Feelings and emotion are drivers of economic recovery, but also a potential pitfall
I wish my grandfather were alive today. Just as when he was a young man in the 1930s, the world is again enraged by capitalist pig-headedness. The last global economic crisis, the Depression, gave way to the heyday of socialism in both Western countries and my native Czechoslovakia, and created the world in which my grandfather lived and into which I was born. As a teenager in the Moravian town of Olomouc, however, watching television images of Prague’s Wenceslas Square overflowing with protesters who toppled communism within weeks, my world was changing dramatically and, I thought, irreversibly. I soon moved to the United States to pursue an education and a career in finance, the engine of the apparently invincible American capitalist model. But, today, the financial market boom to which I attribute my career has brought capitalism into another global crisis.
As political leaders and various experts grapple with which economic structures and values should define the future of capitalism, it is important to reflect on how and why this American model faltered, and offer one important consideration – and caution – to the architects of the new economic order.
The recent U.S. economic cycles were driven by excessive financial engineering, which led to a 20-year finance boom of cheap credit and excess liquidity. This boom resulted in under-pricing of risk, especially in real estate-related financial instruments, and generated massive leverage across the global economy (from households to the corporate sector to the public sector), financed by foreign capital. The flood of this foreign money into U.S. government bonds depressed interest rates, created enormous excess liquidity, and generated a hunger to find investment opportunities.
Most consumers tried to feed that hunger by turning to opportunities in the housing market. Mortgage assets were considered relatively impervious to sharp downturns because of newly created, more flexible and complex financial products that purported to distribute risk safely. While real home prices increased nearly 50 percent in the United States between 1998 and 2006, they increased more than 130 percent in Ireland, 120 percent in the United Kingdom and Spain and more than 100 percent in France. This housing bubble boosted consumption, as homeowners used their housing assets to finance greater consumer purchases and investments. In the United States, mortgage equity withdrawals reached $9 trillion between 1997 and 2006, equal to more than 90 percent of disposable income in 2006. As a result, the Dow Jones industrial average climbed from 803 in the summer of 1982 to 14,165 in the fall of 2007 – about a 12 percent compounded annual growth rate (CAGR). Economic boom was unmistakable; the fact that financial innovation couldn’t expand capital forever was less obvious.
So why didn’t anyone question the sustainability of excessive borrowing by households and businesses? Because, in that economic climate, confidence and trust ran high, and both are wildly contagious. Behavioral economists George Akerlof and Robert Shiller argue in their recent book Animal Spirits that “ideas and feelings” motivate much of human behavior, and the prevailing myth that any loan to real estate was a good loan, and that property values always rise, blinded many to the inconvenient but incontrovertible truth: Over the past 120 years, U.S. home prices have actually declined about 40 percent – nearly half – of the time.
This tale was bolstered by another popular fiction, that tremendous growth in real estate loans was healthy because the underlying risk was distributed soundly. Trust and confidence continued to soar unchecked, and ever-more complex financial assets became less comprehensible to lay investors. This was a recipe for disaster, or, more specifically, for rotten deals. When these pockets of weakness were discovered – at first slowly, and then in a dizzying and seemingly endless rush – consumer confidence plummeted, taking down the economy with it. Awareness of multiplying delinquencies on U.S. subprime mortgages was the catalyst for changing the economy’s course. Americans began abandoning their leveraged homes, and, with them, their faith in the ability of real estate investment to drive the nation’s economic health in perpetuity.
If the root of today’s problem was uncritical trust, it was quickly replaced by free-floating uncertainty and fear. Nervous about banks’ ability to cover their liabilities, people now fear joblessness and destitution. Fear and aversion to risk have led to increasing pessimism, to which policymakers speedily became attuned. Governments around the world quickly went to work attempting to restore confidence. The U.S. government announced reassuringly in the past month that the nation’s large banks will avoid ruin. Critics have pointed out, however, that this turnaround comes at the cost of huge deficits, and a disproportionately large government role in the private sector. Arm-twisting strategies, like forcing government-backed banks to accept pennies on the dollar for their debt in Chrysler’s restructuring, are an effort to save capitalism, but only serve to undermine its fundamental investing principles. Recent polls do reveal these strategies to be working to boost public confidence in the economy.
As I observe the recent two-month surge in the stock market, it seems that the economy might not be driven purely by rational data analysis, but partly again by Akerlof and Shiller’s “ideas and feelings.” J. Edward Russo and Paul J.H. Schoemaker agree, showing that when people are presented with more information, their overall confidence spikes. Counter-intuitively, however, the accuracy of their judgments will actually decline with greater information. The recent increase in information about bank health, job losses, and other indicators, coupled with the encouraging and omnipresent metaphors about the reviving gears of the economic engine, may indeed be emboldening us once again. Yet we must approach the evolving – and hopefully genuinely improving – economy with a measure of caution.
I believe the road to economic recovery is based on restoring overall confidence, but a new kind of trust is in order. Feelings are powerful but can clearly be misleading. Answers do not lie with throwing caution to the wind and burning the capitalist rulebook of sound legal and investing principles and turning over the private sector to government control; nor do they reside in embarking on the same careless consumerist cycle that led to the current crisis. My own relatively short history reveals the improvidence of both such approaches. Our economic recovery must begin with the adoption of a tough-minded optimism. Most importantly, the road to economic health will be long, but well worth it if we, as global leaders, citizens and consumers, can take seriously, and think critically about, the role of confidence and emotion in economic fluctuations. I hope to be around to tell my grandchildren just how we accomplished it.
– The author, a native of Olomouc, is vice president at Lightyear Capital, a private equity firm based in New York City.