The Bigger Short

The markets swoon and swoon, and then precious normalcy seems to return–till we find we’re no longer sure what normalcy is supposed to look like. We’ve so far had the worst 10-day start to a year in the Dow’s history, and there are already dark premonitions swarming about an incipient downturn, to be even worse than 2008.

Of course, plenty of similar warnings have been put out by paranoiacs and scaremongers alike in the years since the worst paroxysms of the financial crisis faded into the drugged calm of this long, strangely infuriating recovery. Alarmism, like any other easily repeatable strategy, has a way of becoming a cottage industry unto itself. And trying to divine the markets’ day-by-day zigzag is a fool’s errand, whether through Nobel-winning economic models, fancy fractal geometry, deep learning or other statistical crunching. (I notice the widespread awareness of “black swan phenomena” has done almost nothing to raise the detectability of black swans themselves, except maybe in the sense of getting Nicolas Taleb on TV a lot more often.)

Faced with this glum reality, we are advised to simply trust in growth–which the market, despite its day-to-day vagaries, must ultimately follow, like a dog that trails you home. Step back to a long enough timescale, and you see the zigzags always head up to new highs. So don’t flinch, don’t get greedy, and you’ll eventually end up (modestly) rich. This is a bit like the investment-class equivalent of the working man’s American Dream–get educated, work hard, be patient and you will make it to the good life.

There actually is one other strategy available in the financial world that doesn’t really have a parallel in the working world, which is to control the system (and the numbers it puts out) so that it proclaims happy days, while delivering an endless payout to its main participants like a broken slot machine. (Too Big to Fail, anyone?) And so, even as pundits declare the fundamentals of the American economy strong and solid, it’s hard not to suspect that the definition of prosperity has been distorted into something that most people wouldn’t connect with that name.

Maybe my cynicism has been turbocharged by seeing “The Big Short” last week, an excellent docudrama based on the unraveling of the financial sector in 2008. All in all, it provides a dose of the ever-useful (if existentially discouraging) takeaway that, no matter how much people pride themselves on their respectability and rationality, they are invariably prone to doing massively stupid and venal things–and as often as not, doing them en masse.

I also haven’t been exactly cheered of late by listening to progressive radio host Thom Hartmann, who is usually a sober and upbeat voice but now is vividly announcing the “Crash of 2016”. He’s just published an eponymous book on the subject.

So alarmism may be the vice of our times, but I think there’s more to the present atmosphere than people misguidedly projecting their memories of ’08, or trying to make a buck peddling 31 flavors of fear.

My own view is that the crisis of 2008 was really just an apprentice-piece; the master-piece is still on its way. It will be related in its causes to 2008 but far more broad-based, as the true culmination of all the corruption, negligence, and wishful thinking that first allowed 2008 to happen, and which to this day has not only not been addressed, but been allowed to become more entrenched than ever.

One of the key differences between the coming crisis and that of 2008 is that its cause will not be as neatly traceable, and its unfolding may be much more complex and multi-staged. In 2008, there was a single massive problem in one distinct system that could be detected, localized, quantified, and then traced out in its repercussions though a common-sense understanding of the financial system. This afflicted system then did indeed fail, more or less on cue.

For example, in “the Big Short”, the whole story gets rolling when Michael Burry, an eccentric hedge-fund manager begins to look under the lid of a motley of mortgage-backed securities and sees that most of the loans comprising them are bound to default once the adjustable rates kick in. It’s not long before Burry’s insight gets leaked to a few other traders, each with their own axes to grind against the financial system, and then things are off and rolling.

Burry was not, as the movie implies, the only one to notice the problem early. Also, the movie’s attempt to portray him and his fellow short-sellers as anti-establishment folk heroes–instead of vultures making a fortune off the misery of millions–is unconvincing to say the least. Still, his example illustrates that a sharp mind, a careful eye, and a determination to dig below a façade that nearly everyone took as solid as a rock (and just as boring) was all it took to correctly diagnose the impending 2008 crisis.

Similarly, once the failure of the mortgage system became evident, it could propagate rapidly because it could be traced and understood by anyone using this compelling and simple story: it turns out A is actually worthless, so B, C, D, and E that were based on A are probably worthless, too. The notion of “contagion” itself became a contagion.

That can’t happen so easily this time around, simply because the problem is universally distributed; it is gaseous, diffusing largely unremarked into every corner of the economy. In 2008, the US had a huge bubble in real estate. Today, it’s more like the country itself is a huge bubble made out of other huge bubbles; at the higher levels, nearly everything is corrupt, malfunctioning, or massively in debt. Not only this or that corporation or government department, but entire fields–medicine, science, politics, finance, and education, to name a few–have become disfigured by cronyism, consolidation, and massive money-ginning schemes, all disguised by vast outflows of paper meant to signify “progress”. The result has been declining or stagnating utility for the society they are supposed to serve.

There is a peculiar symmetry about such a widespread problem, which tempts us to mistake it for stability. It reminds me of an old Simpsons episode where Mr. Burns is diagnosed as “the sickest person who ever lived”. He is only alive, the doctor explains, because all of his diseases happen to be in perfect balance, canceling each other out. “You mean I’m indestructible!” exclaims Burns. The doctor demurs, saying that in fact the slightest disturbance could destroy the precarious stalemate, but Burns, no longer listening, just tents his fingers and repeats triumphantly, “In-destructible…”

Similarly, by a combination of wishful thinking and circular logic, we in the US have made our belief in our own indestructibility our main asset, and also its own proof, instead of a conclusion drawn from the solidity of the constituent systems and how well they play together. Just as in the subprime collapse statistics were used, perversely, to justify that mortgage-backed securities were safely “diversified” because they were made of subprime loans from many different parts of the country, so now we tacitly assume that the widely distributed nature of the problems we face means that the risk is safely diversified away. We do not notice that the underlying causes are similar in structure, and we certainly don’t notice their deepest root–the collision of a faith of unending growth and progress with ever more serious realities of technological and social stagnation.

While that stagnation is quietly inscribing itself in a million forms onto the landscape of American life, the ongoing belief in growth ensures we dare not speak its name. But now, as growth flags in China and the Federal Reserve begins to release its seven-year sleeper hold over the economy, we are about to witness an epic experiment to see just how long illusion–or the studied re-framing of terms such as “prosperity”–can keep a machine as massive as the U.S. national economy floating in mid-air.

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