Thursday, October 02, 2008

Fear's Silver Lining

Here we dig a little deeper into the idea of "Moral Hazard," which we really only alluded to in the post that bore its name.

Before the dot-com bubble was acknowledged to be a bubble, James Grant, whom everyone should read, wrote a book entitled, "The Trouble With Prosperity." Insofar as all asset manias share the same blueprints, the book was a perfect forewarning of our day: the perils of plenty, bringing as they often do sloth and poor judgment in places high and low. The foolishness of excess capacity that results. And the inevitable deleveraging and downward repricing of assets that follows.

There's a useful converse to the idea that prosperity can be troublesome, and that would be that want can be beneficial. How so? By preventing the perils that times of plenty seem to repeatedly bring.

Referring to the VIX chart below -- that's the "Fear Index" -- we commented that not since the 1987 stock market crash has the index had a really powerful spike. In spite of events greater in magnitude and in threat to security, including an incalculably destructive attack on the very heart of finance, fear, as measured by the VIX, has never really been manifest since that Black Monday 21 years ago.

And this is where "moral hazard" comes in. We argued an obvious point: that after the Fed decisively and effectively provided emergency liquidity to the financial system during those trying days in October of 1987, the market concluded, "Oh, we won't have to worry about that happening again." In other words, there was no need to fear, for the Fed was here.

This the lack of fear brought about that disregard for the consequences of the bad side of risk (and perhaps that presumption that risk could be socialized through Fed intervention) that invariably renders many people silly. And dangerous. People who should be habitually and especially sober and self controlled, because of their fiduciary responsibility or the influence they have in the economy.

No, we're not saying the Fed was wrong to intervene on Black Monday, or on any other day, necessarily. Only that doing so seems to have implied a precedent that market disasters will henceforth be prevented, which has been received as an incentive to play more aggressively than one might without the benefit of taxpayer-subsidized disaster insurance ("The Greenspan Put"). And what will prove the precedent to be broken, except...a market disaster? What will offset the tendency to disregard risk, other than the fear of loss? If enough people had just enough of the right kind of fear in them, a whole lot of this particular peril could have been avoided. This is why the issue isn't simply econometric; it's moral: it demands wisdom and self control to avoid the perils of excess.

We said, back in those VIX posts, that the market just isn't scared enough about what it's facing; that it just hasn't registered the magnitude of the problem. We said the VIX argued that stocks must go lower still, and they have. Even Bloomberg picked up on the idea.

Now, as to how high the VIX will go -- that is, how much more real fright is on the way, as manifested in turmoil in the equities market -- I suppose that could be argued, depending on one's assessment of the magnitude of the financial system's difficulty. Ours? Maybe we're in the third inning. Hopefully it's not the first game of a seven game series; hopefully we're wrong.

We said that our problems right now are structural -- that is, that they are caused by market mechanisms like structured-asset-valuation accounting regulations linked to statutory capital requirements that are prone by their configuration to downward (and upward) asset spirals. Structural things are usually fixable, if caught in time (which is why congress' little stalling gambit this week caused a 9+% selloff in world markets and may have caused incalculable damage going forward). But we've only just begun to recognize the economic problems these structural problems have finally ignited.

The unwinding of folly with the reinstitution of the right kind of fear doesn't have to be terrible. It could be, but it doesn't have to be. But hopefully, like that generation that passed through the Great Depression, we and our children will have learned the right lessons.

The great peril on the other side of this is that we fail to learn the lesson; that we place our faith in more ill-conceived regulations and simply don't take our lumps and strive to be smarter and more disciplined and more responsible with our risk taking; that we fail again to recognize the debt we owe to our progeny to keep our houses in order.


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