in US dollars, the result was the immediate insolvency of most major corporations and banks. This coincided with a growing dissatisfaction with the behavior of the children of the autocrat Soeharto, who had ruled the country for 32 years. What followed was a period or riots, lawlessness, and ‘blood in the streets’, accompanied by severe deflation and one of the most serious economic crises of the 20th century. Within six month, Soeharto resigned, leaving the country in the hands of his Vice President, Habibie, who was generally unpopular. In the last year of the Soeharto period, popular opposition to government corruption was manifested by the slogan, KKN, the Indonesian initials for Corruption, Collusion, and Nepotism.
Of the various manifestation of economic cycles, only a few are true 'game changers'.
The three presidents that followed Soeharto were sometimes characterized by the public as the ‘democratization of corruption’. Only in October 2004, with the election of Susilo Bambang Yudhoyono, did this period of transition end. Fortunately, in the latter years of the Soeharto reign, the capital market had been reformed, with a modern securities law, effective regulations, and a modernized stock exchange and clearinghouse.
The fifth ‘game-changing’ period that I have experienced is the Crisis of 2008 that brought to power Barack Obama and wrought the most profound damage on Wall Street institutions in seventy years. This ‘game-changing’ crisis is not over yet and the purpose of this article is to shed some light on how long it might last.
Now, it is likely that over the last 70 years that there have been many other ‘game-changing’ periods throughout the world, but these are the only ones that I have lived through at ‘close range’, so to speak.
The fact that ‘game-changing’ periods are relatively rare explains why many people are disoriented when they do occur.
Anyone born in the US after 1971 is unlikely to have any visceral understanding of the nature of such events and would be poorly prepared for the current crisis.
The Anatomy of a ‘Game Change’
There is no standard pattern for a ‘game changing’ crisis. Such periods may be triggered by an election, an assassination, a market crash, a currency crisis, a coup d’etat, a war, or even a natural disaster.
The duration of such crises is also indeterminate. Some events, like the period that ended with the Brazilian Revolution of 1964, last only a few years. Others, like the Great Depression-World War II-Korean War period, may encompass a whole generation.
The end of a 'game changing' economic cycle would be expected to be marked by the discovery of a new leader, of exceptional character, capable of inspiring confidence in a new, better future.
The Soviet Revolution that was triggered by the monumental stupidity and incompetence of the Romanov’s, lasted for over 70 years.
However, the end of the crisis usually depends upon the rise of a new, conservative leader of high integrity, as well as conditions which facilitate rectification and mending of the damage done to institutions, laws, and the public psyche during the period of crisis, as well as the underlying causes of the event.
Since the 19th century, such periods are often seen as a test of capitalism and are associated with the attempted implementation of socialist, communist, or similar dictatorial regimes, sometimes successfully. This was true of the Great Depression, which resulted in the leftist Roosevelt four-term regime in the US, and Hitler and the Nazis in Germany and Mussolini and the Fascists in Italy.
Usually, the end of such periods is marked by the rise of a talented, new leader of conservative stripe, who has the confidence of the people and the ability to inspire optimism in the majority.
Such leaders as Dwight D. Eisenhower, Margaret Thatcher, Ronald Reagan, Humberto Castelo Branco (Brazil), Fernando Henrique Cardoso (Brasil), and Susilo Bambang Yudhoyono (Indonesia) come to mind.
Unfortunately, such leaders may not always rise to the fore at the right time. This was the case following the disastrous Johnson- Great Society years, when the best that the Americans could find was Richard Nixon.
The end of the current crisis
Based on observation of past ‘game-changing’ crises, I would say that there is little or no chance of the United States emerging from the current hard times while Barack Obama remains in office.
There was a 37 year hiatus between Winston Churchill and Margaret Thatcher. Effective national leaders are not that common.
Furthermore, if the successor to Barack Obama has the weak character of so many Washington politicians, the crisis will almost certainly persist.
To end the current crisis in the US, this hoped-for new leader must be supported by a Congress that is willing and able to correct the mistakes of the interim period, as well as to mend and eliminate the structural deficiencies that caused the Crash of 2008, including Fannie Mae, Freddie Mac, the social security systems, unrealistic pension schemes, over-extension of military commitments, stock buybacks, executive remuneration, the health care system, the public school system, the unionization of government employees, and much more.
If the US is fortunate, such a leader may come forward and the capitalist game may be ‘reset’ and good times start up again.
Otherwise, the crisis may extend for a generation or more. It took Great Britain 34 years to find Margaret Thatcher to lead the country from the socialist morass of the post-war years.
At this writing, although there is growing opposition to Barack Obama and an increasing likelihood that he will be a one term president, there is no opposition candidate, as yet, that seems to have the stature of a Reagan or Thatcher.
Nor has the work begun on reforming the problems in US capitalism that let to the Crash of 2008.
But the future is unknown. There are many people who have the answers to the current problems.
The question is how long will it take to get the proper alignment of factors that will allow necessary reform and change the ways of thinking that led to the current situation.
If Obama is followed by a Nixon (or Carter), recovery may be postponed for years.
We are far from that point yet. The ‘reset button’ has not yet been pushed.
Considering the fact that Barack Obama will be in office at least until 2012 and that it would take even a Ronald Reagan four years to clean up the damage that Obama has done, while reforming the societal institutions that were to blame for the Crash of 2008, I do not expect the country to emerge from this crisis before 2016.
If the successor to Barack Obama is a weak Nixon-type, or worse, a clone of Jimmy Carter, this current crisis could indeed last a generation, like the Great Depression, or the bad times that followed the end of the Brazilian MIracle in the 1980s.
On top of these questions of leadership, we should be aware of the likelihood of ‘Black Swan’ events, such as a successful terrorist attack on the US with weapons of mass destruction.
What this means to me is that willy-nilly, optimistic predictions of an imminent economic recovery, or a ’single-dip’ recession should be taken with a carload of salt. Life will go on in the customary Dickensian ‘best-of-times, worst-of-times’ mode, but prudence would dictate against sudden bursts of excessive optimism for a short-term economic recovery.
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