The market at work

While the US subprime crisis has gone international some perspective is in order.  In recent weeks some very large numbers have been estimated as the "true" cost of the crisis and a major economic meltdown has been predicted.

The betting market has a 72 per cent probability that the US will experience a recession this year.  Martin Feldstein -- immediate past president of the US National Bureau of Economic Research (NBER) -- has written that the US is in recession already.  This is a significant claim as the NBER is charged with dating the US business cycle.

The OECD has claimed the subprime crisis will eventually cost between US$350 billion to US$420 billion while the IMF estimate the eventual cost to be almost US$1 trillion.  To put these numbers into perspective, Australian Gross Domestic Product is about US$1 trillion.

The bad news is that economic growth in 2008 is likely to be low;  the good news is that this isn't the end of civilisation as we know it.

Comparisons to the great depression or the 1970s oil crisis are simply overblown.  Indeed the world has been in similar situations many, many times before and survived.

A paper presented by Carmen Reinholt and Kenneth Rogoff (PDF 40KB) at the recent American Economics Association conference shows, so far, that the current financial crisis has close parallels to 18 previous post-war banking crises in OECD economies.

The run-up in US equity markets and housing prices closely tracks the average run-up of previous crises while the slow-down in GDP growth also tracks the average of previous crises.  On measures such as public debt and inflation the US is in better shape than the average during previous crises.

That is not to say that the US does not have high levels of public debt, but the growth is public debt has lower than comparable economies experiencing a similar crisis.  In short, the Reinhart and Rogoff analysis suggests that the US is experiencing a stock-standard, run-of-the-mill, banking crisis.

The good news is that this crisis will pass.  Of course that statement is cold comfort during the crisis.  World financial markets are frequently buffeted by financial storms but the 2007-8 credit crunch will pass into history.

The real bad news is that all financial crises are associated with regulatory hang-over.  The last crisis gave us Sarbanes-Oxley.  The exact form new regulation will take remains to be seen.  The important aspect to crises, however, is that they clear out the economic and financial deadwood.  During a financial crisis those firms with poor strategy and non-viable business models are exposed.  Many fail.

While that may sound somewhat harsh, that is what is supposed to happen during a crisis.  Assets are re-organised and restructured into new configurations, new business models are developed, and the market moves on.

The real question is, why the hysteria?  If crises are fairly common -- say, 18 banking crises over the last 60 years -- why would we be overly concerned about yet another crisis?  There are at least three answers.

First, this time could be different.  This time the market mechanism may fail to self-correct and fragilities that have been accumulating over time may be too great to overcome.  This is always a possibility.  The ''this time it's different'' argument is very popular, but cool hard-headed analysis suggests that while the actual crisis trigger varies from crisis to crisis, the actual unfolding of the crisis is much the same each time.  If anything the number of failed US banks in the current crisis is much lower than the Savings and Loans crisis of the late 1980s and even the Great Depression.

A second possibility is that the hysteria is all a media beat-up.  John R. Lott Jr, author of Freedomnomics, has argued that some perspective is in order.  Economic statistics for the US, apparently, are slowing but nonetheless the economy remains strong.  Lott's argument is that a left-biased media is playing up the bad news as part of a plan to elect a Democrat to the White House.  He says this is a mirror image of the 2000 election campaign when the media covered up a recession to promote Al Gore.

There are, at least, two problems with this argument.  First, the NBER date the US recession from March 2001 -- so the factual basis of Lott's argument is weak.

The second, more serious, problem is that Lott is promoting a conspiracy theory on a grand scale.  Not only would the media (who themselves are not a single conscious monolith) need to participate in the conspiracy but the "smart money" in the betting market would also have to participate too.  Of course, that does not undermine the argument that the media may be left-leaning, but it does suggest that recession fears are more than just a media conspiracy.

The third possibility relies on a behavioural belief that Bryan Caplan documents in his recent book, The myth of the rational voter:  Why democracies choose bad policies. Caplan argues that people have a number of biases that inform their perspectives on life.  One of those biases is a pessimistic bias.  People have a tendency to overestimate the severity of economic problems and underestimate the performance of the economy.

It is true that the economy, both in Australia and in the US, has experienced some turbulence and volatility.  Yet responses to the crisis seem to be all out of proportion to the crisis itself.  Calls for greater disclosure, for example, ignore the fact that investors already have a lot of information.  One more piece of incomprehensible accounting data will not suddenly reveal all.  Calls for greater regulation of financial markets also ignore the fact that we have yet to see whether the existing, already onerous, regulations have failed.  There is no evidence to suggest that the financial system or economic order has failed to work as expected.

The bottom line is that people who make poor investments or have poor business strategies should lose their money.  Over the past year that is what we have seen.  It is not the end of the world, or the beginning of the next great depression.  It is the market at work.

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