How We Wasted Another Major Crisis

1.Just like forecasts, annual reviews are a bit of a sham. We cut off events at a somewhat arbitrary point in time, late December, move backward 12 months and then conduct the review.

It goes without saying that as one broadens the review's time dimension, the influence of the assessment's arbitrary time period grows in importance - meaning that if you really want to understand what exactly occurred here, a review of the decade is a far better tool. Except that the last year of last decade - 2009 - managed to contain a good deal of the outstanding phenomena of the entire decade, making it possible to easily skip back and forth between the review of the year and that of the decade.

The year 2009 was an astounding year in capital markets around the world, including Israel. But the astonishing returns recorded by the majority of types of investment are in most cases a mirror image of the previous year's losses. Adopting the perspective of a decade, you get a much better and particularly terrifying picture, at least for people who invested in the world's largest and most important stock market, in the U.S.

Newspapers in the U.S. have in recent days been trotting out the dry datum that U.S. stock markets yielded something like zero average annual or cumulative returns in the past decade. Have American investors internalized the consequence of this data on the axiom that stocks always produce high returns over the long term? Or on the basic assumption that forms the core of most American pension plans?

Apparently not. The mammoth marketing mechanisms of the financial industry will do everything possible to persuade Americans, and basically anyone in the world who saves, that the recently-ended decade does not signal anything fundamental. Rather, it was a one-time mishap, an errant and unrepresentative decade.

Worse yet, Americans are not inured to think in real terms, but in nominal dollars. If the Dow Jones index or the S&P 500 would appear in inflation-deducted values, investors would discover that the past decade ended in a real loss of approximately 30 percent.

One could consider the past decade's disgraceful losses in the world's largest capital market as the outcome of the high yields recorded in the two previous decades: the carefree 80s and 90s, throughout most of which the stock markets produced double-digit real annual yields. But it is impossible to disregard the simple economic and fiscal significance of the loss: Tens of thousands of managers and hundreds of thousands of employees at publicly traded companies on Wall Street, and the companies that act as middlemen between investors and companies, have in the past decade raked in salaries and bonuses amounting to hundreds of millions of dollars. This at a time when the overall return to investors and their clients was 0 percent at best, or minus 30 percent when inflation is deducted, and minus 60 or 70 percent when you take into account the premium paid for the risk to which investors were exposed.

How many in-depth articles about this will you read in the American financial journals or local newspapers? Not many. "The industry," which aids in the production of articles that analyze the capital markets, is not interested in having clients, investors, retirees and regulators adopt this perspective. The conclusions they would reach could be troublesome.

It may be that the Americans, or actually anyone in the world with pension savings, need a financial Al Gore - someone to conduct an in-depth examination of the inconvenient truth about the long-term returns of the world's largest stock market. Someone to report if the data of the past decade are one-time only, a counter-response to two decades of steep increases in stock prices, or whether they are indicators of something more fundamental - that wealth in the capital markets is accumulated over the long haul by only a select number of investors.

2.The year 2008 was the most serious year of economic crisis since 1929. When the year was over, we latched onto every superlative that came to mind about failures of the free market, regulation, capitalism and everything else under the sun.

And what was 2009? If we believe the capital markets, it was "the great year of recovery, the fastest and most surprising recovery ever since the worst year of economic crisis in the past 70 years." The thought that the worst financial crisis in history ended within a single year seems a little bizarre, to say the least, which lends itself to two possible conclusions: Either it wasn't such a terrible crisis and it was pumped up by the media, or the crisis has not ended and we are still in the thick of it. We wish to suggest a third possible explanation for the phenomenon: The crisis in 2008 was indeed terrible, and one cannot exaggerate its intensity. And it is the result of economic processes that have occurred over more than a decade.

What happened in 2009 is similar to what happened after the previous, smaller, crises that took place in the American capital market in the past decade: Aggressive medication on a colossal scale was injected into the ill patient's body and got him back on his feet - simply to prepare him for the next crisis which, as usual, would be more surprising and different from the preceding ones.

The American economy and most of the world's economies received a varied, rich cocktail of medications in the past year. But the medications that worked, that brought about the recovery, are those that treated only the symptoms. There was no rooting out of the disease. The doctors have no great interest in such treatment. Just like their patients, they are measured by the short-term results they achieve on their watch.

It was White House Chief of Staff Rahm Emanuel who, in early 2009, said that you never want a serious crisis to go to waste. He was right. Crises are the only opportunity to carry out fundamental changes in large financial systems. But apparently this crisis was largely wasted. Major fundamental changes were not made - not in the U.S. and not in Israel - and it is doubtful whether they will be.

Two main medications were administered over the past year in the largest economies of the world: a drastic and almost unprecedented increase in government expenditure, budget deficits and government debt; and a flooding of the capital markets with cheap money and negligible interest rates.

This kind of medicinal treatment usually sets off an immediate round of inflation that forces the economic doctors - governments, regulators, central bank governors and finance ministers - to reduce the dosage without delay. But that did not happen this time: The economies were so weak, the labor market so feeble and the oversupply so great that rapid inflation has not yet appeared.

However, the huge debts have not disappeared and will not disappear. They are there. They are simply passing from the balance sheets of banks, consumers and corporations to the balance sheets of governments. These loans will have to be repaid or be eroded. In either case, the result will be painful for taxpayers, pensioners, all the weak population groups.

The high unemployment that spread last year is only part of the real anticipated pain, which is still hidden within the system. When will it appear? The years 2008 and 2009 taught us that it is okay to issue forecasts, but you should never specify dates for their realization.

Take, for example, the two largest investment banks in the world: Goldman Sachs and Morgan Stanley. Before the end of the year, each issued a forecast of what could be expected to happen in the U.S. government bonds market in 2010. The movement of government bond prices next year will have an immense effect on the entire capital market, on every company, investor and saver in the world. In 2009, interest rates declined to historic lows, which greatly aided the recovery of capital markets.

So what are the banks anticipating? Very simple. One, Goldman, predicts that interest rates will continue to decline, meaning more of the same. The low interest will create a "floor" for all the world's capital markets, and all of its governments.

The second bank, Morgan Stanley, predicts the exact opposite: Interest will jump to twice current rates. Most investment portfolios around the world, Israel included, are invested in bonds. A doubling of the interest rate in the U.S. means, in most scenarios, a global drop in bond prices and heavy losses to investors.

So who's right - Morgan Stanley or Goldman Sachs? It would be stupid, of course, for us to profess to take a stand on the most complicated question in the world, especially when the two giants of the financial world are of different opinions. So we will offer a third forecast:

Goldman Sachs may be found to be correct in the short term, but Morgan Stanley will be correct in the long term. The moment will come when the gigantic budget deficits will bring about a worldwide wave of interest increases. Even more disturbing: The longer the era of minute interest rates continues, the greater the chance for the bursting of new financial bubbles around the world. And today we already know that a financial bubble is not merely an abstract concept without precedent from the newspaper's financial section, but in fact a destructive economic process, at the end of which the bill is presented to taxpayers or pensioners.