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 Thinkingpresentation, 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.