Review: A Brief History of Doom

By Polly Cleveland

Review of A Brief History of Doom: Two Hundred Years of Financial Crises,
by Richard Vague

A Brief History of Doom is the most important economics publication to come along in years. This short, well-documented, and engrossing book wasn’t written by an economist, but by a banker.

Richard Vague made a fortune as a conservative Texas banker. On retiring, he decided to investigate the cause of boom and bust cycles. His results shocked him. As he told us at a recent Institute for New Economic Thinking presentation, he had always assumed markets were perfectly efficient and that government incompetence or malfeasance caused the problem. Instead, here’s what he found:

A necessary and sufficient explanation [his italics] for a boom and bust cycle is an episode over several years of excessive private sector lending, typically triggered by an exciting innovation. That lending inflates values of land or stocks, and sets off a vicious circle of increasingly reckless and often egregiously fraudulent behavior, with lending driving rising values and rising values justifying more lending. When the bubble eventually bursts, the damage has already been done. The only difference from one bubble to the next is the size, and the degree of competence with which the government contains the aftereffects.

Vague and his research team collected massive amounts of data on financial crises from 1819 to the present, in the US and elsewhere. He begins with the Roaring Twenties and the ensuing Great Depression. Contrary to the assertions of former Federal Reserve Chair Ben Bernanke, not to mention conventional Keynesian wisdom, the boom and bust was not a monetary phenomenon. Rather, as I have written, when the new horseless carriage appeared to open up vast tracts of suburban land to housing, banks engaged in a frenzy of reckless lending to sketchy real estate developments, such as underwater lots in Florida. Two or three years before the stock market crash of 1929, the developments began to fail, stopping interest payments, and sticking banks with worthless collateral. The banks in turn had no money to lend to legitimate businesses, causing these to fail, setting off a downward cascade of failures. Following the market crash, panicky customers began runs on all banks, crooked and sound. The brand-new inexperienced Federal Reserve dithered, allowing the damage to accumulate.

Vague continues by examining the “Decade of Greed” in the 1980s, with the exploits and crash of the Savings and Loan banks, as well as of Michael Milken, the junk bond king. Again—a story well told by Bill Black in The Best Way to Rob a Bank is to Own One—the S&L’s engaged blatant self-dealing and fraudulent real estate investments at the expense of their customers. After the inevitable collapse, the US rescued the customers at the cost of some $480 billion dollars and sent over a thousand bankers to jail

From here, Vague moves to the mind-boggling Japanese real estate bubble of the 1990s, whose collapse together with Japanese mismanagement has left Japan with close to zero economic growth since then. The Chinese have handled their bubbles more effectively, though Vague wonders how long they can continue. Then he backtracks to famous historical bubbles. In the US, these include the canal boom of the 1830’s and the later railroad booms of the 1840s, 1870s and 1890s, which also affected British investors in US railroad companies. Finally, he tackles the giant mortgage boom, crash in 2008, and subsequent Great Recession that we all recently lived through. In this case he retells a story of reckless lending and fraud in the mortgage industry, a story already familiar from such books as Michael Lewis’s The Big Short.

Vague says it’s vital and feasible to identify budding bubbles: When the private loan volume in a particular sector rises faster than GDP, there’s usually a bubble. Inexplicably, the federal government does not separate data on loan volume by economic sector. Yet one has to be blind—or blinded by conventional economic theory—to miss big real estate bubbles. Without knowing anything about the crazy lending behind the last bubble, I personally saw it coming by 2005 in the exploding Case-Shiller home price index. There’s an unmistakable boomlet going on right now in the flipping of single-family houses for rental.

Vague is skeptical of remedies. Should the Fed “take away the punch bowl just as the party gets going” by raising interest rates? By the time the bubble is obvious, the damage is done and the frenzied fraudsters will ignore the signal, as they did in the months before October 29, 1929. Should Congress pass more laws like Dodd-Frank to rein in egregious bank misconduct? Trouble is, when the punch bowl starts to bubble, regulators come under enormous pressure to look the other way and politicians often have accepted huge campaign contributions from malefactors. Remember the “Keating Five” –the five Senators, including John McCain, who had received favors from the notorious S&L king, Charles Keating? Moreover, innovative banksters will find ways around the rules. The mortgage lenders, like Angelo Mozila’s Countrywide Financial, formed part of a “shadow banking” system not subject to bank regulation. Influential bank lobbyists prevented efforts to regulate the “securitization” innovation that powered the bubble leading to the 2008 crash.

I have one quibble with Vague: He says bubbles do their damage by creating “overcapacity.” Well, not exactly. A housing bubble does create a moonscape of vacant lots and even half-built houses, mostly in locations that weren’t suitable to begin with, which is how the developers got the land cheaply. That’s just waste. There’s a more insidious form of waste: the productive investment that didn’t happen, such as the older buildings that weren’t maintained while their owners waited to make a killing in a rising land market. Bubbles are man-made disasters, equivalent to the 2010 BP oil spill in the Gulf of Mexico. They call for the same remedy: first contain the damage then aid the victims and punish the corporate malefactors.

