Sunday, September 28, 2008

The irony of the "self-fulfilling crisis"

one can think of a range of fundamentals in which a crisis cannot happen, and a range of fundamentals in which it must happen; at most, self-fulfilling crisis models say that there is an intermediate range in which a crisis can happen, but need not. It is an empirical question (though not an easy one) how wide this range is. Krugman

In centuries past if one happened to mention the devil or other such evil, one was quickly rebuked, for fear that the mere mention of a thing would evoke the thing. With the benefit of hindsight, this behavior is seen as superstitious.

Unless, of course, one is speaking of economics. Economists have, for decades, been increasingly focused on "expectations" as a causal agent distinct from the facts on the ground. So long as people don't expect high and rising inflation, regardless of actual price changes, inflation will, advocates of this perspective argue, remain under control.

These "expectation gamers" as I like to call them, will only prove effective if the economy in question is in Krugman's "intermediate range."

The irony of this view lies in the effect of gaming expectations. If an economy is in the intermediate range and the expectation gamers successfully convince economic participants "everything is fine" there will be no pressure to change policy- indeed, there will be widespread resistance to such change. To the extent there is this intermediate range, gaming expectations may, in some cases, shrink it, i.e. invite a crisis which could have been avoided.

Consider a "down to earth" example:

Two hypothetical families buy a house in 2005 at twice the price of any comparable sale in 2001.

Family A becomes aware that inflation is rising and real estate prices are topping out as mortgage rates rise and lending dries up. They immediately curtail unnecessary spending, decide against a home equity loan to redo their kitchen, and replace their SUV with a compact car.

Family B (who might get their economic views from CNBC and Fox News) believes that any unwelcome changes in prices or the economy are merely temporary and thus opt to keep their SUV and take out a home equity loan to redo their kitchen.

Family B in the current environment has had their expectations gamed, and will pay the price.

Family A might make it.

The more Family B's there are in the economy at large the greater the chance that a real crisis will erupt.

Interestingly, awareness, rather than ignorance, of an impending crisis may be the best medicine.