The Deus ex Machina of Economic Crisis

In defense of Secretary Geithner’s economic detox plan, Christopher Carroll makes a larger point about the basis of fundamental valuation (“Treasury Rewards Waiting,” The Economist’s Forum, Financial Times, 24 March 2009):

Unlike the critics, the Treasury has absorbed the main lesson from the past 30 years of academic finance research: asset price movements mainly reflect changes in investors’ collective attitude toward risk.

Perhaps the reason this insight has not penetrated, even among academic economists, much beyond the researchers responsible for documenting it, is that it has not been expressed in layman’s terms. Here’s a try: in the Wall Street contest between “fear” and “greed,” fear fluctuates much more than greed (in academic terms, movements in “risk tolerance” explain the bulk of movements in asset prices).

In thinking about economic crises, people have a tendency to contrast fundamentals versus psychology, dismissing so-called psychological factors as “not real” or somehow illegitimately interfering with the proper functioning of the economy. But the economy is not a machine with the humans being somewhat incidental to its operation (at least not yet). Insofar as human desire, priority, ambition, plans and beliefs about what the future holds are more foundational to the enterprise than the material constituents of the economy, psychology is fundamental. At some point, the economy gives way to society as the more fundamental unit of analysis.

This is not to say that the future-oriented plan makers don’t get “spooked” — hence Keynes’s “animal spirits” — and that they are irrational over the medium term to do so; but who can deny that retrenchment is not rational within certain limited considerations. That being said, it is the role of the government to defend the commons.

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