If two-thirds of a group of conspirators avoid prosecution, trial, and imprisonment, but the other third does not, has justice been served? That’s a question raised by the movie The Big Short’s treatment of the 2007-2009 financial crisis. The movie is a dramatization of Michael Lewis’s non-fiction book, The Big Short: Inside the Doomsday Machine.
This is not a review of The Big Short, which was entertaining and amusing, with clever writing and strong performances by Christian Bale, Ryan Gosling, and Steve Carell. The movie did not, however, feature a viable explanation of the causes of the financial crisis. Yes, bankers offered mortgages to people who could not afford them, bundled them into junky mortgage-backed securities and more complicated debt instruments, and with the help of asleep-at-the-switch ratings agencies, regulators, and government-blessed mortgage finance agencies, sold them to speculators and investors whose due diligence extended no further than the triple-A rating.
So The Big Short justifiably prosecutes and would like to put in jail the bankers and ratings agencies, but aside from light slaps on the wrists (a heavily leveraged, pole-dancing real estate speculator and a regulator-regulated revolving door vignette), the two other major conspirators—feckless, often dishonest mortgagees and the government—get off scot-free. However, even if the movie had figuratively hauled them off to the hoosegow, it missed entirely the real cause of the financial crisis: financial and political gravity. Gravity doesn’t make for very good cinema, but it’s an appropriate subject for an SLL piece. (SLL doesn’t have a $100 million production and advertising budget to cover, will never be in contention for an Academy Award, and only needs to appeal to an audience that’s maybe one-day’s tally of Big Short viewers at a typical Megaplex.)
Regulatory capture is the first law of political gravity. Reformers set up a regulator for a perceived social ill, pat themselves on the back, and move on to the next cause, while the regulated sabotage the scheme and turn it to their own ends. The regulated have every incentive to do so—it’s often a matter of economic survival—and everybody else, including the supposed beneficiaries of the regulation, have little incentive to engage in the constant bureaucratic, legislative, and judicial infighting necessary to force the regulators to adhere to the stated purposes of the enabling legislation. So all regulation, without exception, devolves into the cynical charade we’ve come to know and loath: lobbying, influence peddling, legal and illegal bribes, revolving doors, use of the regulatory process to cripple competitors and competition, cartelization, and an identity of interests between the regulator and regulated.
It’s no surprise, then, that the banks and their regulators, particularly the Federal Reserve, are in bed together, and have been for over a century now. There is a free market, highly effective regulator of bank behavior: bank runs. In fractional reserve banking, banks will never have enough immediately available money if a large enough percentage of depositors all want their deposits back at the same time. That possibility keeps bankers honest. They extend loans to borrowers who can pay, maintain a prudent level of cash on hand, are selective about the banks with which they establish correspondent relationships, and do their best to appear as sober, solid, confidence-inspiring members of their communities. Such bankers usually weather the inevitable financial squalls, building reputations for probity, while their intemperate, grasping brethren do not. Over time, customers, the smart ones at least, gravitate towards the former and shun the latter.
Bank regulation has replaced this highly effective free market regulatory mechanism—actually making it the enemy—with a highly ineffective, corrupt, and captured panoply of laws, regulations, and agencies. The Fed’s lender of last resort function, deposit insurance, extensive regulation, and the too-big-to-fail doctrine enshrine the political impetus to banish bank runs and their potentially destabilizing, albeit salutary, effects. The government has become the guarantor of the banking system. A second law of gravity: set up a system whereby heads, the bankers win, tails the government (and taxpayers) lose, and the banks and bankers will win and the government (and taxpayers) will lose, repeatedly, until that system is eliminated.
A third law of gravity: governments establish central banks to benefit governments. Fiat money (actually fiat debt, see “Real Money”) gives the government the first user advantage; it gets to spend it and command resources before its fiat money depreciates. That depreciation benefits debtors at creditors’ expense, and governments are invariably debtors. As debtors, governments benefit from lower, central bank-suppressed interest rates. Finally, governments realize political benefits from central bank debt promotion. An increase in debt can produce a short-term, constituent-pleasing bump in economic activity.
