Saturday, November 17, 2007


Remember irrational exuberance, the creator of asset bubbles? Well, we may now have irrational pessimism, the creator of panic selling in the credit markets. We know this because many of the assets being written off, or sold at a discount by banks and hedge funds, are AAA-rated. It is the highest credit rating possible—the rating of Treasury bonds as well.

This belies the underlying strength of the economy. Consumers are still buying—with retail sales up 5.2 percent annually in the latest October survey. So the credit crunch is not yet affecting overall consumer spending, just what they are buying. Inflation is up slightly, but not what one would expect with soaring oil prices.

A famous 2001 research paper on “Herd Behavior in Financial Markets” stated that “Intuitively, an individual can be said to herd if she would have made an investment without knowing other investors’ decisions, but does not make that investment when she finds that others have decided not to do so. Alternatively, she herds when knowledge that others are investing changes her decision from not investing to making the investment.”

Much of it is generated by media pundits, who love to dramatize the adversity without doing the hard work of actually analyzing the numbers. And it sells ads. Human nature is controlled in large part by emotions, and during crises the motivating emotion can be fear. It magnifies all events. The glass is then half empty instead of being half full, in a word.

One example is predictions that banks may suffer upwards of $250 billion in writedowns before the dust has settled. Yet the top 5 banks’ revenues—banks such as Citicorp, JP Morgan/Chase, Wachovia, and Bank of America that are writing off those losses—have had record-breaking revenues this year. Business Week reports that their revenues could be up 7 percent from last year’s high of $127 billion.

The S&L crisis cost banks and taxpayers some $160 billion in the early 1990s, and helped to cause the 1991 recession. But this was when total Gross Domestic Product was 44 percent of what it is today. Banks were also not in the greatest shape then, with much lower capital and loan loss reserve requirements. Add to this the worldwide glut of savings that has poured into our stock and credit markets, and we see that this credit crunch may mostly be motivated by fear, rather than fundamentals.

And so in the words of a famous radio commentator, we should be looking at “the rest of the story”. What is it? Labor productivity jumped a huge 4.9 percent in Q3, mainly because the business investment that brings new technologies is up almost 8 percent. This will boost incomes while counteracting the high energy prices.

PPI/CPI—Overall wholesale inflation (PPI) rose just 0.1 percent in October, and retail prices (CPI) rose 0.3 percent. But PPI/CPI prices are up 3.5 percent and 6.1 percent, respectively, in 12 months. Still, with oil prices over $90 per barrel and gas above $3 per gallon, this is remarkable.

PENDING HOME SALES—This is signed contracts only, and attempts to predict existing-home sales that will close. The Pending Home Sales Index (PSHI), a forward-looking indicator based on contracts signed in September, rose 0.2 percent to a reading of 85.7 from an index of 85.5 in August, according to the National Association of Realtors. This was the first rise in one year, even though it was 20.4 percent lower than the September 2006 level of 107.6. “Even with relatively low fourth quarter sales, 2007 will be the fifth highest year on record for existing-home sales. The median existing-home price in 2007 will have fallen by less than 2 percent from an all-time high set in 2006,” said the NAR’s chief economist Lawrence Yun.

We know that the concept of irrational exuberance was first trumpeted by Fed Chairman Alan Greenspan in 1996. It wasn’t until 2000 that the stock market bubble burst. Now we are hearing dire predictions that are more due to the herd behavior of media pundits than economic fundamentals. Most of it is based on unfounded fears. This is no substitute for a better understanding of the complex factors that determine economic growth.

Copyright © 2007

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