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.
The yield on Treasury bonds went negative yesterday for the first time in history. Investors are so desperate to avoid risk that they would rather a known small loss than lend to an unknown. Reuters has considerably more information on the state of public sector debt risks and they make it sound much worse than the passing reference in the Financial Times (Siew, Walden, “S&P Says Pressure Building on U.S. ‘AAA’ Rating,” 17 September 2008):
Pressure is building on the pristine triple-A rating of the United States following a federal bailout of American International Group Inc., the chairman of Standard & Poor’s sovereign ratings committee said Wednesday.
The cost of insuring 10-year U.S. Treasury debt against default rose Wednesday to a record high, a day after the government rescued insurer AIG with an $85-million loan. …
Ten-year credit default swaps, or CDS, on Treasury debt widened three basis points to 26 basis points, according to data from CMA DataVision. This means it costs $26,000 per year to insure $10-million of U.S. Treasury debt against default.
Five-year credit default swaps on Treasury debt were steady at 21.5 basis points. That compares to 9.8 basis points on German five-year CDS and 13.2 basis points on German 10-year CDS, CMA said.
A graph of various CDS rates would be a visual of the rise and fall of the great powers.
How bad is the current spate of financial upheavals (the federally backed buyout of Bear Stearns, the federal takeover of Fannie Mae and Freddie Mac, the hasty buyout of Merrill Lynch, the bankruptcy of Lehman Brothers, the impending joint federal-private bailout of American International Group)? In trying to explain the seeming double standard in the actions taken by the federal government in response to Bear Stearns back in March and Lehman Brothers this past weekend, today’s Financial Times Comment & Analysis section includes the following tidbit as one of a number of explanations (Persaud, Avinash, “Lehman Had to Fall to Save the Financial System,” 16 September 2008):
Third, there was an alarming factor not present at the time of Bear Stearns’ collapse that argued strongly against new government guarantees. Since the August rescue of Freddie Mac and Fannie Mae, credit markets have begun to price in the possibility of a default by the US government. The implied probability remains a fraction of 1 per cent but it is an unprecedented development.
It’s hard to know what to make of this. It could be just an investors’ parlor game, like the market on Hollywood has-been career comebacks. Or it could just go to show that unhinged paranoiacs aren’t confined to remote cabins. Some work in the bowels of high finance as well. After the past few months it would hardly be the first sign of a less than steady hand on the till. But there it is. The possibility of a default by the U.S. government has gone from beyond the pale to remote.