The future's so bright?

The markets are pricing in tranquillity as far as the eye can see. The commentariat begs to differ.

By Lawrence H. Summers, LAWRENCE H. SUMMERS is a contributing editor to Opinion.
December 26, 2006

THE YEAR 2007 will begin with a vast divergence between the popular view of global risks and the risks as priced in financial markets. While the commentariat has 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 saving 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% 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.

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?

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 the commentariat 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.

Equally, those who take comfort from the markets' comfort should bear in mind that the markets hardly ever predict serious disruption. Historically, the moments of greatest complacency have been the moments of greatest danger. Over the last 20 years, the world has confronted the 1987 market meltdown, the banking crisis of the early 1990s, the Mexican near-default in early 1995, the Asian financial crisis in 1997, the collapse of hedge fund Long Term Capital Management in 1998 and the Nasdaq decline and 9/11 in this decade. While each of these events was unique, the record does suggest that crises of some variety occur in about one of every three years. At least as far as the markets are concerned, perhaps the main thing we have to fear is the lack of fear itself.