A fourth law of gravity: government and central bank debt divorced from the underlying economy will invariably grow faster than the economy as debt’s marginal impact diminishes, and suppressed interest rates and abundant debt-based liquidity will promote malinvestment and increase consumption and speculation at the expense of savings and investment, leading to unsustainable standards of living, indebtedness, and asset bubbles. The fifth and final law of gravity: that which is unsustainable will not be sustained; the system collapses.
These laws of gravity—not ignorant, foolish, or greedy homeowners and house flippers; not greedy, unscrupulous bankers, ratings agencies, and investors in securitized, subprime garbage; not the government’s and the housing finance agencies’ incompetent and corrupt promotion of home ownership and mortgage finance—are the “cause” of the last financial crisis. Or more correctly, the crisis was the inevitable consequence of gravity’s inexorable operation. A reliable facet of any collapse is that its leading edge will be the financial and economic sector towards which the most credit—relative to that’s sector’s ability to service debt—has been channeled. In 2000 that was the technology sector; in 2007 it was housing and mortgage finance.
SLL noted over a year ago that this crisis’s leading edge was commodities (“Oil Ushers in the Depression”), towards which superabundant credit had been channeled based on a fallacious belief in the perpetual growth of the Chinese economy at double-digit rates. That reality is still not generally grasped, even as credit and economic contraction, falling prices, and gluts have spread around the world, from commodities to transportation, production, distribution, wholesale, and retail. General recognition will leave the current, already battered levels of equity indexes as distant specks in the rear-view mirror.
There could be silver linings. After the ultimate crash, market-based money may replace worthless fiat scrip. Bank risk may be “unsocialized”: banking without government and central bank safety nets. And somebody, perhaps Michael Lewis, may write a book about the religious beliefs in the China growth story and the ability of central bankers to control the global economy; the insanity of negative interest rates; the opacity of balance sheets produced by banks allowed to mark asset values to their own assumptions and models, not to market prices, and the travesty of economic policies that reward leverage, speculation, and a small coterie of crony insiders while penalizing savings, investment, integrity, and honest economic effort. If we’re lucky, that book will serve as the source for a movie as entertaining as The Big Short.
From Daniel Durand, speaking in 1913 from the novel The Golden Pinnacle:
What the government gains from monetary debasement, the wage earner loses. Adjustments to his wage won’t keep up with money inflation. As for promoting economic stability, look at the railroads. Every line upon which the government has laid its ‘benevolent’ hand has come to ruin. You want to make it responsible for the entire economy? The Wall Street moneyed class will a field day with elastic money and financial instability. It’s your average wage-earning American who will be hurt the most.
STRAIGHT LINE LOGIC 
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I would be interested, how do you think the Chinese economy collapse will play out? Big bang like our 1929 or an Abe like Japanese whimper?
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I don’t think the Chinese collapse will play out as slowly or as gently as Japan’s, although much of it is from the same causes: mercantilist economic policies and reliance on debt. The Chinese don’t have the domestic savings base the Japanese had when their economy and stock market topped in 1989. The rest of the world is in much worse shape than it was in 1989, so will offer much less of a safety valve to the Chinese than the world offered to the Japanese. Finally, as we’ve seen, China’s leaders have a statist, communistic orientation, and will do even more of the wrong things than Japan’s leaders have. If China ever adopts true capitalism, sound money, and a government that protected individual rights, it will be the world’s economic and political dynamo.
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While Chinese industriousness and high mean IQ are well-known, I strongly suspect that the East Asian cultural tendency of deference to authority will always throttle back their potential. Despite thousands of years of civilization China never independently produced science, and anecdotal evidence suggests that Chinese engineers are not as brilliant as test scores along should indicate. Being a real engine of innovation requires a modicum of “challenge the boss.” Also, if the studies of twins raised separately are to be accepted, cultural values and even political beliefs are as inherited as are intelligence, hair color and height. This suggests that cultural values should be very, very slow to change.
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drdog09:
Here’s an interesting take on that question. I’m not entirely sure I buy it, but it certainly is worth thinking about:
I think China has done some very intelligent maneuvering particularly since the 2008 crisis. They figured out our fractional reserve scheme was toast but they played along anyway. They even levered up as much or more than we did since then. However, with this increase in credit they have built infrastructure in the form of roads, bridges, cities, plant and equipment …all for and with future uses. The West on the other hand has thrown a “standard of living party” and neglected infrastructure to the point of dilapidation. Yes China’s financial system will implode with all the rest, they may even lead it! But, they will be left with new infrastructure and “money” (our gold) to get started again. President Xi has even said this to his people and to the world. He said the short term would be difficult but the long term beneficial. I think he is telling the truth!
http://www.silverseek.com/article/chinese-silver-fox-15208
“There could be silver linings. . . .”
