Paul Krugman, in his Friday New York Times op-ed piece, “The Big Meltdown,” gives his vision of how this week’s market events will play out. Per the title, his take is apocalyptic.
Frankly, although it’s a plausible scenario, this isn’t Krugman’s best work. He is a very good political economist, but investment strategy isn’t his long suit.
I am surprised that he makes no comment on the state of the economy, which is closer to his expertise (in my mind, running on fumes: the quality of corporate profits isn’t great, consumers are overextended, and the prospects of a housing recovery are overstated), nor does he talk about the role of leverage and excessive liquidity, except indirectly, via overly tight risk spreads and the vision of collapsing hedge funds leading to bankruptcies and defaults (presumably by bringing down a prime broker or some other financial institutions).
In past crises, or near crises, the Fed has responded by flooding the markets with liquidity. We’ve already had high money supply growth (over 10%), so one wonders how much more room the Fed has. But investors have been conditioned to buy on weakness, and if they do (it may take a long time, as Krugman suggests), all will eventually be well, or at least not too bad. One of my trader buddies recalls that after the LTCM crisis, it took a year for swap spreads to get back to a normal range. So a confidence-sapping crisis can take a long time to work its way out of the system. We aren’t there yet, but if investors continue to take a pounding, we could get there.
Now if the Fed finds it necessary to take the same route (as in, the flight to quality continues into the next week or two), it’s likely to weaken the dollar, perhaps considerably. That is an economic stimulus, and will likely be well received domestically, but if the dollar fell far enough, it could create further instability, and work against the outcome the Fed is trying to achieve.
Plus there is the remote possibility that liquidity creation won’t work as well as it has in the past. The story that Friedman and his followers tell about the Great Depression is that the Fed blew it, that the turned a market rout into a recession by shrinking the money supply. That isn’t an accurate presentation of what happened. The only thing the Fed controls is the monetary base, and the Fed did indeed increase the monetary base after the crash. But, due to bank failures, consumers were afraid of putting their money in banks (correctly) and so withdrew their deposits and held cash. That shrank the money supply.
I am not saying we will have a depression, but we could have a decided turn in sentiment. The analogue here is that investors could decide to hold short-term money instruments or other very safe investments. A pronounced flight to quality would be damaging, because it would reduce risk capital substantially. We’d have the reverse of we’ve had recently. Instead of having unusually low risk spreads, we’d have very high ones. That in and of itself would put the brakes on growth.
The great market meltdown of 2007 began exactly a year ago, with a 9 percent fall in the Shanghai market, followed by a 416-point slide in the Dow. But as in the previous global financial crisis, which began with the devaluation of Thailand’s currency in the summer of 1997, it took many months before people realized how far the damage would spread.
At the start, all sorts of implausible explanations were offered for the drop in U.S. stock prices. It was, some said, the fault of Alan Greenspan, the former chairman of the Federal Reserve, as if his statement of the obvious — that the housing slump could possibly cause a recession — had been news to anyone. One Republican congressman blamed Representative John Murtha, claiming that his efforts to stop the “surge” in Iraq had somehow unnerved the markets.
Even blaming events in Shanghai for what happened in New York was foolish on its face, except to the extent that the slump in China — whose stock markets had a combined valuation of only about 5 percent of the U.S. markets’ valuation — served as a wake-up call for investors.
The truth is that efforts to pin the stock decline on any particular piece of news are a waste of time.
Wise analysts remember the classic study that Robert Shiller of Yale carried out during the market crash of Oct. 19, 1987. His conclusion? “No news story or rumor appearing on the 19th or over the preceding weekend was responsible.” In 2007, as in 1987, investors rushed for the exits not because of external events, but because they saw other investors doing the same.
What made the market so vulnerable to panic? It wasn’t so much a matter of irrational exuberance — although there was plenty of that, too — as it was a matter of irrational complacency.
After the bursting of the technology bubble of the 1990s failed to produce a global disaster, investors began to act as if nothing bad would ever happen again. Risk premiums — the extra return people demand when lending money to less than totally reliable borrowers — dwindled away.
For example, in the early years of the decade, high-yield corporate bonds (formerly known as junk bonds) were able to attract buyers only by offering interest rates eight to 10 percentage points higher than U.S. government bonds. By early 2007, that margin was down to little more than two percentage points.
For a while, growing complacency became a self-fulfilling prophecy. As the what-me-worry attitude spread, it became easier for questionable borrowers to roll over their debts, so default rates went down. Also, falling interest rates on risky bonds meant higher prices for those bonds, so those who owned such bonds experienced big capital gains, leading even more investors to conclude that risk was a thing of the past.
Sooner or later, however, reality was bound to intrude. By early 2007, the collapse of the U.S. housing boom had brought with it widespread defaults on subprime mortgages — loans to home buyers who fail to meet the strictest lending standards. Lenders insisted that this was an isolated problem, which wouldn’t spread to the rest of the market or to the real economy. But it did.
For a couple of months after the shock of Feb. 27, markets oscillated wildly, soaring on bits of apparent good news, then plunging again. But by late spring, it was clear that the self-reinforcing cycle of complacency had given way to a self-reinforcing cycle of anxiety.
There was still one big unknown: had large market players, hedge funds in particular, taken on so much leverage — borrowing to buy risky assets — that the falling prices of those assets would set off a chain reaction of defaults and bankruptcies? Now, as we survey the financial wreckage of a global recession, we know the answer.
In retrospect, the complacency of investors on the eve of the crisis seems puzzling. Why didn’t they see the risks?
Well, things always seem clearer with the benefit of hindsight. At the time, even pessimists were unsure of their ground. For example, Paul Krugman concluded a column published on March 2, 2007, which described how a financial meltdown might happen, by hedging his bets, declaring that: “I’m not saying that things will actually play out this way. But if we’re going to have a crisis, here’s how.”
I hate to disagree with an expert like Shiller, but there were two triggers for 1987. One was a proposed change in the tax treatment of highly leveraged transactions (it didn’t get a lot of press coverage, but market participants were spooked), which was floated the day before the Friday decline of 150 points that then set up Black Monday. The second was that Treasuries yields had spiked up sharply that same week (I forget the cause, but this will hopefully remind me to ping my colleagues who’d remember the details).