Not As Bad As It Seems

The sudden shifts in financial markets with the decrease in some asset prices and liquidity crunches are always painful and tend to reduce, on a transitory basis, income and employment. However, financial crises should be seen as an unavoidable consequence of the development and evolution of the markets and not as symptom of their inefficiency.

The sudden fall in the price of equity assets led the two largest stock markets (NYSE and NASDAQ) to report losses of approximate US$ 2.6 trillions, measured by the difference between the highest point in July and the last week. The losses in the mortgage markets are unknown, but according to estimates may reach up to $ 500 bn. These amounts are very large even when compared to the physical stock of capital in the United States, estimated at $40 trillion. However, as stressed by Gary Becker in 1987 after the 20% plus fall in the US stock market, the losses may look extremely large, but are minor when compared to the total stock of US wealth, that is 75% composed by human capital. Therefore, similar to the 1987 crash, the total impact on consumption from the decrease in wealth in the United States does not need to be very significant.

It is clear that investment in capital goods may be negatively affected. Likewise, as stressed by the Fed last Friday, the U.S. may experience a decrease in the growth rate of GDP, with negative impacts for the whole world. Still it is not likely that the financial turmoil will be transmitted to the real sector to the point of triggering a worldwide recession. The current Federal Reserve chairman, Ben Bernanke, is a leading expert of the Great Depression. In his book Essays on the Great Depression he makes an excellent analysis of the factors that led to that episode. Both the lessons learned from the Great Depression as well as the current state of the art of monetary policy endow the Fed with knowledge and credibility to eliminate from financial markets any systemic risk and to fine tune interest rates and other monetary policy tools to prevent a deeper recession. Besides, flexible exchange rates (instead of the gold standard of the Great Depression era) also help to reduce the contagion and foster the adjustment.

Moreover, there is no indicator suggesting that the factors that determined the latest strong cycle of prosperity and growth are being exhausted. China will keep having, at least for a while, high saving rates, add more workers to the formal labor market while private companies will maintain a high marginal productivity of capital. Commodity prices will tend to remain at a level higher than they were four or five years ago, though we may observe transitory decreases in these prices due to the crisis.

Brazil has been profiting by higher commodity prices. Indeed, between 2003 and 2006, higher prices have added $37 bn to total disposable income, or 7% of GDP growth in the same period. On the other hand, a broader crisis would have an impact on the Brazilian economy with a decrease in commodity prices, greater risk spreads and further exchange rate depreciation. Even in this case, the overall impact would be mild mostly because of floating exchange rate, monetary stability and the large stock of international reserves (almost twice larger than the public external debt).

As it has always been the case, crises lead to the emergence of two types of analysts: 1) the ex-post wise ones 2) the reformists. The former type argues that the crisis was obvious and inevitable and that only market irrationality and authorities’ complacency let the bubble to inflate. However, it is usually easier to look facts by the rear mirror. The markets are far from being perfect and psychological and sociological factors go together with rational and technical analysis. However, the fact is that small changes in the companies’ profit growth rates lead to larger changes in their stock prices. Hence, technological changes or structural factors that accelerate the growth of profits may rationally trigger a strong appreciation of assets. Bubbles are easily identified after they burst. Before this fact, the bubble scenario is not that obvious. If this were the case, they would burst earlier.

The reformist types argue for rules to regulate market operations that supposedly initiated the crisis. Besides they argue that some specific groups should be protected from the negative impacts of such crises. In other words, they argue that the subprime mortgage borrowers in the US should be saved because they were misled by the lenders. While it is true that predatory lending, false advertising and other misleading lenders’ conduct should be punished, the reformists’ proposals assume that borrowers are not rational and hence should be protected, thus restricting their access to the credit markets in the first place. However, thanks to the development of the subprime market millions of people got access to homeownership and mortgages – that were repackaged and distributed to diversify the risk – which allowed them to get financial resources that would not be available otherwise. In turn, the losses were spread out among a very large set of investors. In contrast to the 1980’s housing crisis where the losses were focused in commercial banks and savings institutions, the current crisis seems to have protected better the financial system than in 1980s. The problem with measures that change the rules of the game ex-post is the risk of decreasing the credibility of the credit tools and hence, squeezing even further the liquidity crisis and raising the costs for potential/future borrowers.

The development of financial markets has been one of the greatest triggers of economic growth lately. Tools that contributed to diversify and spread out the risk tend to lead to a better allocation of investments, creating more value and generating further economic growth. Excesses are unavoidable because the market will always be testing the limits, based on the past experience. This in turn, does not take into account the unforeseeable and random elements. The role of the authorities is to supervise, foster transparency and protect the system while leaving individual agents responsible for their own acts. Despite the malign side brought by bubbles and financial crisis, the alternative of underdeveloped financial markets is a much worse choice.

Originally published by Valor Economico and translated to English by RGE monitor.