Grantham: Only Four Ways

Insight: Rebalancing the books
By Jeremy Grantham

The proximate cause of our problems today is the breaking of the US housing bubble, and the ultimate cause is the remarkably widespread belief in rational expectations: that economic man behaves like a logical machine that in turn causes markets to tend to efficiency and equilibrium. In such a world the tech bubble was rationalised by Alan Greenspan as an internet-driven productivity burst, and the housing bubble (in reality a 100-year event) was so preposterous an idea that Ben Bernanke could not see it, such was his faith in efficiency.

In an efficient world all asset price changes merely reflect fundamental change and thousands of well informed investors are bound to be right. There is never anything to fear and we can all keep dancing forever.

Asset price bubbles have preceded all the great busts – both in markets and economies. They are extremely dangerous and destabilising and great efforts should be made to moderate these bubbles as they form. Our recent squad of leaders were, if anything, cheerleaders, glorying in the splendid new world order. Unfortunately this includes our current financial leadership, none of whom blew the whistle although all of them were on the scene enjoying, it seems, the “new moderation”.

Well now the tide has gone out and $50,000bn of perceived wealth in the US (stocks and real estate) has declined to below $30,000bn, leaving the original $25,000bn of private debt stranded. Now born-again prudent bankers would not surprisingly prefer better ratios of collateral protection than they had before. Where $50,000bn of perceived asset value supported $25,000bn in debt they would presumably prefer the current $30,000bn to support about $12,000bn.

With brutal speed, we have realised we are not rich after all and that we are dangerously under pensioned and over debted. We suddenly face a long period of frugality that in the long run may be good for us.

So what happens now? How do we get to a more supportive balance of private debt to collateral? There are only four ways:

• We can bite the bullet as we screamed at Japan to do. They had to adjust to a loss in perceived wealth of three times GDP, the US only one and a half times. But one and a half times GDP is still a far larger adjustment than any in US history. Even the Great Depression forced us to write down only 75 per cent of a year’s GDP.

We could in theory inflate asset prices again as Mr Greenspan did with housing in the tech burst. The problem is that we do not like to burn our hands on precisely the same stove too soon. Our memory for such pain seems to last about 20 years. But while we are quite good at learning specific lessons, we are poor at generic lessons, so although we shied away from growth stocks after 2002, we were happy to burn ourselves on the housing stove. Now we have simply run out of new asset classes on which to burn ourselves.

• Although there is little chance of a new bubble over 5 to 7 years, there is a good chance of some modest recovery in asset values back to fair value that is, say, 10 per cent to 15 per cent up from today’s prices .(Stocks could do better but real estate probably worse.)

• We can take 7 years to slowly grow our way out of some of the problems. We might add to true assets by about 15 per cent in 7 years and pay down some debt. This would be quick by Japan’s standard but still a bitter disappointment to us.

• Finally and least painfully we can reduce the debt through inflation. An average of 2 per cent a year for 7 years might be acceptable.

The likely solution is surely going to be a mixture. We will almost certainly take much longer than we thought, and eventually write down much more than we hoped for, say, $4,000bn to $5,000bn. We will very probably throw in some moderate inflation and if we’re slightly lucky some modest improvement from today’s asset price levels.

It will not be pleasant but not the end of the world. When it’s over all the same houses, office blocks, factories and educated workers that make up our real wealth will be waiting to be fully used again and we will be travelling lighter without so many illusions. We have not lost real wealth, only the illusion of wealth.


Jeremy Grantham is the chairman and chief strategist of fund manager GMO
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