The Seven Deadly Sins
By David McWilliams
At school, our Religion teacher, a wise Catholic priest known as ‘Doc Carroll’, urged us to read St Thomas Aquinas on sinfulness. As you can imagine, in an Irish Catholic boarding school, sin was a big deal. The 1980’s moral tug of war for my soul pitted Aquinas at Mass against Bananarama on Top of the Pops. Guess who won?
However, Aquinas has proved more enduring. I can only remember Bananarama chorus lines after too much wine at 50th parties (not pretty); but Aquinas’ observations have stayed with me.
He believed in the idea of a ‘just price’ whereby a ‘good man’ shouldn’t knowingly sell anything for more than it was worth and, under no circumstance, should he lend money for interest to anyone. Usury was a clear sin; absolution from this crime demanded deep penance as the common or garden “a dozen Our Fathers and hail Mary’s” wouldn’t suffice. In Thomas’ world, speculation was a venial sin and using borrowed money to speculate verged towards a mortal sin.
Of course, the reason the great Catholic philosopher was interested in money is because he was interested in human nature and how money affects human nature. He was also interested in the flock or the herd: anything that moves the herd in a certain direction needs to be watched, and speculation (especially leveraged speculation) does strange things to the herd.
The word speculation comes from the Latin ‘speculare’ which is to be on the look out for trouble. The Roman forum with its whores, thieves and moneychangers, had a special corner reserved for the speculari. They’ve been around for a long time. Bulls and bears have long dominated markets, manipulating human nature and undermining rationality in the pursuit of riches.
When other peoples’ money is cheap, the incentive to borrow to drive up prices and sell on to the next guy, pocketing the difference, is as old as humanity itself.
But as Aquinas understood, speculating is a very different business to investing.
In a nutshell, the speculator starts with a small amount of money, hoping to make a lot, quickly. The investor, in contrast, starts with a lot of money and hopes to make a little more, slowly.
It’s all around us
Innovation has always excited the speculator, so too has cheap money. Although investments are subject to wasteful booms and busts, it doesn’t mean they are useless.
Many innovations that have been the subject of wild speculation have lasted or had a profoundly positive effect on the productivity of the economy. Speculation isn’t useless but it is dangerous and with leverage it can link bits of the global economy, which otherwise have no obvious connection.
Many innovations that have been the subject of wild speculation have lasted or had a profoundly positive effect on the productivity of the economy. Speculation isn’t useless but it is dangerous and with leverage it can link bits of the global economy, which otherwise have no obvious connection.
The legacy of various speculative manias is all around us.
For example, I live in a truncated terrace of houses built just after the Napoleonic Wars when Dublin and the rest of urban Britain was in the grip of a building boom. The boom was fuelled by paper profits generated by exotic investment in the first emerging markets mania.
Following British victories over France, the colonies were seen as a place to make fortunes – which in some cases they were. Once the war was won, yields on British government bonds (Consols) collapsed and interest rates fell dramatically. Between 1820 and 1824, powered by the confidence that followed the military victory abroad and rock bottom interest rates at home, local speculators played the arbitrage between the paltry yields on British Consols and the stellar yields of colonial debt. Colonial projects promised vast fortunes. Punters piled in. Banks lent using existing colonial debt as collateral, encouraged by the exciting mathematics of notional arbitrage.
This is a common feature of many booms. The bank’s balance sheet plays tricks on itself, whereby expensive collateral is mistaken for good collateral. Money gushed into the system, linking for the first time, credit with the business cycle. Up to the 1800s, wars and agriculture drove the vagaries of the business cycle. Once credit emerged, it came to dominate the business cycle.
The modern cycle, whereby credit begets credit, first emerged in the 1820s.
In 1825, the Bank of England, fearing that asset price inflation was getting out of control, raised rates and the highly leveraged, post Napoleonic boom came crashing down, driving banks to the wall.
Building on the terrace where I live was stopped as the developer went bust.
Things that last
As I write, looking out the window over Dun Laoghaire harbour towards Wales, Dublin’s only efficient metropolitan railway trundles reliably along just across the road, hugging the coastline. This line was one of the world’s first suburban railways, completed in 1834 to whisk the wealthy Victorians out from the fetid city centre to the refreshing air of the seaside. Following the emerging markets crisis of 1825, the next big financial boom in these parts revolved around railways.
The first railway boom, or ‘railway fever’ as it was called at the time, broke out just after the 1825 crash with the opening of the Stockport / Darlington line. In no time – and again driven by easier monetary conditions after the crash – ‘railway fever’ engulfed both islands, with Liverpool, Manchester and Dublin vying to match London’s enthusiasm for new railway companies.
Not unlike the dotcom boom a few years back and today’s tech boom, the technological revolution wrought by the railways was real. It brought massive social change.
The 1840s and 1850s witnessed a speculative mania like no other in terms of participation and excitement. Railways captured the imagination of all with the promise of cheap transport for the masses, opening up the countryside and connecting people like never before. It’s hard to overstate the impact of cheap transport on a society where up to then, a significant proportion of the population had barely travelled more than a few miles beyond their own villages. The place was giddy with railway exhilaration. As more lines were laid, more railway shares were issued and more and more people were sucked into the financial vortex.
John Mills, head of the Manchester Statistical Society, looked back at the railway boom in the 1860s and noted that “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”
Railways were the future but they still had to make money. Mass transport means cheap transport and the cheaper the tickets the more compromised the revenue stream of the newer lines, which were being built in more and more remote places. In time, the disparity between the soaring speculative share prices buoyed up by ever increasing leverage and the underlying modest profitability of many of the lines themselves, coaxed some to take profits.
