Spontaneous Formation of Global Economic Crises
The walloping “once in a century” tsunami of sub-prime mortgage defaults, financial institution collapses and inter-bank lending freezes has swept eastward, rising tall in the United States, gushing forth and toppling the economies of Iceland, Ukraine and Hungary and unhorsing the economies of the EU. The fallout is felt world wide in the form of wildly oscillating currency prices and erratic stock market performances.
At the epicenter of the “submarine quake” triggering the destructive wave - in the United States - the long term and steady deregulation of financial markets which started under the Reagan administration, continued through three Bush terms (George H.W and George W.) and the Clinton years, along with the faulty economic ideology abode by Alan Greenspan was fatally joined in a “menage a trois” by the loosening of the borrowing criteria. The resulting, unbridled growth culminated in the dot-com bubble. With barely 2 year respite the US housing bubble began rising.
Now that the burst of this latest mass delusion is finally history after years of circulating warnings of which perhaps the most famous is the term - Irrational Exuberance - fingers are being pointed back at the man who curiously coined that phrase, the 1987-2006 Chairman of Federal Reserve - Alan Greenspan. Perhaps rightfully so. He held one of the most important economic policy-making jobs in America 19 years out of the last 25 which when looking at the Inflation adjusted S&P 500, 1925-Present were marked by insatiable and unprecedented stock market boom thwarting all previous highs in American economic history.
A self described Libertarian-Republican, a friend and admirer of Ayn Rand who contributed to her non-fiction book Capitalism: the Unknown Ideal, Greenspan admitted in a congressional hearing in October that his free-market anti-regulation ideology was flawed. At the 1996 Annual Dinner lecture of the AEI sounding quite confused and uncertain, he nevertheless thought that it was possible for “financial asset bubble” to be detached from the “real economy”:
But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.
Such mix of sophisticated thinking and naivete is explainable only through one other quite uniquely human but terrifying capacity: faith. Faith in market fundamentalism in this case. It was therefore possible for Greenspan to set forth monetary policies which premeditated or not engineered the housing bubble, possibly to cushion the post dot-com correction and snatch the US economy off the brink of looming 2001-2002 recession. Whether the aggressive and prolonged cut of interest rates was motivated by twisted neo-conservative patriotism in the face of “post 9/11 world”, greed or naivete, is a matter of perspective. What is certain however, is that along with President Bush’s infamous calls “to shop” as part of the civilian sacrifice required at the time of war (”the war on terror”, the war in Afghanistan and the Iraq war), the interest rate cuts were measures to kick-start the American economy at all costs. The bulk of the cost it appears now, was transferred to the overextended borrower who was actively enticed and encouraged to consume beyond his/her means in order to keep the US economy churning.
Catherine Rampell, the author of “How Long Before the Market Bottoms?” which embeds Robert Shiller’s Inflation adjusted S&P 500 graph, summarizes her post by saying:
After the Great Depression, it took 29 years — until 1958 — for the market to reach its pre-Depression, inflation-adjusted peak. After the 1970s recession, it took 24 years — until 1992 — for the market to make a full “recovery” by the same measure. So no matter whether you start from the recent 2007 peak, or from the market’s absolute inflation-adjusted peak during the tech bubble in 2000, we may still have at least a decade to go before full “recovery.”
It rings true, against voices who speak of one, three or even 5 year recovery. Economists describe the depth and breadth of the oncoming recession in terms of alphabet letters V, U, W, or L. The Wall Street Journal (via The Conscience of a Liberal) ironically predicts the “the W recession” to follow the M shape of the preceding boom.
Robert Shiller who’s S&P 500 historical chart provides such strong visual to the present day crisis, is an economist and a Professor of Economics at Yale University as well as a best selling author of “Irrational Exuberance” which was updated and re-released in 2006 and barely off the press “The Subprime Solution“. The Irrational Exuberance book review states:
Shiller amasses impressive evidence to support his argument that the recent housing market boom bears many similarities to the stock market bubble of the late 1990s, and may eventually be followed by declining home prices for years to come. After stocks plummeted when the bubble burst in 2000, investors moved their money into housing. This precipitated the inflated real estate prices not only in America but around the world, Shiller maintains. Hence, irrational exuberance did not disappear—it merely reappeared in other settings.
He studies investor confidence indexes and is one of the key scholars in the field of Behavioral Economics.
Behavioral finance highlights certain inefficiencies and among these inefficiencies are underreactions or overreactions to information, as causes of market trends and in extreme cases of bubbles and crashes). Such misreactions have been attributed to limited investor attention, overconfidence / overoptimism, and mimicry (herding instinct) and noise trading.
The ongoing global economic calamity, deemed the worst since the Great Depression, is a case in point.
The investors’ reactions to the government’s attempts to contain and control the crisis are arbitrary and volatile. The insights of the economists tackling the Subprime Mortgage Crisis/Credit Crisis, most likely go as deep as the studies ran or aknowledged by Improbable Research that is to say they are obvious, unusable and often absurdly funny. The slap on the forehead - “duh” effect - of hind sight into the recent economic events, in a moment of dark humor seemed not very different from the conclusions reached by the 2008 lg Nobel Prize for Physics winners, Dorian Raymer of the Ocean Observatories Initiative at Scripps Institution of Oceanography and Douglas Smith of the University of California, San Diego who mathematically proved that heaps of string or hair or almost anything else will inevitably tangle themselves up in knots.
It is well known that a jostled string tends to become knotted; yet the factors governing the “spontaneous” formation of various knots are unclear. We performed experiments in which a string was tumbled inside a box and found that complex knots often form within seconds. We used mathematical knot theory to analyze the knots. Above a critical string length, the probability P of knotting at first increased sharply with length but then saturated below 100%. This behavior differs from that of mathematical self-avoiding random walks, where P has been proven to approach 100%.