Should We Fear Fear Itself?

People are worried about the Euro. As bad news flows out of Europe – persistent unemployment, popular discontent over painful austerity measures, and catastrophic bank losses tied to still-deflating real estate markets – international investors continue to cast doubt over the Euro-Zone’s short- and long-term stability. Fear of at least a partial disintegration of the monetary union is rampant. Indeed, Morgan Stanley recently released the results of a survey of 150 of its clients; while only 3 percent of the investors thought there is more than a 60 percent chance that the Euro-zone will break up, three-quarters of the respondents thought there was some probability of a breakup. These statistics raise a double concern. First is the fear that this nightmare scenario will come to pass, an unprecedented event that could fatally wound investor confidence in the Euro, potentially eliminating its viability as a secure store of value. Second, one might fear this fear itself, as these investors’ worries might contribute to their own realization.

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Financiers justify the distinctive double movement of the last several decades by arguing that markets are efficient. Neither the proliferation of capital markets nor the wearing away of regulations on them would be legitimate cause for concern if markets could be counted on to allocate capital to the areas of the economy that deserve it. Yet this period’s continual booms, busts, and crises provide a substantial and ever-increasing body of evidence that these supposedly rational capital markets are, in fact, anything but. As much as Florida’s decaying, uninhabited subdivisions attest to the dangers of irrational exuberance, Ireland’s swaths of unsold houses and imploding, too-big-to-fail banks attest to the power of expectations. They demonstrate that rather than allocating resources on the basis of soberly considered “economic fundamentals,” capital markets have a stubborn tendency to synthesize their own realities from the grist of investors’ expectations.

Consider how the now-familiar contagion of financial crisis replays itself in each of the PIIGS (Portugal, Italy, Ireland, Greece, Spain), adding to the uncertainty about the Euro-Zone’s continued solidarity. First, the hard slap of reality deflates a convenient and officially supported untruth, swamping the government’s budget with red ink. In Greece, it was Prime Minister George A. Papandreou’s acknowledgement that his predecessor had been hiding massive government obligations in complex financial instruments, cleverly designed by the whizzes at Goldman Sachs. Ireland’s difficulties stem from the painful popping of its massive real estate bubble, which hit its banking sector with losses so big they overwhelmed the Irish state’s aggressive bailout attempts. In both cases, deficits quickly piled up and investors started to worry that the governments might default on their sovereign debts.

This is when a new and dangerous set of self-reinforcing expectations took hold of the situation. To appease investors worried about the riskiness of their debts, the Greek and Irish governments were forced to raise the yields on their bonds. Perversely, increasing the price of their sovereign debt service further strained their budgets and made defaults more likely. This, in turn, made international investors more cautious about lending to these governments, necessitating further increases in bond yields. Worse, the more concerned investors become about any one of the PIIGS, the more likely it is that the contagion will spread to the other fragile countries gorging themselves at the trough of international capital markets.

This self-reinforcing cycle was hardly unpredictable. Indeed, John Maynard Keynes’ General Theory of Employment, Interest, and Money is, at root, a treatise on the power our expectations have over anything like economic “reality.” Under ideal market conditions, there should be a diversity of expectations about any particular economic question. A mix of bulls and bears ensures that every seller can find a buyer without reducing his assets to fire-sale prices. Yet the patchwork of institutions with the power to influence investors does not always foster this necessary diversity of sentiment. While the International Monetary Fund and the European Central Bank designed massive rescue packages to shore up confidence in Ireland’s and Greece’s ability to repay their debts, other institutions function to exacerbate financial crises. For example, credit-rating agencies such as Standard & Poor’s and Moody’s have continually downgraded the sovereign debt of countries with troubled balance sheets, providing official reinforcement to the feedback loops threatening the PIIGS. Every rating downgrade unifies global expectations, encouraging investors to bet against these countries all at once, deepening the problem.

There is a dark irony to the credit-rating agencies’ conservative pronouncements as it was only a few years ago that they were bestowing their highest grades on now-toxic mortgage-backed securities. How is it that these ratings agencies calculated that the Republic of Ireland is a substantially riskier investment than a collection of no-money-down mortgages from Tampa? Credit-rating agencies play an important role in the lightly regulated global economy; experts at these companies are supposed to judge the long-term stability of various assets, from sovereign debt to collateralized debt obligations. Their judgments form the basis on which investment firms determine their exposures to risk. Although existing regulatory regimes assume that credit ratings are sober evaluations of assets’ fundamental strengths and weaknesses, in practice, raters are frequently caught up in the same illusions as traders, since they both subscribe to the same theoretical orthodoxies and use similar models. The result is profoundly destabilizing: Instead of pressuring traders to reconsider the Street’s conventional expectations, credit ratings “confirm” the validity of traders’ bets, both inflating bubbles with a false sense of security and violently popping them once feelings start to turn sour.

This myopic logic, which takes the prevailing expectations about an asset to be more important than its “real” strength, usually works, at least in the short term. Both open exchanges, such as the NYSE, and private financial companies’ “market making” activities increase the allure of certain assets by making them appear more liquid. The liquidity that normally functioning markets provide allows professional investors to restrict their attentions to the short term, decreasing the relevance of long-term growth potential or solvency. Keynes compares markets dominated by professional investors to

those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

In supposedly liquid markets, the optimal investment strategies do move to these higher levels of analysis, further from a strategy based on fundamental economic value. Indeed, studies indicate that markets behave quite differently depending on how many degrees of expectations agents consider. In general, “it is not the case that the average expectation today of the average expectation tomorrow of future payoffs is equal to the average expectation of future payoffs.” Rather than stabilizing, these markets tend to accelerate; economic models suggest that asset bubbles and crashes are natural features of such self-reinforcing market dynamics.

Despite the obvious risks of betting big on something as ephemeral as popular sentiment, traders make billions in management fees by convincing clients that they can consistently beat the gun. On the upsides of bubbles, this strategy easily pays off, usually beating the returns of investment strategies based on economic fundamentals. However, as soon as expectations turn against a particular asset, the process works in reverse and huge losses can wipe out years of hard-won gains. During these crashes, investors’ bearish expectations synchronize, causing liquidity to dry up as sellers drastically outnumber buyers. Indeed, Keynes maintains that “of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, [since] it forgets that there is no such thing as liquidity of investment for the community as a whole.” Despite traders’ efforts to insulate themselves from risk with credit default swaps and other complicated hedging strategies, someone will be left holding the bag, full of near-worthless assets. If worries are widespread, rather than restricted to a particular security, this fear can spread from one asset to another as investors try to unwind their risky positions before their competitors. Thus, trying to “beat the gun” on the downside by anticipating others’ expectations of the average expectation about the future not only accelerates the fire-sale in progress but also spreads the contagion to other, unrelated assets. This is why the Portuguese government is watching the Irish situation so closely: Portugal knows it’s next in line.

In the wake of financial crises, it’s common for financiers to renounce the riskiest, most highly leveraged investment strategies in favor of something more “traditional.” Indeed, a long-time Wall Street veteran now dying of brain cancer, Gordon Murray, recently released a book condemning the entire concept of active money management. People would do better over the long term pinning their portfolios to an index like the S&P 500, he claims, than paying high-priced traders to try to beat the market. While some people burned by the recent crises may heed such advice for a time, history suggests that this conservatism will last only as long as the painful memories retain their sting. This moment has likely already passed. So long as traders can convince the holders of international capital that they can beat their competitors to the next big thing, one would be well-served by recalling FDR’s first inaugural address. Then, as now, negative speculation threatened banks, markets, and political stability. Fear itself might not be the only thing we have to fear today, but it’s certainly one of the biggest.