The very psychological act of defiance that is selling early, undermines the shaky edifice of the boom.
In the end, the railway boom came to a shuddering halt weighed down by its own internal contradictions between price and value. As always, value elbows its way into the speculative group trip and wrecks the buzz.
That’s not to say the railway mania was an irrelevant wasteful period in our history. Not at all. In fact, after I finish writing this I’m going to hop on a new train on the old Victorian line into the city. But the point is that boom and bust cycles tend to follow similar paths.
The most expensive four words of all are: “This time it’s different”.
Credit cycles, as Thomas Aquinas understood, are part of human nature. Boom / bust episodes do strange things to us. It is easy to be caught up in the effervescence, misdiagnosing flakey speculation in the asset of the moment for a solid long-term investment.
The Kindleberger / Minsky framework
When thinking about asset bubbles, I frequently turn to the work of two economists whose work on credit bubbles, booms and busts seems, to me, extremely accurate. Charles Kindleberger and Hyman Minsky, rejecting classical economics that took the irrational human out of the equation, both recognised the importance of the human propensity to panic, indulge in herd behavior and believe our own propaganda. They outlined the stages of a credit boom, where investors go from optimism and euphoria to depression and panic – a journey that leads to the destruction of wealth.
Like Aquinas, they understood human nature.
Because we are a flock or a herd, we are essentially pro-cyclical. That is why we tend to act in ways that reinforce whatever economic trend prevails at a given time. In other words, most people are what is known in financial markets as ‘momentum investors’, who follow the crowd, buoyed up by the excitement of it all, rather than value investors who are constantly asking themselves whether prices are reflecting real value or something else. The predominance of momentum investors has the effect of amplifying the high and low points of cycles.
It is this sort of behaviour that leads to bubbles and can also push the economy out of kilter for long periods of time. It is simply not true that the self-interested economy naturally rights itself and finds equilibrium. In fact, the opposite is the case. The self interest of banks, market players and leveraged speculators can lead the economy to long inflationary periods or can find itself stuck in long periods of unemployment and deficient demand.
Kindleberger’s seminal work – Manias, Panics and Crashes – is well worth a read over Christmas. In it he rejects two widely-held views in classical economics: that financial markets are efficient and that people are rational. He quotes Isaac Newton, who lost a small fortune on the great 18th century speculative punt, the South Sea Bubble, “I can calculate the motions of heavenly bodies but not the madness of crowds”.
Kindleberger observed that panic can be sparked by a relatively trivial event. Once there is leverage in the system, small events have the tendency to become amplified, particularly if there is no hegemon that will backstop the system when a panic occurs.
Such a hegemon in a financial crisis is a large active central bank with sufficient ammunition to mollify the panic. If a panic occurs when rates are high and unorthodox monetary policy has not been used, the central bank’s powder is dry so to speak. But today, after nearly a decade of QE, this is not the case.
Looking at the Great Depression and sharing some of Kindleberger’s analysis, Minsky observed how the financial system can go from rude health to fragility extremely quickly. He also identified the five sequential stages of a credit crisis: (1) displacement; (2) boom; (3) euphoria; (4) profit-taking and (5) panic.
At the beginning something real happens to displace or disrupt the old order and replace it with something new. This can be a monetary event like the ZIRP or QE where monetary conditions are changed dramatically. This has a real impact on valuations. The displacement or disruption can also be an innovation, which changes the market, such as the emergence of railways, the Internet, Amazon or Uber.
Prices of assets start to rise rapidly and people who usually remain aloof from these events become involved. The boom period leads to gearing as the banks fall over themselves to get involved. The next stage is euphoria, when the herd gets excited. This is when balance sheets play tricks on both lenders and borrowers. But of course success breeds a healthy disregard for the chances of failure. The thundering herd is galloping.
During the euphoria stage, leverage amplifies prices. At these lofty levels, some savvy players take this as a signal to cash in their chips. A prescient few take profits. This begins the process of unraveling when the herd realises that prices are falling and, in an effort to get out, everyone rushes for the door in panic. The edifice collapses, fortunes are lost and we start again.
The essence of a credit cycle is a debt build up combined with old fashioned human nature fueling humanity’s pathological optimism as we end up believing our own propaganda.
Minsky made another crucial observation which helps us to understand panics; it is important to look at the types of borrowers who obtain financing during a boom.
There are the ‘hedge borrowers’ who can finance their borrowings, both the capital and the interest, out of their own income.
Then there are the ‘speculative borrowers’ who can finance the interest on their borrowing but need to roll over the principal.
Finally, there are the ‘Ponzi borrowers’ who can’t afford the interest or principal; only the rising value of the asset makes their investments viable. In this type of deal, money doesn’t change hands. The Ponzi borrowers buy ‘on paper’ and sell ‘on paper’ and if the market goes up quick enough they make a tidy killing. If the market falls, they are goosed and so too are those who lent to the Ponzi borrowers!
When the bubble pops, the first guy to fall is the Ponzi borrower – but it doesn’t stop there. The generalised fall in asset prices affects the speculative borrower too, because the bank will only allow him to rollover the principal if the asset has value; if the asset value falls, the bank slams on the brakes.
As the withdrawal of credit causes the economy to seize up, everyone’s income falls. This affects even the hedge borrower’s position because although he could finance both interest and capital out of income, as everyone’s income is falling, his is too, making it difficult for even the hedge borrower to meet his payments.
As markets go ever higher and the gap between valuation and prices becomes more and more stretched, it would seem injudicious to ignore the repeated warnings from history and overlook our human capacity for individual and collective self-delusion.
At Christmas time, even the faithful could do with a little self-doubt.
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