The Big Short

Lynn and I watched the 2015 movie The Big Short yesterday. It is a fairly faithful adaptation of Michael Lewis’ 2010 book of the same name, and well worth watching. It tells the true story of a small group of hedge fund managers who saw what no one else on Wall Street saw – that Wall Street banks, through fraud, greed and simple stupidity, were perilously leveraged against the housing bubble and due for a disastrous fall, which of course came in 2008. The movie is entertaining, but also instructive. If you don’t understand the arcane financial instruments that brought on the crisis (credit default swaps, collateralized debts obligations, synthetic CDOs, etc) this movie will teach you about them, and in entertaining ways.

 By the way, some of Michael Lewis’ other books are also worth reading – The Fifth Risk (2018) which details the Trump administration’s bumbling transition after the 2016 election, and Boomerang: Travels in the New Third World (2011) a sort of entertaining travelogue which details how the worldwide flow of cheap credit from 2002 to 2008 destroyed the finances of nations like Iceland and Greece and Ireland, not to mention California.

But back to my point. In The Big Short what those few hedge fund managers saw was, in retrospect, obvious. Except that everyone else was embedded in the delusion that the good times were here and would surely continue indefinitely. There is a common misperception among us humans that the past predicts the future – that however things are now will continue indefinitely. There is a good (2011) book by Carmen Reinhart and Kenneth Rogoff, two well-respected economics professors from the University of Maryland and Harvard, entitled This Time is Different: Eight Centuries of Financial Folly. It too is well worth reading, though it is an academic tome, full of figures and charts, and takes some discipline to read. But the effort is worth it for the lessons learned, namely that empires and nations keep making the same fiscal mistakes over and over again, each time thinking that “this time it is different”.

Also worth the effort are Nassim Nicholas Taleb’s main books, Fooled by Randomness (2001), The Black Swan (2007), Antifragile (2012), and Skin in the Game (2017).  Taleb tends to be arrogant and sarcastic, and has little good to say about traditional economists, financial analysts, or politicians, but I think he is essentially right.

The mathematics behind Nassim Taleb’s books are complex. The reader can find the underlying mathematical arguments at Taleb’s website (https://www.fooledbyrandomness.com/quant.html), or you can read his highly technical 2020 book Statistical Consequences of Fat Tails: Real World Preasymptotics, Epistemology, and Applications. I have worked my way through much of his mathematical arguments; enough to convince myself that his assertions are essentially correct. But one doesn’t really need the mathematics to understand his three essential main points developed in his four main books: (a) the human mind is very poor at understanding probability and risk, (b) most so-called “experts” in economics, government, politics, risk management and finance are just as poor as the general public at understanding risk and probability, but they think they are better, and (c) it is morally reprehensible to make policy for others if one is personally insulated from the consequences of that policy, as most political and economic “experts” are (ie. if one has no “skin in the game”). I think especially of this last point as I watch COVID “experts” put tens of millions out of work while still drawing their own generous paychecks.

So where am I going with this? What I am wondering right now is what other crisis awaits us that, in retrospect, would have been perfectly obvious if we had just gotten out of our “everything will continue as-is” bubble and really looked around. And the nation’s debt seems to me a likely candidate.

Since the end of the Clinton administration in 2001the US has been running a substantial federal deficit, growing progressively worse under each administration, Republican and Democratic alike. For most of those years we were having to borrow another $500 billion to $1 trillion each year to balance the budget. Then COVID came along and the first eight months of this year we have already borrowed another $3 trillion to finance stimulus packages, and whether Trump or Biden wins the next election, we will probably have another stimulus package early next year requiring us to borrow another $2-4 trillion. Here is a chart showing the growth of the federal debt:

At the same time that we are spending more for COVID stimulus, our aging population is causing more spending on Medicare/Medicaid and Social Security, while the COVID shutdown is reducing federal revenues (86% of federal revenue comes from individual income taxes and payroll taxes). And as Peter Zeihan’s demographic charts show, we are about to retire a huge number of boomers, who will start to pull money out of investments in their retirement, probably driving the cost of capital (ie – interest rates) up, so that the borrowing cost for the government, and hence the yearly interest on the federal debt, is likely to begin to rise.

