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How Bad Could It Get?
George
Washington's Blog
Wednesday, Dec 10, 2008
In "What
Goes Up", I discussed the law of booms and busts. A big boom
with easy credit leads to a big bust.
The question is, given the boom we had between 2001-2007, how
bad a bust might we have?
Real Estate
Well, in the greatest financial crash of all time - the crash
of the 1340s in Italy, which brought on a new dark Age - real
estate prices fell by 50 percent by 1349 in Florence when boom
became bust.
How does that compare to 2001-2007? The
price of Southern California homes is already
down 41%, Southern California hasn't fallen as fast as some
other areas, and we're nowhere near the bottom of the market.
(ARTICLE CONTINUES BELOW)
Moreover, the bubble was not confined to the U.S. There was a
worldwide bubble in real
estate.
Indeed, the Economist magazine wrote
in 2005 that the worldwide boom in
residential real estate prices in this decade was "the biggest
bubble in history". The Economist noted that - at that
time - the
total value of residential property in developed countries rose
by more than $30 trillion, to $70 trillion, over the past five
years – an increase equal to the combined GDPs of those
nations.
Housing bubbles are now bursting in China,
France,
Spain,
Ireland,
the United
Kingdom, Eastern
Europe, and many
other regions.
Derivatives
Moreover, the real estate bubble
formed the base upon which a series of bubbles in derivatives
were built. Specifically, mortgages were packaged in "collateralized
debt obligations" (CDOs), which were sold in enormous volumes
all over the world. Credit default swaps were then bet against
the companies which bought and sold the CDOs.
Now, with housing prices crashing,
the CDO bubble is crashing, as is the CDS bubble.
A series of other derivatives bubbles
are also crashing. For example, the "collateralized
fund obligations" - sort of like CDOs, but where the assets
of a hedge fund are the asset being bet on - are getting creamed
as hedge funds are forced to sell off many hundreds
of billions i assets to cover margin calls.
As everyone knows, the size of the
global derivatives bubble was almost 10 times the size of the
world economy. And many areas of derivatives are still hidden
and murky.
So the bust of the derivatives bubble
could even be bigger than the bust of the housing bubble.
What Does It All Mean?
The bigger the boom, the bigger the bust. Because we have likely
just lived through the greatest boom in history, we may see the
biggest bust in history. (No
wonder the guys who predicted this crisis are gloomy
about the future. Is this why the big players are selling
everything that's not nailed down to raise cash?)
If true, this is saying something dramatic. Because the bubble
in 1340 Italy was so big that its bust brought on a new dark age.
Believe it or not, I am an optimist by nature, and believe that
we can dig ourselves out of this hole if we restore sound financial
policies, a true representative government, and a return to sanity
and living according to the time-tested ideals of liberty, justice,
freedom and living within our means.
If we don't, it could get very dark . . .
Note: I hope the Economist
is wrong, and that the 2001-2007 bubble was not the biggest in
history. If someone can produce inflation-adjusted figures for
the 1340 Venice bubble, it would help to double-check the relative
sizes of the bubbles.
I also hope I'm wrong, and
that the unprecedented size of the boom will not lead to a catastrophic
bust. Boom-bust cycles are highly complex, especially when they
involve billions of people around the world, and complex instruments
such as derivatives. It is thus impossible to map out what will
happen with any confidence. Hopefully, things will somehow get
better due to factors which we have not included in our boom-bust
model.
Finally, while some writers
have blamed the plague, famine and other problems which came after
the 1340 crash on that financial crash, others have blamed climate
or other factors. So the crash might not have been as bad as suggested.
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