Tuesday, June 02, 2009

Giant Error Of Pessimism And Ever Blowing Bubbles

Someone, who is very well orientating himself in the ECRI's web site, was hinting me to the excerpt form ECRI's Professional Report on 19th March 2009, while I was confronting ECRI's WLI and Dean Baker last week. Here I excerpt from that ECRI report:
Still, most will be skeptical about our forecast of a business cycle upturn. This is precisely what we’d expect. Why is that?

Wesley C. Mitchell was a mentor to ECRI’s late founder, Geoffrey H. Moore, whom The Wall Street Journal called “the father of leading indicators.” More than 80 years ago, Mitchell described how the error of optimism at the heart of every boom “grows in scope and magnitude.... But since the prosperity has been built largely upon error, a day of reckoning must come… Then the past miscalculation becomes patent – patent to creditors as well as to debtors, and the creditors apply pressure for repayment. Thus prosperity ends in a crisis.”

Then, as Mitchell quotes A. C. Pigou writing in 1920, “The error of optimism dies in the crisis but in dying it ‘gives birth to an error of pessimism. This new error is born, not an infant, but a giant; for (the) boom has necessarily been a period of strong emotional excitement, and an excited man passes from one form of excitement to another more rapidly than he passes to quiescence.’”

The “giant error of pessimism” is now rampant. This is why many will be blind to the light at the end of the tunnel that marks the exit from this recession. But to ECRI’s array of objective leading indexes, designed specifically to spot recessions and recoveries, the end of the recession is now in clear sight.
Well, but note that ECRI's WLI is for the U.S. And indeed, this time around the U.S. may be not the one who will suffer the most ...

Interestingly, but now on global scale, that Paul Krugman was commenting on "A Tale of Two Deprressions" by Eichengreen and O'Rourke in the beginning of April with these words:
It’s only to the extent that we understand these things a bit better than our grandfathers — and that we act on that knowledge — that we have any real reason to think this time will be better.
Even more interesting is to look at the equity markets today, and read latest note by James Montier, where he summarizes on the ever blowing bubbles as follows:
As the US market is now back at fair value, I’ve been pondering what could drive the market higher. Jeremy Grantham provides some answers in his latest missive to clients. He argues that “the greatest monetary and fiscal stimulus by far in US history” coupled with a “super colossal dose of moral hazard” could generate a stock market rally “far in excess of anything justified by…economic fundamentals”. This viewpoint receives support from the latest finding from experimental economics. The evidence from this field shows that even amongst the normally well behaved "experienced’ subjects, a very large liquidity shock can reignite a bubble!
  • I have long used a Minsky/Kindleberger framework for thinking about the inflation and deflation bubbles. This process ends in revulsion, when everyone has given up hope on the asset class in question. However, in the past, US authorities have short circuited the process and avoided sliding into revulsion via monetary and fiscal policy response.
  • The evidence from experimental markets (in which participants trade an equity-like asset) is that experience helps to prevent bubbles. The first time people play the game, they create a massive bubble (like the dot.com bubble).
  • The second time people play the game, they create yet another bubble. However, thisseems to be driven by overconfidence that this time they will get out before the top. The third time subjects encounter the game, they generally end up with prices close to fundamental value.
  • This might suggest that bubbles should become harder to create amongst experienced market participants. Certainly, the evidence from the tech bubble shows that it was the young fund managers who got suckered in, whilst their older brethren were happier to sit it out. A good reason to keep those of us who have lived through multiple bubbles around!
  • However, new research by the godfather of experimental economics, Vernon Smith, shows that it is possible to reignite bubbles even amongst the normally staid and well behaved subjects who have played multiple bubble games. The key to this rekindling is massive liquidity creation. In fact, in his experiments Smith doubled the amount of liquidity available.
  • Now, I have no idea if the current policies of the Fed and its allies around the world constitute a large enough liquidity shock to reignite a bubble. But it certainly seems as if many market participants are now focusing upon the policy response as a key source of optimism. If this is indeed the case, then perhaps Smith's latest work could sound a warning bell about the risk of yet another bubble (and in time another crash!).
Huuuhhh. Complicated world?
Let's see how the errors of pessimism, hope and bubbles cope with debt load ...

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