Five Lessons of the Great Recession We Probably Won’t Learn

As I wrote on Friday, lists of lessons we have learned from the current economic troubles have been enjoying a vogue lately. A dim view of my fellow humans prevents me from being so optimistic as to believe that we are going to emerge from this fiasco meaningfully wiser. But I do have a list of lessons that we could learn from recent experience. But probably won’t.

Attrb Binary Ape In the best case scenario, regulators are just as smart and capable as the people they regulate. And, just to be clear, best case scenarios are rare. Many of the complaints about how the Fed, SEC, et al. blew it by not foreseeing and preventing the Wall Street meltdown are unfair. If the thousands of people making seven figures at meltdown ground zero didn’t see it coming, why would we expect the hundreds of government employees watching them from the outside to pick up on it?

25 years is not forever. Amongst my many brilliant theories is this: especially in the realm of culturally significant business phenomena, if something has been going on for more than 25 years people will mistake it for a permanent always-has-been-always-will-be thing.

For example, by the mid-1980s the three television networks appeared to be the unalterable center of the American video universe. They had, it seemed, been there forever and were as sure to stay there as New York was to stay at the mouth of the Hudson. And yet they had, in fact, only had that central status for about 25 years, something that now seems like a passing golden age.

Similarly, by 2007 the stock market had been up 20 of the previous 25 years, averaging over 14% annual returns. That those 25 years were just about the best in stock market history wasn’t discussed much. The kind of returns we saw over the period became "normal" and financial gurus offhandedly estimated future returns at 10%+.

There is no free lunch on Wall Street, particularly in fixed income. One of the many horrors experienced by individual investors last fall was the shock of significant losses in what they thought were safe cash-like investments. I am thinking particularly of the few money market funds that "broke the buck" and the auction rate preferred shares whose auctions failed.

The money market funds that ran into trouble were the ones that delivered higher than average yields by, for example, loaning money to Lehman Brothers. And the auction rate preferreds behaved a lot like money market funds, except that they paid better.

Apparently, many buyers of the auction rate preferreds never asked themselves why the issuers of the debt didn’t just borrow from the money market at a lower rate. As may have dawned on them by now, the issuers were willing to pay a higher return because the auction rate debt had the feature that if something went badly wrong in the credit markets the buyer of the debt would be left holding the bag. And that is exactly what happened.

Risky means risky. Perhaps the greatest achievement of the mainstream personal finance establishment in the late 20th Century was convincing Americans to put some of their savings into risky assets such as stocks, rather than the traditional bank accounts and mattresses.

That really is a positive achievement, but it was done with a lie. People were led to believe that if they took appropriate steps, diversified and held for many years, they could cure the riskiness problem. They can’t. The risk of investing in the stock market may be justified by the reward, but it cannot be made to go away. Years like 2008 don’t happen often, but they do happen.

It’s always politics as usual. Expecting politicians to rise above the fray and convert themselves into resolute statesmen when a crisis emerges is like expecting a drunk driver to sober up the instant his car drifts over the median.

Rahm Emmanuel’s famous and deliciously cynical quote "never let a serious crisis go to waste" is relatively new, but the sentiment is as old as politics. This is what these guys do for a living. It’s who they are. When something really nasty happens, our elected leaders and the punditocracy don’t step back, reevaluate, and come up with fresh new ideas. Mostly, they seize on events as a justification for what they wanted all along.

So the Great Recession was greeted by calls for more government regulation, massive spending on a great variety of programs, and limits on executive compensation, primarily from those who always wanted those things anyway. If the administration has its way, the great lasting legacy of this period will be, of all  things, a healthcare overhaul. (And to be fair to the Democrats, these are no less plausible reactions to this crisis than tax cuts and invading Iraq were to the September 11 attacks.)

[Photo: Binary Ape]


  • By Rob Bennett, September 22, 2009 @ 9:46 am

    The risk of investing in the stock market may be justified by the reward, but it cannot be made to go away.

    We disagree re this one, Frank. My view is that the risk of stock investing is greatly exaggerated. Those who paid attention to valuations saw what was coming many years before it happened. They were not surprised even a little bit. When things happen that anyone who pays attention to the basics can predict years in advance, that’s not “risk.”

    There were lots of people who chose to ignore the realities. They made stock investing many times more risky than it needs to be by electing that choice. But it’s not stocks that are risky. It’s investing passively that is risky.

    Years like 2008 don’t happen often, but they do happen.

    They don’t come up randomly. There has never been one time in history when such a thing happened when stocks were not selling at insanely dangerous prices. There has never been one time in history when stocks were selling at insanely dangerous prices and such a thing did not happen. The correlation is perfect.


  • By Frank Curmudgeon, September 22, 2009 @ 5:10 pm

    So you think the risk can be made to go away? No, I think you mean it can be greatly reduced.

    And not to quibble, but I don’t think the market was particularly overvalued at the end of 1930 and it went down almost 43% in 1931.

  • By Rob Bennett, September 22, 2009 @ 6:40 pm

    So you think the risk can be made to go away? No, I think you mean it can be greatly reduced.

    Stock returns 20 years out are 78 percent predictable for those who look at the P/E10 value before buying. I think it would be fair to describe the unpredictable 22 percent as the only risk associated with stock investing for those willing to look at valuations. That risk level compares favorably to bonds that are not inflation-adjusted, in my assessment. Stocks are less risky than bonds for valuation-informed investors.

    And not to quibble, but I don’t think the market was particularly overvalued at the end of 1930 and it went down almost 43% in 1931.

    That’s not a quibble. That’s an intelligent question.

    Price drops that do not remain in place long are possible starting from any price level, Frank. But price drops that do not remain in place long do not do any real harm to long-term investors.

    The killers are the price drops that are permanent. When we go from insane overvaluation to fair value, that’s money lost to the investor forever (because it never existed in any but a nominal sense in the first place).

    To invest effectively, we need to distinguish price drops that are real (price drops from high valuation levels to fair value) from price drops that are temporary and essentially meaningless phenomena (price drops starting at fair value or lower). Investors who experience a price drop to levels below fair value can rest confident that that money will be restored in the not too distant future (usually within 10 years).


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