Business deals were often done with handshakes

This started out to be an article in the investing series, but began to wander into other areas. While I am overdue for the investment article and hope to have it out soon,  I thought I would publish these ramblings.

There will be a major article out mid-week on QE2. It will be the basis of my current thinking on where the economy is going. Investors should not miss this.
I have been an investor for decades. When I started, investing was simpler in the sense that there were fewer choices for individual investors. Stocks, bonds and real estate were the primary ones. Brokers had to be involved and outrageous fees were charged compared to today. Now trading costs are almost zero, information is instantly accessible and it is possible to trade almost any market at any time of day from anywhere.
Government played a smaller role in the economy and in markets. The Keynesian notion that government was necessary to offset slumps and equilibrate the economy had not yet taken hold. Once it did, politicians exaggerated its claims and abused the tool. Spending, under the guise of economic necessity, became a preferred vote-buying vehicle. Earmarks quickly became a staple of political behavior.
Honesty and integrity used to characterize relationships between people. Business deals were often done with handshakes, without hundreds of pages of legal documents. “His word is his bond” was assumed until proven otherwise.
People believed in what was “right” rather than what was “legal.” Today the ethical “right” has been replaced with “is it legal?” To paraphrase what passes for today’s morality: “I don’t care what’s right; can I get away with it legally?”

Justice Brandeis

Ethical behavior is rarer now, perhaps for the reason cited by Judge Brandeis:

In a government of laws, the existence of the government will be imperiled if it fails to observe the law scrupulously. … If government becomes a lawbreaker it breeds contempt for law: it invites every man to become a law unto himself. It invites anarchy.

On the other hand, perhaps none of this is new. Edmund Burke, reflecting on the French Revolution, expressed similar concerns over societal deterioration:

The age of chivalry is gone. That of sophisters, economists and calculators has succeeded.

Perhaps it is just a natural cycle of civilization where moral decay precedes and then accelerates the decline of a nation.
Our economy used to be driven by manufacturing and productivity. Growth could be expected to be about 3% per year, except in years when recessions hit. Recoveries were generally quick, characterized by rapid growth that offset prior bad quarters and returned the economy to its 3% trendline.
Our economy is now diminished. We no longer manufacture much, at least on a percentage basis as compared to the past. Instead, we have driven GDP via massive consumption. Consumption is not a bad thing, but to sustain it requires the creation of value or wealth. That comes from production and productivity growth. We have recently engaged in massive consumption without either.
When you are not producing, the only way that to increase consumption is via the draw-down of savings/investment or debt-based purchasing. Both have occurred and both have been the main drivers of our economy for the past three decades. Both are unsustainable over the long-run.
The capital base (real savings and investment) of an economy is the most important determinant of wages. Economies that have tools for their citizens are more productive than those that don’t. Hence they have higher wages. Our people earn more than most of the world not because we are “chosen.” We earn more because we have more capital in the form of machinery and equipment. A bulldozer operator moves more dirt in an hour than a primitive-based economy using hundreds of workers with crude implements can do in a day. The bulldozer operator as a result earns much more than he would without the equipment.
If physical capital is not growing faster than the population, real wages must come down. In our consumption economy, capital has been used up and not replaced. As a result, the average real weekly wage today is lower than it was in 1964.  Nominal wages are higher, but the dollar buys less as a result of inflation.
The other driver for consumption has been debt. For at least the past twenty years, people lived beyond their incomes. Consumption soared, but production did not. Many of us borrowed our way to a better life. The financial industry was abetted and encouraged by the government to create easy credit.
For a while, this behavior appeared rational. After all, credit was cheap and our monetary wealth exploded primarily due to a run-up in the stock market and housing prices. When the dot-com bubble burst in 2000, Alan Greenspan dropped interest rates too low and held them there for too long. This created the housing bubble which was also assisted by a loosening of credit standards for those buying homes.
Existing homeowners felt rich as the value of their homes soared. Many used these increased values as a source of better living by refinancing to higher loan levels and taking cash out of their homes. Reality set in when housing values began to collapse and return to traditional norms, leaving many homeowners “under water.”
There are plenty of villains in the saga of the last few decades. There is no need to affix blame other than to say that when government intervenes it distorts prices. Prices are information. They are “language” in the sense that they tell us how to behave – conserve here, expend more there, invest more or less over here, etc. Distorted prices cause a distorted allocation of resources. By distorted allocation, I refer to one that cannot be sustained once the interventions end.
It is useful to offer a few comments on “greed.” Many individuals were “flipping homes” and were wiped out. They have been accused of being “greedy.” Greed is always something that someone else engages in. When we engage in similar behavior, we think of it as self-interest, trying to improve the quality of life for our families. I don’t know how to define greed and neither does anyone else. As Gordon Gecko stated: “Greed is good.” I interpret greed that way so long as it stays with the law and ethical norms. Then, it is no different than ambition or motivation.
The story of the last couple of decades was distorted prices that misled consumers and investors. Government intervention distorted housing prices. For several years, home prices rose rapidly in some markets. Stock prices were languishing. Many believed that the best investment they could make was in second homes, expanding their existing homes or flipping homes. Rising home values signaled to people that they were “rich.” Based on signals from the marketplace, there was no need to continue to save for retirement because their homes would provide that. People unfortunately borrowed against what they believed to be real wealth.
None of this behavior was irrational unless you were a knowledgeable economist who understood what was happening. And even economists missed what was happening. Most of the world was behaving rationally by taking actions that we now know were wrong. They trusted our information system known as prices. They did not know that government intervention had produced false and misleading prices, driving housing values beyond what could be sustained.
The tragedy of housing and other asset bubbles is that people trusted their government and trusted the price system that government was distorting.  They had no way of knowing the the government had ruined this information transmission mechanism. It was not “greed” that created the economic mess but government intervention.
In hindsight it is easy to see that housing was a massive bubble. Yet the average Joe is not a sophisticated investor. He has innumerable interests, probably none as important as improving the quality of life for his family. Economists like Ben Bernanke missed the bubble. Why would we expect a plumber, accountant or even a business executive to spot it?
Unfortunately government intervention is still distorting prices. Investing success will come to those able to spot these distortions and properly estimate how long they might continue.