Joe and Judy, on the other hand, find themselves in a much more benign world. They both work in the services sector, where jobs are able to adjust to changing economic conditions. Service companies are not immune to reducing their workforces, but their cycles are less deep and not as synchronised as they are in manufacturing. Moreover, both Joe and Judy have fungible skills that are valued by industries outside of their current employers – should either one of them temporarily lose their job, the family can get by on just one income. To take advantage of rising house and share prices they borrow to gear into these markets. Innovations in the financial services sector make it easy for them to do so.

With the same attitudes to risk in different social and employment environments, each family engineered its finances so that the amount of risk assumed was more or less the same. Edward and Mary’s lives were inherently risky, so they kept their financial leverage as low as possible. Joe and Judy have inherently stable and high incomes relative to the food and shelter needs of a small family. They used financial leverage to bring the riskiness of their finances up to that of Joe’s grandparents. As markets in stocks, bonds and housing were all booming before 2007, they were able to support a consumption pattern far in excess of their grandparents.


The leveraging cycle


The leveraging cycle enjoyed by Joe and Judy lasted so long that most people thought it was the norm. Phrases such as “the new economy” and “this time it really is different” were a common refrain. And while innovations have had a profound impact, they masked the risk that was building due to too much leverage. Beneficial innovations were not easily distinguished from those that have had negative impacts. Much financial innovation was really no more than a way to borrow beyond your means with blissful ignorance. While the regulators were right to improve the operation of free markets, they forgot that free markets can only be effective inside a sound legal environment that inhibits negative externalities.

Joe, Judy and their generation were not only able to borrow freely to pay for their consumption, they were encouraged to do so. Interest rates fell from the high teens in the 1970s to some of the lowest levels in three generations. Financial “innovations”, such as home equity loans, margin lending and consumer credit, made them the spend-nowpay- later generation. And, of course, this demand for consumer goods and services provided the very fuel of economic growth, which in turn drove company earnings and thus share prices to higher levels. It also enabled families to purchase homes at much higher prices relative to their incomes. Stock and house prices continually growing over several decades made people feel wealthier and they could access this higher wealth through the financial innovations already mentioned.

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