Reflections from Europe | OCTOBER 21, 2008
Cheap Talk: A Weapon of Mass Destruction: Asset Values, Expectations and the Apocalypse
Cheap talk about the economy these days revolves around two topics. One is the "abject failure of neo-liberalism, capitalist free-for-all and Thatcherism". Since World War II, but even more painfully since the demise of the Soviet Union, all on the Left were forced silently to suffer derisive comments about socialism that does not work and capitalism that does. Their half-hearted mutterings about social justice and inequality were swept aside with the reminder that it was capitalism that has lifted over a billion Third World people out of poverty. Now, however, the tables were at last turned. Subprime mortgages were worthless, asset-based securities were "toxic", banks were falling like ninepins and stock markets had no bottom. Deregulation proved to be irresponsible and gave free rein to bankers' greed. Governments had to step in at every turn to shore up the rickety edifice.
The other central topic of cheap talk is the dreadfulness of the recession that is now enveloping the world (for has the IMF not reduced its 2009 world growth forecast from 5 to 3 per cent?). Parallels between the present and the Great Depression that broke out in 1929 are made. The US economy may still be growing, much as a dead man's nails keep growing for a little while, but the UK, Germany and France are already in recession and worse is to be expected. Most disturbingly, China is slowing down; the government expects only 9 per cent growth for 2009.
(It is interesting to reflect on the ways the same statistics can be put before the public. French GDP was reported down 0.3 per cent for the second quarter of 2008 and was forecast to fall by 0.1 per cent in the third and fourth quarters. This has set off shrieks of horror and despair by the commentators. The general public took its cue from them. One wonders what would have been the reaction if the report had stated that output in the second quarter was 99.7 per cent of that of a year ago and was expected to rise to 99.9 per cent in the next two quarters. Likewise, unemployment in 2009 is likely to rise by 2 percentage points—something deeply to be regretted. But would it sound just as ominous to be told that the payroll of the representative firm will decrease from 100 to 98?)
Needless to say, the round-the-clock barrage of half-literate panic-mongering can hardly fail to have some self-fulfilling effect. Told again and again that it may be 1929 all over again, though it is more likely to be just a very nasty recession, any businessman may feel duty bound to defer his expansion plans, for even a small probability of a 1929-type collapse will drastically reduce the (probability-weighed) expected value of his project. It must be added that while central banks all over the world have been busily cutting their discount rates and helping to push up bond prices, the near-collapse of stock prices is acting in the opposite direction and on a vaster scale. It is ironical to note that while government, through the central banks, is pushing both short and, indirectly also, long bond prices upward, the most fervent advocates of government action are pushing stock prices downward by their rumour-mongering about the fragility of financial institutions (a perfectly self-fulfilling prophecy and cheap to spread, too) and by the talk of "the worst is yet to come".
Warren Buffett, the most successful investor alive, calls financial derivatives "weapons of mass destruction". Much could be said about their effects. However, their destructive power, massive as it can be, is as nothing to that of cheap talk.
From January 1 to October 10 2008, the stock market valuation of all listed European companies was roughly halved—an apocalyptic result. How can European business be worth half of what it was less than a year ago?
By rational calculus, a company's equity is valued by the marginal holder as the sum of all future net profits discounted to the present at his private discount rate. The latter, in turn, is the riskless pure interest rate, (e.g. the yield of long Treasury bonds) plus a subjective risk premium he needs to compensate him for the possibility that future profit may not be as good as he expects. This premium is a bit too much like "double jeopardy" or two hits for one fault, for his sum of expected future profits must be a composite of alternative likelihoods, the certainty equivalent of good, bad and middling profit figures and which allows for bad outcomes. However, let that pass. It may be noted that the present value of the stock will be greater if seven fat years are expected to be followed by seven lean ones than if the lean years come first and the fat ones later. In any case it is barely thinkable, to put it mildly, that either the discount rate, or the sum of probability-weighted future profits, or their time pattern between fat and lean years, or all three together, should change sufficiently in less than a year to cut the value of all European companies by a half. Can we all be out of our minds?
For an explanation of elasticities, see Elasticity and Its Expansion, by Morgan Rose.
For a podcast on bubbles, see Robert Shiller on Housing and Bubbles, on EconTalk.
The answer is "maybe we are". Economics offers a sort of possible explanation by using the concept of "elasticity of expectations". Suppose that an asset is priced at 100 today and we expect it to be priced the same 100 in the near future. If the actual price falls to 90 and our elasticity of expectations is 0, we still expect it to be priced at 100, providing us with some incentive to buy today. If our elasticity is 1, our expected price goes to 90 and we might as well stay put. An elasticity of, say, 2 makes us expect the future price to fall to 80 and our best bet becomes to sell before it does go to 80. Elasticities of less than 1 (including the somewhat eccentric "contrarian" case of negative elasticity) are consistent with market stability, elasticities above 1 are inconsistent with it. In fact, they are consistent with the notion of a "bottomless market" when triggered off by a downward move and with a "bubble" when set off by an upward one. (The "dot.com" bubble of 1999-2000 was the most recent example of people being driven out of their minds by cheap talk of a brave new world.)
Why, or when, is the elasticity of expectations of a wide enough swathe of marginal economic agents, businessmen, future pensioners and institutional asset managers, likely to be greater than 1? Economics is not psychology, and strictly speaking it has no answer. (Psychology probably has none, either.) Non-professional common sense suggests, though, that cheap talk—the ever wider avalanche of frightening scenarios, self-feeding dire forecasts and the round-the-clock battering of our senses by data that can be read and commented on in more than one way—does unsettle the mind. A febrile atmosphere is created by the great firepower of modern media with the bias toward bad news (for good news is no news) and the instinctive wish of the majority of commentators and politicians is to consign the capitalist order of things to hell and replace it with "something better". As a result, our sense of proportion is gradually worn down.
It is as this atmosphere thickens that the elasticity of expectations may overshoot the mark of 1 and all kinds of self-feeding processes may gather speed. There was no good reason why the European and American economies should lose their cruising speed, kept up with some variations since 1992. However, some potholes in the housing markets, messy consequences in financial markets that were poisoned by the undermining of confidence beyond all measure, and perverse effects of regulations (such as "marking to market" and solvency ratios) that made things much worse than they needed to be, were blown to epic proportions by cheap talk. Once expectations became very elastic in the climate of nervousness, every adverse move generated a greater one. Thus were reasons contrived for a recession that was on "objective" grounds quite unnecessary.