September 21, 2008
By DAVID LEONHARDT
The past week, by any standard, has been an extraordinary one for
America's economy and its financial system. Merrill Lynch, which was
founded during Woodrow Wilson's administration, agreed to be bought
for a bargain-basement price, while Lehman Brothers, which dates back
to John Tyler's presidency, simply collapsed.
By the end of the week, the federal government was preparing to buy
hundreds of billions of dollars in securities that no bank wanted. It
appears to be the government's biggest fiscal intervention since the
Great Depression, designed to get the financial markets working again
and keep a credit freeze from sending the economy into a deep
The announcement of the plan changed the mood on Wall Street and sent
stocks soaring at the end of the week. But even if the economy avoids
a tailspin, the next couple of years aren't likely to feel especially
good. It's been a long period of excess, and the hangover could be
long, as well. For the near future, the most likely outcome remains
slow economic growth, scant income gains for most workers and, for
investors, disappointing returns from stocks and real estate. If
consumers begin to cut back on their debt-fueled spending things could
On Friday morning, the economists at Lehman Brothers sent out their
usual weekly roundup of the news, but it came this time with a short,
italicized note, explaining that the report would be the final one to
appear under the Lehman banner. That bit of understatement preceded
some more: "This episode of financial crisis," Lehman's economists
explained, "appears to be much deeper and more serious than we and
most observers thought it likely to be. And it is by no means clear
that it is over."
Yet, historic though this week has been, there is something familiar
about what is happening. Once again, we are seeing the puncturing of a
speculative bubble that was the result of asset prices soaring high
above the underlying value of the assets. For as long as markets have
existed, bubbles have formed. And whenever one of those bubbles begins
to leak, it typically needs years to deflate, causing enormous
economic damage as it does.
Only now, for instance, are the bubbles of the past decade and a half,
first in the stock market and then in real estate, starting to go
away. It's easy to think of the turmoil of the past 13 months as being
unconnected to the stock bubble of the 1990s, which appeared to end
with the dot-com crash of 2000 and 2001. That crash brought down the
overall stock market by more than a third, its worst drop since the
1970s oil crisis. Corporate spending on new equipment then plunged and
employment fell for three straight years.
But dramatic though it was, the dot-com crash did not actually come
close to erasing the excesses of the 1990s. Indeed, by some of the
most meaningful measures, Wall Street after the crash looked a lot
more like it was in a bubble than a bust.
As late as 2004, financial services firms earned 28.3 percent of
corporate America's total profits, according to Moody's Economy.com.
That was somewhat lower than it had been over the previous few years,
but still almost double the financial sector's average share of
profits throughout the 1970s and '80s. By 2007, the share had fallen
only marginally, to 27.4 percent.
Meanwhile, the share of wages and salaries earned by employees of
financial services firms continued to climb and reached a peak last
year. Of every dollar paid to the American work force in 2008, almost
10 cents went to people working at investment banks and other finance
companies, up from about 6 cents or 7 cents throughout the 1970s and
How did this happen? For one thing, the population of the United
States (and most of the industrialized world) was aging and had built
up savings. This created greater need for financial services. In
addition, the economic rise of Asia - and, in recent years, the
increase in oil prices - gave overseas governments more money to
invest. Many turned to Wall Street.
Nonetheless, a significant portion of the finance boom also seems to
have been unrelated to economic performance and thus unsustainable.
Benjamin M. Friedman, author of "The Moral Consequences of Economic
Growth," recalled that when he worked at Morgan Stanley in the early
1970s, the firm's annual reports were filled with photographs of
factories and other tangible businesses. More recently, Wall Street's
annual reports tend to highlight not the businesses that firms were
advising so much as finance for the sake of finance, showing
upward-sloping graphs and photographs of traders.
"I have the sense that in many of these firms," Mr. Friedman said,
"the activity has become further and further divorced from actual
Which might serve as a summary of how the current crisis came to pass.
Wall Street traders began to believe that the values they had assigned
to all sorts of assets were rational because, well, they had assigned
Traders sliced mortgages into so many little pieces that they forgot
what they were really trading: contracts based on increasingly shaky
loans. As the crisis has spread, other loans have started going bad as
well. Hyun Song Shin, an economist at Princeton, estimates that banks
have thus far absorbed only about one-third to one-half of the losses
they will eventually be forced to take.
One of the few pieces of good news is that Wall Street finally seems
to be coming to grips with the depth of its problems. You can see that
most clearly, perhaps, in stock prices, which have at long last fallen
from the stratospheric levels of the past decade.
The classic measure of whether the stock market is overvalued is the
price-earnings ratio, which divides stock prices by annual corporate
earnings. At the height of the bubble, in 2000, companies in the
Standard & Poor's 500 Index were trading at 36 times their average
earnings over the previous five years. It was the highest valuation
since at least the 1880s, according to the economist Robert Shiller.
By 2004, surprisingly enough, the ratio had dropped only to about 26,
still higher than at any point since the 1930s. At the start of last
year, it was still 26.
But after the market closed on Friday, the ratio was down to roughly
17, which happens to be about its post-World War II average. At least
by this one measure, stocks are no longer blatantly overvalued.
This doesn't necessarily mean they are done falling. For one thing,
corporate profits could decline, particularly if households begin
pulling back on spending. The unusually rapid rise of consumer
spending over the past two decades is arguably the third bubble
confronting the economy. It has happened thanks in part to a huge
increase in debt, which may now be coming to an end, just as Wall
Street's love affair with debt appears to be ending as well.
And even if the economy does better than expected, investors may still
turn pessimistic. "We tend to go through pendulum swings," said Joel
Seligman, the president of the University of Rochester, a longtime
Wall Street observer. There are long periods of overexuberance, in
which investors worry that they are missing the next great thing,
followed by crises that make those same investors fear that the world
as they know it is coming to an end.
That seemed to be the case last Wednesday, when share prices of
Goldman Sachs and Morgan Stanley plunged even though the firms were
still making money. Glenn Schorr, a UBS analyst, wrote an e-mail
message to clients saying, "Stop the Insanity."
But bubbles inevitably produce insanity, both on the way up and the
way down. On Friday, the formerly laissez-faire Bush administration,
along with the Federal Reserve, announced that the only way to restore
sanity to the markets was for the government to buy an enormous pile
of mortgage-related securities. Theoretically, the government could
turn a profit on the securities if they can be sold for higher prices
when normal conditions return.
But few expect that outcome. Senator Richard Shelby of Alabama, the
ranking Republican on the Senate Banking Committee, estimated that the
ultimate cost to taxpayers could be in the range of $1 trillion, or
about two-and-a-half times as large as this year's federal budget
A guiding principle of economic policy in recent years has been that
nobody is smart enough to diagnose a bubble until it has already
deflated. This was one of Alan Greenspan's mantras during his tenure
as the chairman of the Fed. His successor, Ben Bernanke, said much the
same thing when he took office in 2006. As they saw it, no matter how
high stock prices rose relative to profits, or no matter how high
house prices rose relative to rents, regulators deferred to the
collective wisdom of the market.
The market is usually right, after all. Even when it isn't, Mr.
Greenspan maintained, pricking a bubble before it grew too large could
stifle innovation and hurt other parts of the economy. Cleaning up the
aftermath of a bubble is easier and less expensive, he argued. We're
living through that cleanup now.