I saw “The Big Short” this past weekend. It was better than I expected and depicted the madness of crowds and greed run amok.
While most will see the movie as an indictment of bankers and Wall Street, they will be missing one of the most important lessons from yet another financial crisis.
The problem that led to the mortgage meltdown wasn’t just that banks made many, many bad mortgage loans, the ultimate cause was once again leverage. Archimedes is famous for his quote about using a lever to move the earth, "Give me a place to stand on, and I will move the Earth." Leverage in finance speak means borrowing and Wall Street’s version of this quote is “Give me enough leverage and I will ruin any economy”
All economic bubbles and subsequent crashes can be traced at their root to too much leverage in the economic system. The Tulip Mania of the 1860’s resulted from what was futures contracts with no margin requirements. The stock market crash of 1929 was a direct result of too much leverage in the markets where a dime could control a dollars’ worth of stock. The Long Term Capital crisis of the late 1990’s was a result of too much leverage. If you can identify where leverage has gotten out of control you can predict and profit from the next bubble.
So looking around the world today where has borrowing gotten out of hand?
China comes immediately to my mind. Public and private debt (and it is really, really hard to distinguish the two in an economy directed by a central committee) has ballooned to over 28 trillion dollars or about 300% of the nation’s total GDP. China has built shopping malls where no one shops and entire cities where no one lives. In the US these developers would be bankrupt in short order, but in China things just seem to move on as if this is a normal way to do business.
Making matters worse, China is committed to being considered by the world as a stable economic powerhouse. Although a fall in the value of the Renminbi would spur exports and help the Chinese economy, the ruling class is opposed to any move that would make them look to be anything but brilliant. As if they believe they can control everything indefinitely they recently warned investors and George Soros in particular that shorting the Renminbi would result in economic ruin. Ha! Even after spending over $500 billion of their foreign currency reserves to support the currency, outflows continue to pressure the Chinese economy.
Markets are self-correcting and the world economy is big. Do not believe the Chinese can distort the markets indefinitely.