After the stock market crash of 1987, measures were taken to prevent a new financial drama in the future. Under Ronald Reagan, “The President’s Working Group on Financial Markets”, now better known as the Plunge Protection Team, was formed in 1988.
A year earlier Alan Greenspan became chairman of the Federal Reserve. Under Greenspan the economic cycle flattened. Recessions were fought hard with the Goldilocks scenario as the objective. The economy was just right, neither too hot nor too cold. Nevertheless, things did go wrong from time to time. In the mid-1990s, there was the tequila crisis; in one week, instead of three pesos in a dollar, ten, as a dollar went up. Mexican companies had their revenues in pesos, but their debts in dollars.
‘Irrational exuberance’
In early 1995, the crisis spread to South America. Together with finance minister Robert Rubin, Greenspan continued to support the market. The phenomenon of the Greenspan put was born. Market participants were encouraged to take risks and if things went wrong the central bank would rescue them. Not long after, in December 1996, Greenspan tried to slow down the market by accusing market participants of “irrational exuberance”. With hindsight, this proved to be the starting pistol for a further rally.
This was followed in 1997 by the Asia crisis, with the IMF as the saving grace. In 1998, the Federal Reserve of New York sat around the table with twenty commercial banks that were allowed to take over LTCM’s book. The message: take risks and if things go wrong, you will be rescued by the central bank. Thus, during each crisis, the seed was planted for the next crisis.
Then came the dotcom crisis, followed by the attacks of 11 September 2001. Policy interest rates were lowered to 1 percent. Risk-taking, again, was encouraged. If things went wrong, the central bank came to your rescue. The extremely low interest rates resulting from the bursting of the dotcom bubble thus sowed the seeds for a housing bubble. Risks are now created by bailouts.
Financial gain suppresses reason
Greenspan counted on commercial banks being well able to absorb some risk. Although an individual bank is perfectly capable of making the right judgement, the system is as strong as its weakest link. If one bank accepts higher risks - doing so meant it could earn more in the short term - others will follow. At banks which, as a matter of principle, did not want to run too many risks with their financing, the best people were bought out, and sometimes even the entire bank was taken over.
This was a case of moral hazard. It led to a further increase in debt. Finally, the Great Financial Crisis of 2008 followed, a direct consequence of the generous monetary policy after the dotcom bubble and the attacks of 11 September 2001. Large capital injections kept the banks afloat, while excessive risk-taking was again hardly punished. The Fed did try, however.
In 2008, the Federal Reserve discussed the risk of further moral misconduct. After the rescue of Bear Stearns, Bernanke announced in summer 2008 that the Federal Reserve would not rescue every investment bank. This would encourage too much moral misconduct. In the fall of 2008, the Fed tried to get the concept of risk right once and for all.
The central bank dropped Lehman Bank and simultaneously rescued Merrill Lynch by merging it into Bank of America. Lehman, and with it the market, had to learn that moral misconduct does not pay and the risk of contagion was contained by rescuing Merrill Lynch, or so the Fed thought. The rest is history.
Excesses remain
The downside of all these bailouts is that the self-cleansing system that is part of capitalism does not work. Each time, excesses are not solved, but buried under even more debt. Another consequence is that modern society can no longer do without big government. Not only do we want protection against a recession, but also the negative consequences of the coronary crisis.
When energy prices rise too much, the government has to compensate immediately. Risks are no longer accepted and this undermines the natural resilience of capitalism. It is even questionable whether capitalism can survive this in its present form. After banks were no longer allowed to fail, it is now the turn of all companies. More and more companies are kept alive artificially by extremely low interest rates. The percentage of zombie companies has risen sharply in recent years. These companies will not survive a further rise in interest rates.
The usefulness of a recession
With the intervention of the central bank, the principle of “survival of the fittest” disappears. Bad behaviour is rewarded, no company goes bankrupt. That normally happens in a deep recession and that is actually good for the economy.
Just as a poorly maintained forest is more susceptible to forest fires, those fires do make room for new strong trees. But central bankers still seem convinced that a recession must be avoided at all costs. With such a mountain of debt, this is hardly surprising. A recession is precisely what causes the weak brothers to go under. It is the basis for creative destruction, although nowadays the emphasis is more on disruptive innovation. Without a recession, the losers stay alive and stand in the way of innovation and higher productivity.
A bailout for everyone
Continued support of financial institutions continues to encourage financial misconduct. Today, government intervention in the market means that everyone gets a bailout. In 2020, it was not just banks. Companies such as Boeing, Carnival Cruise and AirFrance-KLM were also bailed out.
In many cases, even companies that had been buying up shares for years, making the insiders rich in particular, were saved. Households also received a government bailout. At one point, three quarters of the unemployed in the US had a higher income than when they were still working. All these bailouts ensure that weaker players stay alive and thus stifle innovation. Those who have taken too much risk are quickly bailed out by the government.
Communists save capitalism
An environment has been created in which investors cannot lose, the Fed put is stronger than ever. Losses are a problem for governments, for central banks, but not for investors. This system also creates a growing unequal distribution of income and capital. Unfortunately, it is not possible to escape from this mountain of debt without pain.
If we do nothing, we will be left with many monopolies and many zombies, growing income inequality, lower productivity and lower economic growth. Social unrest and ultimately revolution will be the result. The alternative is that we make choices today that hurt in the short term, but which make for a more robust economy in the long term.
In a democracy, it is difficult to take short-term pain with the prospect of a better long-term future. Politicians are governed by a four- or five-year election cycle. China does not have this problem. Confucius teaches to look at the long term. In that respect, it is encouraging that the Chinese government is not extending a helping hand to Evergrande. Chinese project developers are now rapidly learning the consequences of financial misconduct. The irony is that it is the communists who are saving capitalism in this way.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. Dieperink provides his analysis and commentary on the economy and markets. His contributions for Investment Officer Luxembourg are published on Thursdays.
This column was originally published in Dutch on InvestmentOfficer.nl