Sadly, It Appears I May Be Right

Alternatively titled: Investors are a Superstitious, Cowardly Lot.  Skittishness over Spain and Italy, coupled with the U.S. downgrade to AA+ Friday afternoon hit the markets today, leaving the Dow down 5.5% and threatening to make the Eurozone a house of cards.

As I caught up on my news feeds from a weekend at the station, I came across an article from Nobel-Prize winning economist Paul Krugman that explains the risk of investors making Italian default happen by panicking – creating a self-fulfilling crisis.  (Note: Reading this article counts towards your 20 free monthly articles at NYTimes.)  As he says, much more eloquently that I could manage:

In the Italian case, you have big debt but also a primary budget surplus. So if interest rates stayed low, as they would if no default were expected, it wouldn’t be hard to service the debt with only modest further fiscal adjustment.

But if people expect a default – and also if they believe that once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors – then you could see interest costs rising to a point where default indeed becomes the preferred option.

So there is a reasonable case that what we’re seeing in Italy is a self-fulfilling crisis trying to happen, in which fear of default is precisely what leads to default. And that’s exactly the kind of case in which intervention could short-circuit the crisis. Let the ECB buy lots of Italian bonds, in effect guaranteeing a low interest rate, and the possibility of default fades – which in turn means that further intervention isn’t needed. It’s certainly worth a try.

I was very sad to read this article, because it means that I, who am by no means a trained economist, predicted something over a year ago that is now playing out in todays markets.  I’ve experimented with several blogs in the past before settling on this one as the main format for everything.  On one of those now-defunt blogs, Thoughts on Foreign Affairs, I had this to say back on May 10th, 2010, just as the Greece crisis was developing and Portugal and Spain were also being eyed up:

My main problem is with the flightiness of investors and their frankly incredible ability to generalize.  By generalize, I mean that investors, when worried or in a panic, don’t distinguish between good and bad economies.  That was proved well enough by the Asian crisis, when strong and weak economies alike found investors fleeing after conditions in a few countries deteriorated.  This behavior on the part of investors takes what could be a localized crisis, and spreads it over large areas.

That is the risk to the EU presently.  The euro fell against the dollar again, closing at $1.3019, after dipping below $1.30 at one point during trading.  In short, investor behavior risks creating a self-fulfilling prophecy.  If investors stand strong against uncertainty, and keep their money in the EU, the zone in general would be stabilized and better equipped to deal with any potential problems that emerge in individual member states.  If investors flee from the EU, sovereign debt crises will manifest because government incomes would plummet while their debt levels remained the same.

My feeling that this would happen has held until the present,when we now see some of the biggest economies in the Eurozone at risk because of the flightiness of investors.  How did I know this was coming?  Because what I’ve learned by living through a global recession is that investors are not so different from sheep, as described by Douglas Adams in one of my favorite books:

From another direction he felt the sensation of being a sheep startled by a flying saucer, but it was virtually indistinguishable from the feeling of a sheep being startled by anything else it ever encountered, for they were creatures who learned very little on their journey through life, and would be startled to see the sun rising in the morning, and astonished by all the green stuff in the fields.  He was surprised to find he could feel the sheep being startled by the sun that morning, and the morning before, and being startle by a clump of trees the day before that.  He could go further and further back, but it got dull because all it consisted of was sheep being startled by things they’d been startled by the day before.

The market, it would appear, also learns very little on its journey through life, because it has seen a situation like this before, and it’s now doing the EXACT SAME THING.  Not so long ago, they completely destroyed several major Asian economies by completely, for lack of a better term, loosing their shit when a few hot properties ended up been all flash and no substance.  This is because investors panic easily and can cause a local crisis to go global in a matter of days.  It has taken a bit longer, but we’re now seeing the same thing happening to the Eurozone.  When confronted with bad news, the majority of investors seem to react in a panic of “Oh my god!  The world is ending! Sell, sell sell!  For the love of God, SELL!”

One thing that would surely bring us out of this downward spiral is if investors everywhere stop, take a deep breath, look around and realize that their frantic behavior, penchant for panic, and astounding ability to make sweeping generalizations causes many of the things that they panic about to happen when they arguably otherwise wouldn’t.  Instead, when a fairy doesn’t wave a magic wand and instantly fix the world economy, they act just like my favorite rendition of sheep.

Also: Points for understanding how much of a geek I am for writing that alternate title.