The title of this memo isn’t a joke; I mean it. Nobody knows the real significance of the recent events in the financial world, or what the future holds. Everyone has an opinion - there’s an off-color joke to that effect - but opinions are entirely different from knowledge. As usual, the bulls are optimistic, the bears are pessimistic, and the rest are uncertain.

This is a great time for my favorite quote from John Kenneth Galbraith: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” No one knows about the future, and that’s more true now than ever . . . literally. Excesses were committed at financial institutions that we’ve never seen before in terms of their scale or their breadth, and many new inventions are in place that never existed before. So clearly no one can know how things will pan out.

My conviction that this is true frees me from having to methodically assess the strength and weakness of economies and institutions, and it permits me to limit my comments to what I consider strategic realities.

I’m flattered that people have asked for my opinion, and I will give it. But that’s all it is: an opinion. In setting it down, I will repeat things I’ve written before. So if you find something that you think you’re reading for the second time, you’re probably right.

Boom-Bust

Those two words say it all. If you have a boom, eventually you’ll have a bust. And the further the boom goes, the worse the bust is likely to be. If there’s no boom, on the other hand, there needn’t be a bust.

There was no great boom in the U.S. economy in 2003-07, and that’s one of the reasons why it has held up reasonably well despite the recent turmoil.

But there was an incredible boom in the financial sector, and it has led to an incredible bust. (It remains to be seen whether its effects will slop over into the real economy. As you know, we think they will.)

Finally, there wasn’t a boom in the U.S. stock market, and so it hasn’t busted. (If you think your stocks have given you pain, realize that their decline isn’t at all commensurate with the end-of-the-world thinking roiling the financial sector).

How Things Got This Way

Much of the current problem can be attributed to a decades-long bubble in the financial sector that made it the employer of obvious choice; attracted employees who were “the best and the brightest” (although often untrammeled by experience); contributed to greed and risk taking; drove out fear and skepticism; and carried institutions, behavior, expectations and asset prices to unsustainable levels.

What are the factors that got us in the current mess?

• Excess liquidity, which had to find a home.
• Interest rates that had been reduced to stimulate the economy.
• Dissatisfaction with the resulting prospective returns on low-risk investments.
• Inadequate risk aversion, and thus a willingness to step out on the risk curve in search of higher returns.
• A broad-scale willingness to try new things, such as structured products and derivatives, and to employ massive leverage.
• A desire on the part of financial institutions to supplement operating income with profits from proprietary risk taking - that is, to be “more like Goldman.”
• A system of disintermediation, selling onward, and slicing and dicing that caused many participants to overlook risk in the belief that it had been engineered away.
• Excessive reliance on rating agencies which were far from competent to cope with the new instruments, and on black-box financial models that extrapolated recent history.