Markets say we are winning

Laurence Summers:


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% 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.

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 real 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.

Summers is talking about the difference between the perception of the media and the perception of the market place. While I have more confidence in the market than the media, I think one of the reasons for the media gloominess is the performance of its own in the market place during this time period. The NY Times stock has been in serious decline during the same five year period as has the stock of most of the major media companies.

The performance of the markets is also a huge strategic loss for Osama bin Laden and al Qaeda, who had banked on the a plunge in the markets after toppling the world trade center. Al Qaeda hope to win the war by destroying the US economy. Now they are losing not only militarily but strategically.


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