Friday, February 20, 2009

The Lost Decade

Everybody is trying to figure out what caused our current financial crisis. There are in fact many factors that led us to this place, including lack of private savings, high government spending and debt, and loose monetary policy.

But those factors have been around quite a while before we fell off the edge of this cliff. Many will argue that those factors alone are enough given enough time. While I agree with that, we did in fact have a moment in our recent history which led to the acceleration of our wasteful ways and made our current crisis a reality.

In 1998, Long Term Capital Management was sitting on top of the world. That is, until they got hit by huge losses. To avoid a total market collapse, or so we were told, the Fed organized the major banks to put in billions of dollars (now considered pocket change) and take over LTCM. To help the financial system and the new owners of LTCM, the Fed dramatically lowered interest rates, even though the economy was performing well and did not justify lower rates. It also created a moral hazard, whereby failing companies will get bailed out, encouraging risky bets knowing that the rewards will be huge but the risks will be limited as the government eventually bails out those that are "too big to fail." This combination of monetary inflation and moral hazard led to a rampant wave of speculation, first in the stock market with Internet stocks creating a bubble that ended in 2000, followed by a bubble in real estate, followed by yet another bubble in commodities.

Thanks to the government's loose money and the moral hazard, the economy over-leveraged itself and speculated on get rich quick schemes (options on Internet stocks, buying multiple houses with nothing down no interest loans) instead of saving and investing in solid profitable business ventures.

Today, the Dow hit its lowest point since October 1997. Back in 1998, the government supposedly saved the day with its actions. But the wave of speculation, bubbles, and crashes that resulted have created a lost decade for American equity investors.