Are Bond Prices too High?
Applied Philosophy: Representation, Metarepresentations, and Qualia

Fear of Lack of Fear

Economists have three very different and opposed reactions when they look at the global configuration of asset prices:

  1. For most of the past century risk and default premia have on average been too large to make sense as the appropriate price that a well-functioning utility-maximizing market would produce--so the fall in risk and default premia relative to historical averages is welcome.
  2. Risk and default premia are much smaller than historical averages, and past experience suggests that these premia will return to their averages--which is scary, because it means some kind of a crash is likely.
  3. Risk and default premia in markets are low relative to perceived geopolitical and other risks, but this is more-or-less what we would expect--if the world goes to hell in a handbasket, geopolitically or economically, we have no clue which asset classes will do least badly.

Here Larry Summers comes down on the side of reaction (2): / Columnists / Lawrence Summers - Lack of fear gives cause for concern: The new year will begin with the greatest divergence for a generation between the general view of global risks as reflected by conventional wisdom and the risks as priced in financial markets. While the commentariat has been more alarmed about the state of the world than global markets for some years, the gap increased in 2006 as markets became more serene and everyone else grew more anxious.

The headlines and opinion writers focus on how the US is badly bogged down in wars in Afghanistan and Iraq; on an increasingly unstable Middle East and dangerous energy dependence; on nuclear proliferation that has already occurred in North Korea and that is coming in Iran; on the potential weakness of lame-duck political leaders in the US and other major democracies; on record global trade imbalances and rising protectionist pressures; on increased levels of public and private sector borrowing combined with record low saving in the US; on falling home prices and middle class economic insecurity.

At the same time, financial markets are pricing in an expectation of tranquillity as far as the eye can see. Stock prices in the US are at all-time highs. The risk premiums to cover the possibility of default that corporations or developing countries have to pay to borrow money are at or near historic lows. In addition, estimates of the volatility of the stock, bond and foreign exchange markets inferred from the prices of options are near record lows.

Why the divergence between the headlines and the markets? Will the journalists or the investors be proved right about the state of the world? Or will the divergence continue?

First, in spite of all the adverse news, the world economy in aggregate grew more during the last five years than in any five-year period since the second world war. The US is enjoying a rare combination of low inflation and 4.5 per cent unemployment and has not suffered a deep recession in a quarter of a century. Given the natural tendency of markets to extrapolate from experience, optimism is to be expected and is to some extent justified. The great danger is that optimism can become a self-denying prophecy if it leads to excessive extension of credit, irrational capacity creation and unsustainable levels of spending.

Second, some of the divergence between the editorials and the markets reflects the markets’ narrower focus. September 11 2001 was an epochal event, but not one that had a great impact on the cash flows of most corporations and did not have an enduring impact on market valuations. Those who liquidated positions during the transitory dip in the aftermath of the attacks probably regret having done so.

Whether markets are right to be so narrowly focused is less clear. They are surely right to recognise that even events of great historic importance may not affect the value of particular securities. On the other hand, there is the real possibility that they are myopic in not recognising that important geopolitical events can have lasting effects on the global economy. A turn towards protectionism, for example, would be unlikely to affect the ability of companies or nations to service their debt next year, but history suggests that over time such a turn would have profound effects on the ability of businesses to profit and countries to pay off debts.

Third, changes in the structure of financial markets have enhanced their ability to handle risk in normal times. The percentage of any loan a given institution has to hold has been reduced with increased securitisation and syndication. It is natural that associated risk premiums have also declined. Greatly enlarged pools of speculative capital can also reduce volatility by pouncing any time an asset price gets significantly out of line. Financial innovation through derivatives has made the hedging of risk much easier. As institutions have become more sophisticated in their approach to risk, they have felt comfortable in taking positions they might have been reluctant to hold even a few years ago.

We do not yet have enough experience to judge what happens in abnormal times. As we observed in 1987 and again in 1998, some of the same innovations that contribute to risk spreading in normal times can become sources of instability following shocks to the system as large-scale liquidations take place. How dramatic increases in speculative capital and the use of credit derivatives and other hedging tools will affect the system’s response to the next large shock is a profoundly important but ultimately unanswerable question.

We will know much more about whether the market view and the general view can converge a year from now. In the meantime, it is fair for those who look to markets to point out that the easy path for the commentariat is to foretell disaster. If disaster occurs, it was foretold. If it does not, credit can be given for timely warning. Anyone who liquidated stock holdings a decade ago when Alan Greenspan, former Federal Reserve chairman, worried about “irrational exuberance” learnt painfully that for those who put money behind their convictions' unwarranted pessimism can be very expensive.

Equally, it is fair to point out to those who take comfort from the markets’ comfort that they hardly ever predict serious disruption and historically the moments of greatest complacency have been the moments of greatest danger. Over the past 20 years the world has confronted the 1987 market meltdown, the banking crisis of the early 1990s, the Mexican near-default in early 1995, the Asian financial crisis in 1997, Long Term Capital Management in 1998 and the Nasdaq decline and September 11 in this decade. While each of these events is unique, the record does suggest that crises occur in about in one out of every three years.

At least as far as the markets are concerned, perhaps the main thing we have to fear is lack of fear itself.