Commentators vs. Markets

The distinguished economist (and former Harvard president) Larry Summers has a great column in the L.A. Times.  His main point:

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.

I think it’s true that many pundits have been doomy and gloomy.  And it’s certainly true that the markets seem to expect great times.  If not, we’d see junk bonds paying very high interest rates relative to U.S. treasuries.  That’s not happening.  The explanation gets more complex when you study derivatives markets, but Summers is right: the markets are pricing securities on the assumption of fairly positive economic conditions.

I’m with the markets.  There are certainly risks, but the "global imbalances will cause a recession" crowd goes too far.  Maybe I remember all the previous times I heard doom and gloom from people about budget deficits, trade deficits, low savings rates, etc.  I have yet to see any harm to the American economy from "imbalances."  I’ve seen recessions caused by the Fed overtightening, combined with past overspending in key sectors or with oil shocks.  However, I think one has to just WANT to be a pessimist to see a major decline due to imbalances.

That said, I still think there’s a risk to the economy from the housing sector.  The business cycle is not dead.  We have not–and cannot–insulate ourselves from economic risk.  So do your contingency planning, but keep your base case looking positive.

(Hat tip to Rich Karlgaard )