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There is a bull market in pessimism these days. Just look at the outpouring of books on the credit crash, subprime debacle, real estate bust, U.S. dollar collapse, and so on. I found over a dozen of these gloomy tomes while digging around for some summer reading — see the list in my blog if you like.
The situation does seem grave. House prices in the U.S. are down an unheard of 15%, the financial system is teetering on the brink, inflation is shooting up, and jobs are evaporating. And things may get worse as the battered U.S. banking system continues to conserve its capital by restricting lending. In fact, U.S. bank credit recently began to contract at rates never seen since the compilation of credit data began in the 1970s.
But I just can’t seem to get anywhere near as pessimistic as the chroniclers of crisis and prophets of doom. There have been traumatic times before: in the early 1980s interest rates spiked past 20%, inflation accelerated beyond 10%, and unemployment soared to unprecedented levels. The lesson I learned having lived through this tumultuous period (as a university student) was that no matter how certain economic chaos appears to be, things will work out.
The crisis books back then were as gloomy as they are today, if not gloomier. If I recall correctly, some advised heading for the hills, digging an underground shelter and stockpiling tinned food. No matter. What it boils down to is this: we must not underestimate the ability of policymakers to pull rabbits out of the hat.
Don’t overlook the extent to which they will go to avert a calamity, even if it involves changing the rules in the middle of the game. You can see some of this behavior already, a recent example being the squeeze on short sellers provoked by the Security Exchange Commission’s (SEC) decision to curtail naked short selling of selected U.S. financial stocks.
And it’s not hard to imagine more extreme responses by the authorities. One could even be a covert propping up of the stock market in the event it tumbles too far. A mechanism is in place: it’s called the President’s Working Group on Financial Markets, known colloquially as the Plunge Protection Team. President Reagan set it up after the crash of 1987; members are the Secretary of State and chairpersons of the Federal Reserve, SEC, and Commodity Futures Trading Commission.
Could we already be seeing some of their handiwork in the 30% rally that occurred in financial stocks within two weeks during July? Of course, the SEC short selling ban and other factors deserve some credit, but could they alone account for such a sharp jump in such a short time?
Lastly, times of crisis are usually when the seeds for the next era of prosperity are planted. Policymakers are finally given the motivation to deal with the root causes of predicaments. This time around, that could result, among other things, in an international agreement to address the long-standing issue of trade imbalances and distortions.
It would not be surprising to see China and other emerging countries agree to greater appreciation of their currencies. We could also see elimination of other market distorting interventions, such as the subsidization of domestic oil prices below market levels in China (which would contribute to “demand destruction’). Combined, the measures would help bring about a reduction in the U.S. trade deficit and soaring commodity prices, which in turn, would help clear the way for a return to prosperity.
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