Falling Stocks And The Dire Economy: Rational Fears

Over the weekend the NY Times ran an interesting article discussing “Rational Fear” with respect to the economy, the stock market, et al:

From Breakingviews.com via the NY Times:

Imagine a big control panel for a complicated machine with a big problem. The dials that indicate how well the apparatus is working are showing “Red Alert.” A group of skilled technicians is furiously twisting knobs and pushing levers well into the zones marked “Danger.” But the machine doesn’t seem to be responding.

That machine looks like the world’s economy today. Economic and financial indicators like gross domestic product, trade flows, credit availability and confidence are still going badly wrong. Policy makers are playing the roles of the vainly struggling technicians. They have embarked on a collection of highly hazardous experiments: gargantuan fiscal deficits, ultra-low policy interest rates and increasingly unfettered creation of money.

The dire economy and desperate policy environment make it impossible to know what stocks , bonds and other financial assets are actually worth. Their value will be determined largely by future rates of default and inflation. But those depend on how the technicians’ maneuvers work out.

Everyone involved wants to get the machine back to normal. The technicians think - or hope - that they have found the right way to get from here to there. The general idea is that lots of spending from governments and ultra-easy money from central banks will soon get the credit system working, while the recession will cut destabilizing trade imbalances down to a manageable size.

Some of these technicians claim the pace of economic decline has already started to slow. But these are mostly the same professionals who thought the machine was working until shortly before it went haywire.

Why trust them now? Their theoretical models have been proved inadequate. Nor can they turn to historical precedents, because there has never before been a need to work off so much debt in so many countries.

The author raises a good point in that there are a lot of policy makers, analysts and pundits who talk as if the crisis can be resolved by injecting “confidence” into the system, instead of looking at the things that have caused people to lose confidence in the first place. Fear doesn’t necessarily occur in a vacuum, and in many cases people are afraid due to the very real financial problems they’re facing, legitimate concerns about various securities, companies, etc. Portraying the current crisis as a function of confidence is a analogous to telling people trapped in a burning that their fear of fire is the real problem, instead of finding a way to put the fire out.

If you want to help these people feel confident again you have to address their actual problems, as opposed looking for token gestures you can use to make them feel confident in spite of the evidence that tells them that they should be cautious.

This is not to say that people should be paralyzed by fear or let fear control their decisions, but to point out that in many instances the actions that are being chalked up to fear are actually quite rational.

E.g. if someone has some very real concerns about being laid off, cutting back on their spending is a very rational response. After all are the people encouraging them to spend going to pay that person’s bills if they are in fact laid off?

Another example are the companies whose collapsing stock prices were often blamed on fear, as if their opaque balance sheets, mounting losses, weak assets, etc, weren’t a factor. Fear is only a relevant argument if the company in question was legitimately healthy, as opposed to being in genuine dire straits if not in danger of collapsing.

Instead of dismissing the fears investors, consumers, etc, have about the markets, the economy, the financial sector, perhaps it’s time to start addressing the root cause issues that are raising their concerns in the first place.

You can read more here.

Source:

Breakingviews.com via The NY Times: “In This Economy, Fear is Rational” — February 22, 2009

Disclosure: at the time of publishing the author didn’t own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn’t be viewed as financial or investment advice.

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