Sooner Rather Than Later...

Sooner Rather Than Later By Philip I. Levy

Why would the U.S. stock market drop so dramatically this week, just after Europe and the IMF agree to back Greece and the Greeks adopt a painful package of fiscal measures? Even if Thursday's roller-coaster ride turns out to be partly due to the mother of all typos that cannot explain the week's global stock market slide. One possibility is that long-term economic arguments are telescoping into the short-term.

One of the great memes to emerge from the financial crisis was that economists had no idea what they were talking about. After all, professional economists had urged deregulation and faith in markets; an internet full of amateur economists could easily see that such misguided nuggets of advice were solely responsible for all the woe that ensued.

This analysis was always a bit problematic. First, we may need a bit more perspective to properly attribute causality in the crisis. The snap analyses have been politically convenient, in that they have supported snap policy responses, but they have their flaws. For example, what about Fannie Mae and Freddie Mac? These were hardly paragons of unfettered market extremism and they were central to the housing bubble and to the cost of the eventual government bailout. I know firsthand that this was a crisis foretold by economists, since I served as a senior staff economist for Greg Mankiw when he chaired President Bush's Council of Economic Advisers. Greg, working with excellent economists like Karen Dynan, now of Brookings, was vocal about the dangers posed by these government-sponsored enterprises and helped formulate proposals for reining them in. Congress blocked the proposals.

Economics is best at describing incentives for behavior. As a forecasting tool, economists assume that sooner or later people will respond to those incentives. This works reasonably well in the long run, but far less well in the short run, when psychology dominates.Setting aside the pathology of the financial crisis, there is a second problem with the refutation of economics that is more fundamental. Economics is best at describing incentives for behavior. As a forecasting tool, economists assume that sooner or later people will respond to those incentives. This works reasonably well in the long run, but far less well in the short run, when psychology dominates. Economists are not so good at predicting next quarter's consumer behavior; they are much better at predicting the ultimate consequences of unsustainable debt.

And so we come back to today's shaken market. Financial economists have for decades espoused the "efficient market hypothesis," which roughly said that all the relevant information for stock prices would be built into today's quotes. If not, there would be an incentive for someone to act on the omitted information and make some money off it. Yet the persistence of housing bubbles and overvalued feeble institutions in the prelude to the crisis seemed to mock the very idea. Prices could be wrong for a long time, it seemed. But the incentives for acting quickly were still lurking out there. Investors did not heed them in the past, and they got burned for waiting. What about the next time?

Now turn to Europe. Its crisis was supposed to play out in an orderly and gradual fashion: Greece would look ready to crumble, but it would be small enough to risk a bailout. There was not much hope that the healthy European economic powers could bail out every troubled country on Europe's perimeter, but by taking care of Greece today, they could buy themselves some time until the next country went. Maybe something good would happen in that interregnum (e.g. a surprise burst of growth, which cures many ills) or maybe today's politicians would leave office, in which case it would be somebody else's concern.

From an efficient markets perspective, there was a serious problem with a crisis unfolding in such an unhurried fashion. Looking ahead to the final stage, when a truly big country like Spain went and was too big to be bailed out, those left holding the debt of the fallen countries--or of the banks who had lent them money--would be hurting badly. Investors might always try to enjoy high yields on debt for a while, then sell before things really turned bad. But who knew when that would be? That strategy failed miserably for those entangled with Lehman Brothers. Perhaps it would be safer to exit now and not lend to anyone dubious.

CNBC reported today's stock market swoon thus:

The Dow plunged Thursday amid buzz in the market that European banks have halted lending.

One trader . . . said he heard fixed-income desks in Europe shut down early because there was no liquidity--basically European banks are halting lending right now.

"This is similar to what took place pre-Lehman Brothers," the trader said.

And thus longer-term incentives telescope into the short term. Beware the return of efficient markets.

Philip I. Levy is a resident scholar at AEI.