Hey Chicken Littles: The Sky is Not Falling
November 14, 2008
Today I’m going to use the blog to test out a big claim: the financial crisis amounts essentially to mass hysteria and we should all just relax and go shopping (as George W. Bush famously advised Americans just after Sept 11th). It would be an understatement to say that I am in the minority in believing that the financial crisis is not a crisis at all, but merely a blip. I have not seen one single person in a major newspaper arguing that the crisis is not all its cracked up to be (though please let me know if you have). In fact, it seems that the columnists in the newspapers I read (and unlike Sarah Palin, I don’t read “all of them,” mostly just the NYTimes and FT) are competing as to who can be the most effective messenger of doom. A friend in New York said that he recently attended a talk by this year’s Noble Prize in economics Paul Krugman where the take away message was “Nothing is safe. Hide your money under the mattress.”
Hogwash (and yes, that’s a technical term). My argument is constructed around four points. First, we’ve been here before, and it’s never as bad as it seems in the moment of the crisis. Second, because we’ve been here before (lots of times over), we are better equipped to deal with the crisis. Third, the crisis has to date been marked by an impressive (and unprecedented) spirit of international cooperation. And finally, economic crisis are largely determined by sentiment. The worse public opinion makers make it out to be, the worse it gets. So what we really need around here is a bit of Pollyanna-ism. Let’s take these arguments in turn.
We’ve been here before. What I want to ask all of the people who think this is a crisis of Depression proportions is: do you remember, for example, the East Asian financial crisis? During the East Asian Financial Crisis, which brought a huge number of Asian and other emerging market economies (Russia, Brazil, etc) to their knees in 1997 / 1998, predictions of what the impact of the crisis on Asia was going to be resembled a bottomless pit. Asia would never recover. The Asian model of development was permanently discredited. Etc, etc. 10 years on and who is driving growth in the global economy? Asia. Which countries look the most resilient in the midst of the current crisis? Asian economies. Which emerging markets look well placed to withstand the chaos? Well-governed countries like Brazil and countries with large currency reserves in Asia and elsewhere (there’s a change on both counts).
I’m not underestimating either the massive impact of the Asian crisis on economies and lives in the immediate crisis period or the work that had to be done to get Asian economies back on track. But it’s important to keep things in perspective and remind ourselves that a) it didn’t take as long as we expected and b) the result is much better than we could have anticipated. Additionally, this crisis will never get as bad as the Asian crisis did in terms of politics, society or economics. The level of political and social instability that the crisis caused in Indonesia and other places is inapplicable in OECD economies because there are democratic channels to express discontent with the regime: Obama’s election is the equivalent of the bloody, chaotic downfall of Suharto in post-crisis Indonesia. And Asian economies were severely traumatised by the quick outflows of Western capital at the start of the crisis, which sent currencies and reserves plummeting. It’s just not a comparable situation in the US and Europe, especially given the international response to date (see point 3 below). Given space constraints and attention spans, I won’t talk about other crises in depth. But I think that the general idea is similar: despite dire predictions, things always turn out better than we expect. The sky was not falling then, and I don’t think it’s falling now.
We’re better equipped. If you read my post on ideas the other day, you can already guess where this argument is going. We have economic and political policies at our disposal that we understand better each time there is a crisis. We know what works, what doesn’t. We know, for example, that the fiscal retrenchment suggested to Asian economies during the crisis was disastrous (not that Western governments were going to try that particular part of their own medicine anyway). We know that fiscal stimulus worked during the Depression. We can craft a package of policies and reforms more intelligently to make sure that it never gets as bad as these examples did. The Depression cannot be repeated: we know too much about why it happened and how it got better. We may compromise on out of the box thinking on economic policy as a result, but we have some tried and tested tools in our toolkit.
The crisis to date has been marked by cooperation internationally. This to me is the strongest augur that things aren’t as bad as everyone is saying. I can’t remember a single financial crisis in modern history where there was such strong solidarity between developed and developing countries on finding a solution, and where international institutions were called upon to take such a sensible role. China, which has essentially been funding the US balance of payments deficit for the past decade, has agreed to implement a fiscal stimulus package to ensure that their economy can continue to serve as an engine for world growth. Never mind whether this is actually the appropriate policy for an economy which is still forecasted to grow at more than 8% next year, the point is that they are demonstrating their willingness to assist the Western countries that caused the crisis and are suffering most from it. European countries, even those where the impact of the credit crisis has been minimal to date, have put together packages to rescue their banking sectors and made conciliatory statements about solidarity with the US. The G20 is meeting this weekend and large developing countries are supporting the efforts, and looking to the discredited IMF again for rescue packages that are more important for calming markets than ensuring their own good fortunes. The answer to “can’t we all just get along?” seems to be yes. And that’s good news for economic stability.
Crisis have a self-fulfilling element. If journalists, policy makers, politicians and economists (and any combination thereof) tell each other and all of us that things are desperate, a cycle of negative sentiment begins which is self-fulfilling. My own research demonstrates that markets often overreact to bad news, often way beyond what a theory of an “efficient” market would predict, and the general literature on the topic focuses on the herding element of markets, where selling begets more selling. Markets often look for something to focus on (because you don’t buy or sell without news). And bad news is a much stronger candidate for action than good news.
Additionally, in the real economy, many decisions about staffing and inventories for the near term are made based on expectations, and with journalists walking around saying the sky is falling, its no wonder that firms decide to retrench today even if their own sales and profits have not yet been impacted. Consumer expectations are also affected in a similar way. A non-scientific example? A friend who works in the not for profit sector, and whose partner works in government. They have stable jobs outside of the private sector, their mortgage payments are fixed and they don’t have any other debts. Yet they are cutting back on spending because the general sentiment in the marketplace is that things are going to be bad, and get worse. This is not an irrational response, it’s a rational response given how bad the press and policy makers are making things out to be. To borrow and corrupt a famous idea by the International Relations scholar Alexander Wendt “Anarchy is what markets make of it.” If we continue to believe things are bad and getting worse, unfortunately, they probably will be.
I realise that there’s a large chance I am wrong, especially as all the people with Noble prizes disagree with me. But a bit of perspective and history (and a PhD on market behaviour and financial crises) makes me confident that we can turn the situation around before it becomes a real crisis. Some bad months are definitely ahead of us. But I think that its perfectly sensible to believe that it will be a series of bad months, not bad years. If a couple more people with more prominent soap boxes believed this, things could turn around much more quickly.