Tuesday, August 31, 2010

Bad Investment

I kind of understand the reasons behind the dot-com bubble. The emergence of new, paradigm-shifting technology suggested that untold fortunes might be made by the fearless who got in on the ground floor. The real estate bubble is more mysterious.

Who really thought that housing prices were accurately reflecting a balance between the number of available units (supply) and the ability of consumers to pay (demand), circa January 2006? Or even a year earlier, for that matter. Even casual attention to the loan-making process during this time would suggest a problem with the direction of the investments that were being made. Hindsight is 20/20, but at the time I did decline to take on such a loan myself because it just all seemed so ridiculous (though I should have taken it, had I been a more rational actor). 

I'm clearly no economist, but I think that the bubbles during the last halves of the last two decades must have a common cause. In both cases enormous investment was made on a basis of careless speculation bordering on willful self-injury. Why?

Some people talk about interest rates being artificially low and blame Greenspan and Bernanke. I'm no expert on that one, but I do wonder whether interest rates were low only because of the actions of the Fed. My suspicion is that low interest rates alone didn't cause all that bad investment, but that both the low interest rates and the bad investment were caused by a third factor.

I'm not quite sure how to phrase it, but doesn't it seem like there was an awful lot of capital that needed someplace to go during both of these booms? I've heard the phrase global savings glut bandied about, but I'm not sure exactly how to evaluate that. One thing seems sure: typical due diligence prior to investing was not being practiced in 1996 or in 2006. Is it simply that there were not enough quality investment opportunities available during these periods? Too much money chasing too few opportunities? That story seems to fit the facts, but I can't quite make sense of it.

Under what circumstance is there too much money ready to be invested? It's not the kind of thing I've heard debated, but I can imagine a world where saving is happening at a higher rate than is consumption. In that world, each saved dollar 'wishes' to be put to use producing, but most production is giving slim returns because demand is weak (e.g. most needs are already satisfied, so there's not a strong incentive to buy more). That doesn't sound like the USA we know and love, and whose savings rate has been negative in very recent memory. But it might be a description of the world when evaluated on net. 

Don't look at me like I have data to support that argument, because I don't. But imagine how a world like the one I've described might behave. Because many, many people are choosing to postpone spending until a later date, there are many dollars available for investment. But they can't be profitably put to work building factories to make gadgets to sell to people, because people are saving instead of buying gadgets. So investment dollars are available cheap, chasing every opportunity to earn some kind of return. Consequently, interest rates fall (with or without Bernanke's say so). In such an environment risky investments that pay well look much more attractive than they usually do because investors are desperate. Investment schemes based on the promise of unproven new technology or the faulty hope of perennially rising home values almost make sense. Eventually this kind of bad investment gains a certain amount of respectability and even becomes an indispensable part of every portfolio, because no one wants to be left earning pennies on securities that give Treasury Bill-like returns while the stupid money (other banks, municipalities, and private investors) make relatively good returns and don't seem to be blowing up.

This story is so simple that it must be wrong. Please tell me how it's wrong.

But if we assume that it's right, what policy can fix it? Or should it be fixed?

What if the solution is for governments to tax and spend in order to forcibly lower the savings rate?

What if we believe that taxing and spending is the solution, but it turns out that taxing and spending in the US doesn't fix the problem because we don't save much anyway, and that the real savers are in China and India?

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