Here’s another: Maybe Mr. Gore will finally get the large audience he has earned.
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You may be right about the Chinese, and thanks for that last comment. I’m optimistic that my audience will continue to grow.
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This is yet another of your simply astute and penetrating articles. I have tried to think of something to add beyond my uninspiring agreement.
Having also just seen the movie, I cannot help but laugh at the mental ease, excluding the emotional, with which those so inclined choose to game the system. In the final analysis it is made possible by those who already have done so, but smugly believe they are smarter than their “fellows.”
As the next and far greater consequential economic crisis plays out, what do you think may be the impact politically? Is there enough potential courage and integrity in the House, led by Ryan, to actually dealing with the underlying crisis? Can the dismantling of Leviathan with a concurrent cascade of reductions in taxation and regulation to generate sufficient attraction of the world’s capital to “politically” mitigate the consequences of doing so?
I so enjoy your articles as well as your books.
Dave
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Thanks for the compliment. Leviathans will be dismantled of necessity; governments are bankrupt. The “winners” will be those nations which then embrace individual rights and limited government, protect contract and property rights, and promote economic and political freedom. That may be the US; it may be someone else. Only time will tell which countries decide to attract producers and capital, and which countries regress to ever more statism and repression.
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By the time that movies are made about this collapse, movie admission may be $2 again….
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I applaud your shining the light on govts., corporations, and banks with their mendacity being operative at the same time their contempt for everyone else is on display. Being one of the “everyone” else, I sometimes ponder why these entities don’t have any regard for anyone other than themselves……..and then I remember that thieves, tyrants, and thugs don’t even think like we do. I should know, I was married to a thief for a long time, and even on her death bed, she wouldn’t come clean.
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Reblogged this on lisaandrews1968 and commented:
From Daniel Durand, speaking in 1913 from the novel The Golden Pinnacle:
What the government gains from monetary debasement, the wage earner loses. Adjustments to his wage won’t keep up with money inflation. As for promoting economic stability, look at the railroads. Every line upon which the government has laid its ‘benevolent’ hand has come to ruin. You want to make it responsible for the entire economy? The Wall Street moneyed class will a field day with elastic money and financial instability. It’s your average wage-earning American who will be hurt the most.
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The question remains, what do prudent people do to increase resilience in the face of such gravity? If all the King’s Horses and all the King’s Men can’t keep the credit bubble growing, and the Bond Ocean (full of IOU’s currently trusted to be worth essentially face value) begins to evaporate rapidly, in what medium should one sit out the process?
I see this as an inverted pyramid with weaker issuers of debt piled on top of the next less-weak issuers. Once trust begins to erode, each layer of the pyramid should begin to pancake onto the next layer, step-wise, as gravity crushes each layer as its “trust mortar” loses cohesion. Given the unimaginable (mental) wealth now residing in all those IOU’s, should this not be the largest evaporation of wealth—ever? Or is this all just doomer-babble and we truly are in some sort of new paradigm? This question is not rhetorical. For 20 years (since Prechter published At the Crest of the Tidal Wave) it has seemed inevitable, but disbelief (and distrust) was suspended this whole time. Have you an opinion? And is the performance of JNK any indication that the top layers of debt (weakest issuers) is in pancake mode?
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I believe you have the essential scenario correct, and the performance of JNK is indeed an “indication that the top layers of debt (weakest issuers) is in pancake mode.” Much of the future will be characterized by breakdown and chaos. My basic recommendation has been to own physical precious metals and cash, and to have a good store of the things required to survive in that sort of environment, including firearms. There are some great preparation websites, and I would direct you to the Western Rifle Shooters Association website and its blogroll. It is not just on this level that one must be prepared. The impending collapse will present the best opportunity for the liberty-minded to establish, at the least, enclaves of liberty and rationality. That is an opportunity we must be prepared to seize.
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