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Larry Summers (December 2006): Lack of Fear Cause for Concern

Larry Summers: Lack of fear gives cause for concern:

The US is enjoying a rare combination of low inflation and 4.5 per cent unemployment… has not suffered a deep recession in a quarter of a century… markets… extrapolate from experience…. 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.

There is the real possibility that [markets] are myopic…. 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….

Changes in the structure of financial markets have enhanced their ability to handle risk in normal times…. It is natural that associated risk premiums have also declined…. Financial innovation through derivatives has made the hedging of risk much easier…. 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….

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…. 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… 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.