Friday, August 17, 2007

The Market Mess

So what is going on with all this subprime housing mess anyway? Economists are always much better at explaining the past been predicting the future, so take what follows with several grains of salt. But the turmoil on Wall Street around the world is revealing in several respects.

I often tell my students in the class I teach on globalization that rapid financial-market meltdowns following sustained run-ups are really just a weeding-out process, the elimination of mistakes that occurred, perfectly justifiably, during the boom. In particular, whenever there is some significant change for the better in economic policy or economic potential, investors know that there is great potential out there, but there is also tremendous uncertainty. And so for a time they throw their money at everything, uncertain of exactly how the new potential will play out. Ultimately, many of these bets turned out to have been misplaced, and so they have to be liquidated. The rapid crash following the long, sustained buildup, accomplishes this.

The stock market has been rising for some time, and I confess that the underlying economic fundamentals in the US seem unable to explain it. However, the rest of the world is undergoing what Fortune magazine, with lamentable timing perhaps, recently called "the greatest economic boom ever." And American companies of course have been deeply wrapped up in the amazing transformations going on in places like India, China, in Vietnam.

But in some respects this crash almost seems like the reverse -- the uncertainty is not about the upside in the past, but about the downside in the present and near future. Many commentators are saying that huge numbers of companies and funds all over the world are turning out to have been enmeshed in the American housing mess, and right now financial markets are in the process of discovery -- of trying to figure out just who owns what bad assets. In the meantime, they punish stocks across the board. This is not "panic," but a rational reaction to the information set available -- lots of whatever the opposite of potential is, plus great uncertainty about how it is distributed. Eventually the markets will oversell, and bounce back; the fundamentals of the global boom are still in place. I wish I knew when, but if I did, I would be living the life of a Corona beer commercial instead of toiling away in the groves of academe.

The first lesson I take away from this is that the United States is still critical to the global economy. During the financial turmoil 1997 and 1998, it was the resilience of US financial markets that largely prevented disasters in East Asia, Russia and Brazil from turning into a global recession. The strength of the tech boom in the US led to many a week in which markets would decline all over the world until some gigantic rally on Wall Street would save them. That seems not to be happening this time, which has led some to suggest that the US is a substantially diminished economic force

In recent years there has been a lot of comment about how the rise of China and India means that the US economy is less important to the global economy than it has been in many decades. The US can stagger, and yet emerging markets can continue to surge forward. And yet it is really surprising to see how investors all around the world react badly to perceived weakness in the US economy. There does not seem to be any obvious reason why credit-market difficulties in the US should devastate markets in Europe and Asia, unless the US continues to be a bulwark of the world economy. The US still matters, a lot.

The second thing that is worth saying is a few words in defense of subprime mortgages. The narrative that always takes hold during these times -- of financial excesses, criminal behavior by predatory fraudsters, etc. -- is already beginning to rear its head, and it is best to strike it down now. It is certainly true that the innovative mortgages created in the last 10 to 15 years have left a number of people -- overstretched home buyers and investors alike -- in significant financial trouble. But it is also true that they have allowed many people to buy homes who otherwise never could.

The chart below is from a doomsaying Website called The Market Oracle:

How do we interpret this? Very optimistically, if we think about it in terms of enabling people to achieve their dreams rather than in terms of what are in the big picture momentary financial-market fluctuations. Five out of six subprime mortgages are not even delinquent. Only seven percent are in actual default. Thus, significant corrections will have to be made to account for those sections of the housing-credit market having problems, but the big picture is that these innovative instruments (which the website calls “toxic waste”) have put people who -- either because most of their income is in cash or because they have poor credit relative to the price of housing where they live -- could not make use of conventional mortgages in a position to achieve the American dream of home ownership. These new instruments will long outlive the nitpicking criticism of them that currently prevails. Assuming, that is, they are not regulated to death in a hysterical overreaction to an ordinary part of the business cycle. Such controls will have the same effect that they always do -- penalizing the most economically vulnerable, and preventing the vast majority of responsible people among this group from achieving things that the rest of us take for granted. The subprime mortgage should be celebrated as a tremendous financial innovation.

We are still living in economically transformative times, the momentary ups and downs of particular markets in particular countries (and breathless reporting of same by the media in need of a good story) notwithstanding.

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