From that angle, the US response in 2008 was a travesty. Yes, bailouts of $700 billion and still counting prevented the collapse of the banking system. But the bankers responsible for the calamity proved “too big to jail,” and the tens of millions of homebuyer victims were not allowed to write down their inflated mortgages to the post-bubble value of their homes. Vague says that such debt restructuring, like the Biblical debt-forgiveness “jubilee,” would indeed have stimulated a rapid economic recovery.

Finally, what about preventing bubbles? I asked Vague about his native Texas, which suffered relatively little in 2008. That was possibly due, I suggested, to relatively high property taxes that kept down land values, and a well-enforced loan to value limit of 80% of equity. Yes, laughed Vague, and Texas also has a constitutional prohibition on second mortgages—we bankers lobbied furiously to get that undone, to no avail. I trust that as he and his team will further pursue the prevention possibilities of combining high property taxes with stiff regulation.



From Germany to America: A Dialog on Inequality

By Polly Cleveland

At a coffee break between sessions at the annual History of Economics Society meeting, I chatted with D___, a tall, blond young woman, a professor of political science at a German university. On hearing that I work on inequality, she immediately challenged me.

D: “I don’t believe in equality. Inequality is just a statistic, a side effect. What’s relevant is how people actually live. What matters are policies to improve citizen’s wellbeing, like health or education, not policies to reduce inequality.

P: But aren’t those statistics useful in identifying those societies that are or are not doing a good job providing those services? After all, there are many statistical studies showing that more equal societies have grown faster and have a higher GDP per capita.”

D: No. Inequality statistics are just an artifact. They don’t mean anything. We could all be perfectly equal in extreme poverty, like we were in East Germany. [Obviously before she was born.] Is that what you want?”

P: In the United States, our Congress just passed a new tax law reducing income taxes for the rich and for large corporations.  That will surely lead to reduced services and other benefits to poorer people.

D: Well, what do you want? A flat tax? The same tax on each person? That would be a perfectly equal tax.

P: A flat tax would be regressive because it would take a higher percent of the income of poor people—if they could pay it at all. How about a flat percentage tax on wealth? Since wealth is much more unequal than income, that would be more progressive even than an ideal progressive income tax.

D: That’s not the point. We need to focus on ordinary citizens’ wellbeing. If we do that, the rest will take care of itself.

P: OK, how about a basic income grant, that is, the same sum paid monthly to every citizen of a country, man woman and child, rich and poor. A large enough sum to provide a modest living. That idea has become very popular lately. It is being promoted by some Silicon Valley tech entrepreneurs.

D: No, I don’t think that’s a good idea. People should contribute to society. Basic income would give people bad incentives. They would take it easy.

P: Wait a moment, there’s a difference between basic income with no strings attached, and public assistance money. Here and I assume in Germany, public assistance is phased out as people earn more income. What’s amazing is that some people who receive assistance keep on working even though they lose income. The dignity of holding a job is very important.

D: Well you may be right about that, especially in Germany.

P: In the 1970s there was a guaranteed minimum income experiment run for five years in Manitoba, Canada. Recipients received additional income which—as with public assistance—was phased out as they earned more. A few years back Evelyn Forget, who’s here at the conference, analyzed the data. She found that only new mothers and teenagers worked substantially less. The teenagers became more likely to finish school, presumably due to less pressure to support their families. New mothers and school age teenagers are just the people you’d want to stay home. Remember, this was not a fixed basic income, but a guaranteed minimum with a sharp phase-out at 50% or more effective tax.

D: Still, you have to make a choice. Do you want equality of opportunity or equality of outcome? You can’t have both.

P: Actually, I think you can, sort of. A basic income grant, plus the public services we expect in a modern society—health, education, pensions, security, justice –including protection from unfair practices like monopolies—those should guarantee a rough equality of opportunity. Above that, it should be OK for people to earn high incomes by hard work, talent, or even luck. But you need progressive taxes to finance the system.

Whoops, just as I was getting to the punch line, the elevator arrived to take us downstairs to the next sessions. I would have said that as Adam Smith wrote in the Wealth of Nations (1776), taxes should be proportional to benefits received—a notion more radical than any proposed by today’s leftists. Chief among benefits received, Smith included government protection of title to land, in an era when some 2% owned most of the land in England. The tax he favored was a tax on the value of that land, a tax that would capture the “rent” or unearned income England’s “great proprietors” gained from the mere title to land granted and protected by the king. England had a land tax, but at low rates and poorly administered. The French “Philosophe” reformers whom Smith visited in Paris is 1766 advocated land taxes, as did the next generation of economists such as David Ricardo.

A hundred years later, in 1879, the American economist and radical reformer Henry George took Smith’s idea and ran with it. In his world-wide bestseller Progress and Poverty, George argued that all taxes should be replaced with taxes on land values only, and the revenues used for public purposes like schools and infrastructure (including public bath houses!). This was a perfectly practical proposal: property taxes then and now are assessed on land and buildings valued separately. In the heyday of George’s influence in the late 19th and early 20th century, assessors just left out the buildings and raised the rate on land to make up the difference.

Now almost 140 years later, as support for basic income has grown, some advocates have made the obvious connection: why not finance basic income with a land tax? That squares the circle, doesn’t it? Equality of opportunity at the bottom via a basic income grant, financed by a tax that limits inequality of outcome at the top.

That might be too theoretical for my pragmatic German acquaintance. She’s right, though, that we need to be more specific in talking about inequality.