Investors, journalists view world differently

By LAWRENCE H. SUMMERS
SPECIAL TO THE LOS ANGELES TIMES
The year 2007 begins with a vast divergence between the popular view of global risks and the risks as priced in financial markets.
While commentators have 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 U.S. 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; on record global trade imbalances and rising protectionist pressures; on increased levels of public and private-sector borrowing combined with record low savings in the United States; and 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 U.S. are at all-time highs. The risk premiums 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 World War II. The United States is enjoying a rare combination of low inflation and 4.5 percent 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.
Narrow focus
Second, some of the divergence reflects the markets' narrower focus. Sept. 11, 2001, was an epochal event, but not one that had a great impact on the cash flows of most corporations -- and it 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 recognize that even events of great historic importance may not affect the value of particular securities. On the other hand, there is the possibility that they are myopic about the effects geopolitical events can have on the global economy. A turn toward 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, and associated risk premiums have 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.
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 will dramatic increases in speculative capital and the use of credit derivatives affect the system's response to the next large shock?
Year from now
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 commentators 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" learned painfully that for those who put money behind their convictions, unwarranted pessimism can be very expensive.
Summers is a contributing editor to the Opinion section of the Times.