The history of finance progresses through different eras with their distinct characteristics. Each is guided by an ideology which influences fiscal, regulatory and monetary policies. The past quarter of a century has witnessed the triumph of monetarist economics, whose most famous exponent was the late Milton Friedman. In a new book, George Soros argues that the current crisis signals the “end of an era”. The period of financial liberalization and innovation, and of laissez-faire attitudes towards the regulation of capital markets, may be coming to an end. Soros’ thesis, if correct, spells bad news for stock market investors.
The so-called “New Era” of the 1920s had much in common with developments of recent years. The Federal Reserve of the 1920s, like its counterpart today, focused on maintaining stable consumer prices while ignoring strong credit growth and speculative behaviour. Inflation was non-existent and productivity growth strong.
Deposit-taking banks set up securities affiliates in order to evade regulations and sell stocks and bonds directly to their customers. They also lent heavily to the booming real estate sector. Debt soared as a percentage of national income and the quick fortunes coined on Wall Street contributed to soaring income inequality. The New Era of perpetual prosperity was associated with a cult of equities. If stocks could only go up, it seemed sensible to buy them on margin.
The economic collapse which followed the downturn of the stock market in late 1929 revealed the flaws of the New Era. Banks collapsed not just because the Fed allowed deflation to set in. Many banks were heavily exposed to the declining stock and property markets. Wall Street insiders were later excoriated for manipulating the stock markets, for flogging dodgy securities and for a number of other abuses. The central bank, together with the establishment economists who believed the tilting economic ship would right itself without intervention, were discredited. The age of big government had arrived.
The economic catastrophe left both individuals and corporations with a lasting fear of debt. This change of attitude is reflected in Freeman Tilden’s A World of Debt (1935), which provides a pathology of the debt disease or “credit sickness”. The world, wrote Tilden, had entered a “receivership of civilization”.
“New eras” reflect the belief that the authorities can control the business cycle while simultaneously delivering stable consumer prices. Keynesian demand-management policies in the 1950s proved effective in turning potential depressions into mild recessions. Equity valuations soared. However, the outbreak of stagflation in the mid-1970s undermined investors’ faith in the competence of the Fed. The demise of Keynesianism was accompanied by a declining stock market. In August 1979, the cover of the BusinessWeek famously announced the “Death of Equities”.
The latest era in the history of finance started with the Reagan/Thatcher “revolution” of the early 1980s, and with Paul Volcker’s successful battle against inflation.
The new found confidence in the abilities of monetary policymakers was reflected both in the “New Paradigm” of the 1990s, which argued for higher equity valuations on the grounds that stocks were less risky now that the business cycle had been tamed, and later in the “Great Moderation” of this decade, which was used to justify ever increasing levels of debt and financial leverage. Unfortunately, the New Paradigm gave way to irrational exuberance and a stock market bubble, while the Great Moderation was accompanied by a real estate bubble and the proliferation of increasingly complex debt securities, based on risk models which turn out to be fundamentally flawed.
In The New Paradigm for Financial Markets, Soros claims the current crisis is so pervasive that it constitutes the end of an era. He assumes the authorities in Washington have lost control over events. There’s already some evidence for this. Despite the frantic efforts of the Bernanke Fed, securitizations have dried up, credit growth is slowing and lenders are tightening. “We are in a period of forced deleveraging and the destruction of financial wealth,” says Soros.
If we have come to the end of one era of financial capitalism, what might the next one look like? Soros suggests there will be a move away from what he calls “market fundamentalism”, towards greater regulation of the financial system. Monetarism as the dominant economic ideology may have had its day. Soros hopes its replacement will incorporate his own theory of “reflexivity”, which views the financial markets as fundamentally unstable. In the future, the authorities will be forced to respond to asset price bubbles. And, just as the Great Depression brought about the demise of the Gold Standard, Soros believes the current crisis heralds the end of dollar as the international reserve currency.
All this is just speculation. Historical precedent is more instructive in one respect. If the Fed loses both its grip on inflation and its ability to drag the economy out of recession, then investors will demand a higher risk premium for stocks. That’s what happened in the 1930s and 1970s. Such an outcome isn’t currently priced into the market.