December 9, 2008 2 Comments
Several bloggers have pointed to this Brad DeLong piece on the financial crisis. For my money the analysis there is a cut above the usual drivel people shove, which either tells a cartoonish story about the crisis either being caused by some mythical detail-free thing called ‘deregulation’ supposedly implemented by conservatives, or claims it’s all caused by giving loans to minorities, or just goes the easiest path and blames it all on ‘greed’. DeLong’s piece is more interesting than any of that.
He identifies 5 known causes of fluctuations in global capital (which is what has imploded recently). In short they are
1. Savings and investment (particularly, the amount of the former that is transformed into the latter)
2. News (including resources, technology, and politics)
3. Default discount (fear that people will default)
4. Liquidity discount (desire to have money in liquid things)
5. Risk discount (desire to have money in non-risky things, i.e. for its future value to stay known)
DeLong says that (1) and (2) couldn’t have changed things much, that (3) has basically already been priced in, and that it’s (4) and (5) that are operating in our current credit crunch. He concludes with a mystery, because nothing in current economic thinking (according to him, and he would know) would predict that the appetite for liquidity would be so high and that for risk would be so low.
He is arguing primarily with folks who tell a story of the financial crisis being primarily caused by the ‘impulse’ of subprime/home-price writedowns. He says that’s not enough to understand the crisis because it only was a $2 trillion ‘impulse’ whereas global capital has shrunk by ten times that much. Not only that but the causes of this ‘impulse’ are not well diagnosed. All of this strikes me as accurate enough.
Here’s where I think DeLong goes wrong: by dismissing the effect of (2) – news. He dismisses it practically at the beginning of his analysis. Possibly this is because he welcomes the Obama victory. So, news hasn’t changed much, he says (or anyway, there’s no bad news to speak of), so that can’t be part of the explanation.
Oh, but I think it can.
The United States – the most important economy in the world, and the locus of the housing bubble – was going to change its governing regime. Obvious this was known prior to 2007 but it was a looming event in 2007, something that could no longer be ignored, because it was coming up. And not only that but Bush’s popularity had plummeted, making a party change all that more likely. So if the markets had gotten used to one regime – Bush, and his cabinet, and whatever they tend to do or not do, good or bad – they would have had to start incorporating into their thinking the fact that this regime and all its patterns were likely to change significantly.
I know this is simplistic thinking but the more I think about it the more striking it is – the tech stock bubble collapsed in ’99-’00, the housing bubble collapsed in ’07-08. What did both of those time periods have in common?
Regime uncertainty. One long regime going to end, and a far different regime possibly due to take over. I’m not saying this as a way of calling the Obama Presidency (or the Bush Presidency) bad (or good); I’m just saying.
I suspect the effect of regime uncertainty on the markets is being wildly underestimated by most commentators.