How Can We Prevent Future Economic Crises?

How Can We Prevent Future Economic Crises?

Dr. Horace “Woody” Brock is an author and economist, and the founder and president of Strategic Economic Decisions, an economic think tank.  He believes the growth of “bubbles”– such as the real estate bubble that had such a devastating effect on world economies in 2008 – can easily be controlled.

In a recent interview with Bob Veres, a well-known financial services writer and commentator, Brock explained that all the economic crises we’ve encountered in the last twenty years – the housing crisis, the Tech bubble, the collapse of LTCM in the 1990s, etc. – have been caused not by normal manufacturing cycles such as companies overproducing products and laying off workers, but by leverage and speculation in asset prices.  Brock asserts that financial bubbles have replaced inventory bubbles as the primary cause of economic recessions.  Unfortunately, if that is true, the primary monetary policy lever the federal government utilizes to regulate booms and busts in the manufacturing sector is too blunt to work effectively on asset bubbles.  Take the housing sector prior to 2007, for example.  If the Fed had decided that it wanted to discourage thousands of Americans from flipping homes or buying them with zero money down, it could have dramatically raised interest rates throughout the economy.  “That certainly would have killed the housing bubble,” Brock said.  “But it would also have kicked 15 million people out of jobs on Main Street at a time when inflation was low.”

There is, according to Brock, a better way to control excesses in asset pricing without clobbering the corporate/manufacturing sector.  It is simply to raise margin requirements on any financial asset – stocks, real estate, or whatever – as its price goes up beyond its average historical valuation.  In other words, reduce the amount of permissible leverage in proportion to the degree of deviation from the mean.

Take last decade’s housing bubble again.  Using this methodology, as housing prices continued to climb, the government would have increased the minimum down payment required for a mortgage.  Imagine in 2007 having to put down 25% or 30% of the price of a home in cash.  That certainly would have discouraged most of the speculators who were buying fully-leveraged properties at the time, and would very likely have deflated the bubble.

The same requirement would have prevented Lehman Brothers and other investment banks from  buying & selling stocks and other assets with margins leveraged as high as 50 to 1, possibly enabling them to avoid going out of business and wrecking the economy in the process.  And while the details of such a methodology need to be worked out, there is no shortage of historical data on most asset classes to enable someone to come up with an appropriate mean value and appropriate trigger points for decreasing leverage requirements.  In the case of the S&P 500, the average P/E ratio has been about 15 for the past century. So when stock prices rise to the point where the market P/E ratio becomes 20, then you have to put more down if you want to buy stocks.  As Brock states, “When the PE goes up to 34, as it did in 2000, you bloody well better be putting 95% down, and in doing that, you deflate the tech bubble.”

Interestingly there is historical precedent for this proposal.  A review of margin requirements shows that investors who could put virtually nothing down to buy shares of stocks before the 1929 crash were later required to limit their margin accounts as low as 0% and as high as 55%, with the figures moving around as the markets did.  According to Brock, in January 1958 when the Dow was at 440, an investor could buy stock with 50% down.  By December, when the Dow was trading around 580, the requirement had grown to 90%.  “When everybody has to put 90% down,” said Brock, “You no longer have a bubble.”

I am personally encouraged by out-of-the box thinking such as Brock’s.  Unfortunately, the Dodd-Frank financial reform legislation includes none of this.  There are also those who will object that using this methodology would be interfering with the normal processes of capitalism.  Brock’s answer:  “Excess leverage is an externality. That means that doing it hurts a lot of other people who weren’t involved.”  Most Americans would probably agree that it’s the government’s role to prevent companies from polluting rivers and poisoning citizens in order to make money.  If so, why not additionally prevent financial institutions from making huge gains and avoiding huge losses during asset bubbles that cause millions of people to lose their jobs.  “That,” Brock insists, “is not capitalism.”

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