'Big Short' Hero Is Wrong This Time
It’s a sad truth that human genius isn't as versatile as we’d like. A basketball legend may be a mediocre baseball player. A great scientist may be a terrible investor.
Few would question the investing prowess of Michael Burry, the one-time hedge-fund manager featured in Michael Lewis’ book "The Big Short." Burry proved his brilliance as a value investor in the early 2000s, and became a legend by predicting the collapse of the housing bubble. It would be very difficult to find an economist who could match Burry’s skill in the markets. And yet, this doesn't mean that we should trust Burry’s theories when it comes to economics.
In a recent interview with New York magazine, Burry lays out his thoughts on the current economic situation. His ideas are fairly typical of the conventional wisdom that has developed on Wall Street in the years since the 2008 crisis. Unfortunately, much of this conventional wisdom is gravely mistaken. Burry says:
The crisis, incredibly, made the biggest banks bigger. The major reform legislation, Dodd-Frank, was named after two guys bought and sold by special interests, and one of them should be shouldering a good amount of blame for the crisis. Banks were forced, by the government, to save some of the worst lenders in the housing bubble, then the government turned around and pilloried the banks for the crimes of the companies they were forced to acquire.
This quote demonstrates the ambivalent attitude that many on Wall Street have toward banking policy -- Burry criticizes the government both for supporting banks too much and for pillorying them. More worryingly, Burry repeats a theory of the crisis that has long since been discredited -- the idea that the government caused the crisis by encouraging home loans to the poor. Actually, housing bubbles manifested in many countries that had no equivalent to the government-sponsored enterprises Fannie Mae and Freddie Mac, the bubble was driven by middle- and high-income borrowers, and the borrowers who drove up prices were primarily speculators rather than owner-occupiers.
The interest the Federal Reserve pays on the excess reserves of lending institutions broke the money multiplier and handcuffed lending to small and midsized enterprises.
In actuality, the money multiplier had never been a stable relationship. As for small business lending, while it has declined, the interest rate that small businesses pay on loans has not risen as a result of the Fed’s interest rate on reserves -- a rate which is, in any case, dwarfed by the risk premium on small business loans. In other words, small businesses are borrowing less, but not because the Fed’s interest-paying reserves are crowding them out of the market.
Burry is also dismissive of monetary policy and overly critical of the Fed:
We are trying to stimulate growth through easy money. It hasn’t worked, but it’s the only tool the Fed’s got. Meanwhile, the Fed’s policies widen the wealth gap...It seems the world is headed toward negative real interest rates on a global scale. This is toxic. Interest rates are used to price risk, and so in the current environment, the risk-pricing mechanism is broken…The public sector has really stepped up as a consumer of debt. The Federal Reserve’s balance sheet is leveraged 77:1.
It’s just not clear how important monetary policy has been in the U.S.’s recovery from the recession. There has been quite a lot of research on the topic, but little consensus, since macro effects are so hard to identify with statistics. But Burry’s conviction that monetary easing was ineffective simply isn’t warranted by the data.
Burry also seems to make a mistake when he talks about risk pricing. The interest rates that are headed toward negative territory are government bond rates. Government bond rates going to zero should lower interest rates for private businesses, but it shouldn't affect the spread between private and government borrowing, since private borrowing rates are not being pushed to zero. It is this spread which is key for risk pricing, not the absolute level of rates.
Finally, Burry’s statement about the Fed’s leverage is misplaced. Since the Fed’s liabilities are simply the reserves that banks hold at the Fed -- i.e., money -- there is no chance of a run on the Fed, as there is at a private bank. The Fed might inadvertently cause inflation, but it won’t go bankrupt and cause another financial crisis.
Why does Burry buy into discredited theories of the crisis and embrace dubious criticisms of the Fed? It isn't clear, but the reason might be an anti-government, libertarian ideology. Burry says:
Government policies and regulations in the postcrisis era have aided the hollowing-out of middle America far more than anything the private sector has done...Capitalism is on trial.
In fact, this idea pervades Burry’s arguments -- government is always a villain. Libertarianism is fine and good, but ideology can distort reality and prevent people from efficiently assimilating the available evidence. Unfortunately, that happens too often on Wall Street. When we ask why even the most brilliant and competent investors can succumb to bad ideas outside of their area of expertise, ideology too often is the culprit.
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