"If I were the editor of the business section for just one day," wrote the comedian/economist Ben Stein in the Sunday New York Times business section, "I would run one immense headline: 'Everything Is Going to Be Fine. Go Back to Work.'"
The intense aggravation caused to intelligent consumers of economic news by the New York Times' inexplicable decision to keep running Stein's columns is more than adequately expressed today by Portfolio's Felix Salmon, freshly returned from vacation. But if you're looking for the smartest, most cogently argued demolition of the fatuous complacency underlying Stein's "there, there, everything will be just fine, don't you worry your little head over the big bad economy my little snookums" approach to economic analysis, then I recommend reading the concluding remarks delivered by Martin Feldstein at last week's 2007 Jackson Hole conference of the Kansas City Federal Reserve, which was devoted almost entirely to the housing crisis.
Feldstein is a professor of economics at Harvard University and the President of the National Bureau of Economic Research. One of the perks of his NBER job is that he is the man entrusted with the awesome responsibility of officially deciding whether the country has entered a recession. Judging by his speech, the likelihood that he might have to exercise that unwelcome duty may arrive sooner rather than later.
Feldstein isn't responding to Ben Stein; he's summarizing the gist of all the research presented at Jackson Hole and adding his own analysis. The whole thing rewards a close read, but I want to focus on just one section. Commentators such as Stein are wont to emphasize that the subprime mortgage sector is just a fraction of the overall mortgage industry, and, on top of that, only a relatively small fraction of subprime borrowers are defaulting on their loans. So, not to worry. Subprime's an isolated problem, a small part of a big economy. If people would just stop panicking we'd all be OK.
Stein is either willfully missing the point, or just not paying attention. As Feldstein observes, astute financial market watchers have been worrying for years that investors were not properly valuing the riskiness of their investments. One clue to this was that the difference, or "spread," between the interest rates yielded by a U.S. Treasury Bond (traditionally considered an extremely safe investment) and that yielded by, say, some kind of structured financial product whose value was tied to whether a consumer paid off their credit card bill or subprime mortgage, was very small. In other words, the markets were treating riskier investments as if they were as safe as Treasury Bonds. Which, of course, is crazy talk.
Feldstein states that the perception that risk was mispriced was widely shared on Wall Street. But nobody could make a move to act upon this knowledge, because to do so would have hurt them financially. This was especially true for hedge fund managers, whose compensation was tied, in the short term, to their ability to generate positive returns by trading with other people's money.
From Martin Feldstein's "Housing, Housing Finance, and Monetary Policy":
Most of the institutional investors who thought that risk was mispriced were nevertheless reluctant to invest on that view because of the cost of carrying that trade. Since virtually all such institutional investors are agents and not principals, they could not afford to take a position that involved a series of short term losses. They would appear to be better investment managers by focusing on the short term gains that could be achieved by going with the herd to enhance yield by assuming increased credit risk.
But these investors also shared a widespread feeling that the day would come when it would be appropriate to switch sides, selling high risk bonds and reversing their credit derivative positions to become sellers of risk. No one knew just what would signal the time to change.
It was the crisis in the subprime mortgage market that provided the shock that started the wider shift in credit spreads and credit availability.
The subprime crisis revealed that the emperor wasn't wearing any clothes, or at the very least, that no one had properly calculated the risk to the emperor's reputation that would ensue when people realized he was parading stark naked in the street. It was a trigger, or catalyst, for Wall Street to take a long hard look at everything else that might turn out to be as dodgy a bet as wheeling and dealing with repackaged pools of home loans made to people with bad credit. In the aftermath, Wall Street has frozen in its tracks.
Maybe if you're Ben Stein, a credit crunch and a recession are no big deal, a mere squall that can be waited out while in the comfort of your non-foreclosed upon home. But for millions of Americans -- and for the economies of the world whose growth has been fueled by the buying power of those Americans -- a downturn will be no fun at all.