Who should have known the crunch was coming

Sunday, 15th February 2009

Who should have known that the credit crunch and ensuing recessions were possible, let alone likely? I think I can safely say far, far more people than those who actually did — not least because those few did try to warn the rest of us, but because there were other indications of trouble ahead.

First, those who warned of the coming crisis. Nouriel Roubini was perhaps the most vocal in warning that US house prices, warning of a housing lead financial crisis since 2006. In 2005, Raghuram Rajan warned that lack of regulation and new financial products had increased systemic risk at a time when. Warren Buffet warned that derivatives carried “dangers that, while now latent, are potentially lethal”. He also used the word “mega-catastrophe” to make the extent of possible problems clear.

What more warning did people need than those from leading economists and the world's best known successful investor? The discussion was not limited to a narrow audience either: At least in Britain, the mainstream press was full of both speculation on whether high house prices were a prelude to a crash, as well as stories of false information in self-certified mortgages and high gearing by buy to let investors.

We had warnings about system risk to the banking system, high house prices and a link between them. That should have been enough to tell us all that equities and the broader economy were vulnerable as well — although, I will admit that I, for one, did not expect it to be this bad.

The biggest problem was that people were simply avoiding facing the truth. Trying to tell people who had borrowed heavily to buy UK property simply met with blank refusal to face the possibility. The response reminded me strongly of the dot com bubble. The arguments were different but had a common theme: “its different this time”.

The dot com arguments were radical new technology, high growth, a permanently shrunken equity risk premium and a permanent loss of investor interest in value shares. The housing arguments (in the UK) were better managed economies leading to permanent prosperity and immigration leading to population growth and therefore pressure on housing. Derivatives were assumed to be safe because banks would use sophisticated risk models to measure the risk, and would be motivated to avoid taking risks: both assumptions proved to be wrong, as did the models.

Many of these arguments were easily seen to be wrong. Although central banks had a good few years, their ability to ward off recession had not really been tested. No one really knows what the principal variables that determine population growth — fertility, life expectancy and net migration — will be. They are all affected by the economy, the second by medical technology, and the last by conditions in the rest of the world. It is worth remembering that Britain has a high emigration rate, and that

Add to that the political uncertainties. When house prices were high the government considered loosening planning laws — that would have made a huge difference, as I have explained before. The same applies to immigration, especially from outside the EU. Recession might well fuel more remigration, particularly from the UK which has a low level of job security (in good times we call it flexible labour laws).

There is a lesson in all this: if you want to out-perform the markets, the first step is to be more detached than everyone else about your investments. If you can keep your head when all about are losing theirs, you will be rich.

We have already been through the warnings on derivatives. If that is not enough, Nicholas Nassim Taleb describes what happened in characteristically forthright style.

Who should have known? With all the smugness that can be summoned up by someone who does not own a house and has been out of equities from well before the crunch, I can say you should have known. It has all happened before and will undoubtedly happen again. It is never different this time, and people on the roller-coaster can never manage to be detached.


Saturday, 28th February 2009 11:11AM

Congratulations on getting out of equities as well as housing. I've been a house price bear for years, but equities still seemed reasonable value. In fact, I'm not convinced they weren't but I'd certainly rather be musing from the sidelines.

The best quote not in your article is Minsky's 'Stability is unstable'. Sums it up I think - and as you say, explains exactly why it will happen again when the new safety nets create a new fearless climate.

Moneyterms Blog > The best crunch prediction yet
Friday, 7th August 2009 11:32AM

[...] have blogged before about who did, and who should have, foreseen the credit crunch. Brad Delong has a lengthy quote of Michael Musa, that is the best pre-crunch explanation of what [...]

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