 And then there is the question of just how big our debt really is. The federal debt really is only part – a small part – of the nation’s true debt load. First there is the state and local debt load. Lots of states are deeply in debt, especially for unfunded pension obligations. The total state and local debt load is currently estimated at about another $2 trillion. Then there are the unfunded future federal obligations for things like Medicare and Social Security and federal pensions. This is currently estimated by several different sources as around $200 trillion. And all this against federal revenues that average only about $3.5 trillion on a good year.

This is not a pretty picture. It seems to me essential that we have the stimulus packages, expensive as they are, to try to limit the damage to the economy, but unfortunately because of our imprudence we are having to pile that debt on top of an already heavy federal debt.

Crushing national debt has been what has brought down a number of empires in the past, as Reinhart and Rogoff’s book documents. Of course “experts” are quick to reassure us that “this time it is different”; the dollar is the world’s reserve currency, so we can get away with more debt. Or our national assets are so large (estimated at about $120 trillion) that the current level of federal debt is not a worry. Or there is so much capital flight from other parts of the world to the US that we will never have trouble rolling over our debt when Treasury Bonds come due. Or…or…or.  

But I wonder….if we opened our eyes and really looked around would we trust these “expert” reassurances so much?

The Big Short

I just watched the 2015 movie The Big Short, which is a retelling of hedge fund manager Michael Burry’s recognition, before anyone else, of the housing crisis that set off the 2008 market crash. It is quite a good movie, well worth watching. But it is depressing in what it reveals of the level of fraud and greed in Wall Street and in the government.

Of course the government – meaning us taxpayers – bailed out the banks in 2008-2009. But in the end no banker was ever charged (in fact there were millions in bonuses paid out to those who caused the crash – and paid out of the taxpayer bailout money!), nothing happened to the credit rating agencies who participated in the fraud, nothing happened to the government regulators who looked the other way, and the banks which were deemed to be “to big to fail” are now bigger than ever (only 10 banks now account for more than 70% of US banking activity). In other words, as usual those with good Washington connections got away scot-free, and even got richer. This isn’t a partisan issue; the problem grew under the Bush administration, and the bailout and subsequent failure to punish anyone came under the Obama administration, so both Republicans and Democrats were complicit in this.

Along the same lines, there is much fuss among Democrats about Trump (supposedly) not paying any taxes for the past ten years. It is outrageous if true, but in fact it is minor compared to the huge corporations who regularly don’t pay any taxes, including in 2018 Chevron, Delta Airlines, IBM, Gannett Publishing, Whirlpool, Eli Lilly, FedEx, Honeywell, Halliburton, Starbucks, Amazon, and at least 80 more. (see here for an incomplete 2018 list, or here for a 2019 list). Not that they have done so illegally – they are simply using the many loopholes that have been provided for them by a complicit Congress, often in return for generous campaign contributions to various politicians.

Politics has always been a dirty business, with scandal and corruption inevitable where so much power and money is concentrated. Trump was elected in 2016 because a sizeable proportion of the population thought they were being screwed by the system – and they were right, but probably had no idea just how many ways they were being screwed. We may get Biden for this next administration, but while he isn’t quite the sociopath or egomaniac that Trump is, he is nevertheless tainted by the way his son used his connections to enrich himself in China and the Ukraine. And of course Congress will remain as tainted as ever by campaign contributions from corporations and special interest groups, for which favors in return are expected.

I am normally an optimist (I was once accused by a colleague of being a “malignant optimist”), but I find the sleaze and corruption of Washington politics these days to be depressing.  Politicians lying is one thing - that is more or less expected in politics – but the way the Washington elite manage to protect one another from the consequences of their many misdeeds is really frustrating. Whoever wins this next election, things in Washington won't really change. If Biden wins there will be welcome changes in style, but the underlying corruption won't change no matter what campaign promises are made  - there are too many people and institutions involved and on the take.