Fear of cliffs

If you expected an article about the white cliffs of Dover, you will be sorely disappointed. I am referring here to cliff events in the context of the economy.

In recent days there have been frantic efforts by many in the government egged on by many reputed economists including advocates of free markets to intervene in the market and prop up failing institutions. They have intervened, but seemingly to little effect. What's going on? Why is there such a panic?

Underlying the theory of free markets is an assumption that free markets, even when not perfectly efficient, are mean reverting. This is why advocates of non-intervention speak of "market correction". The idea is that while there can be a distortion in value for a time, ultimately everything will automatically revert to a true value. Of course, this view assumes the existence of such am invariant 'true value'.

There is, however, a more interesting set of theories that have been evolving that postulate that natural systems, including financial markets are chaotic. This means, that while they may occasionally appear to be mean reverting, there is no reason that they should revert to a mean. Instead, even small changes can have extremely magnified effects resulting in a different level in the long run. In such systems, small changes can have huge, often catastrophic effects. Examples of such chaotic changes are literally the straw that breaks the camel's back or the butterfly effect. In this view, there are times when a financial system like the economy can stand at a brink, where on one side, it seems unwell but curable, and on the other it faces complete ruin.

Let me illustrate with an example.

In the early part of this decade, as Enron devolved into a financial debacle, disclosures made to ratings agencies put the ratings agencies in a quandary. On the one hand, if they continued to maintain the same credit rating, then it was possible that in the interim time the company could find a way to pull itself out of the mess. On the other hand, if they reduced the rating, then it would automatically trigger a series of obligations that would hinder Enron's ability to borrow. The resulting mess would lead to further downgrades, and so on, quickly reducing Enron to junk bond status.

This was an example of a credit cliff. It's a situation where a small change in the conditions, i.e. Enron's credit rating, could push it over a cliff.

Two things to note.

• Firstly, the cliff was characterized by the value was driven belief that was ultimately self referential - i.e. it had value because people believed it had value. It was solvent as long as people believed that it was and would continue to be solvent.

• Secondly, the fiction was ultimately unsustainable.

How does this relate to the US economy? Well, you see, all those panicking economists are actually worried that the US economy is at such a cliff. The value of US companies, US markets, US debt and ultimately the US economy is ultimately dependent entirely on everyone's belief in the US economy and its ability to survive this crisis.

The problem is that the US economy as a whole is over-leveraged and over valued. The US need a HUGE amount of money to dig itself out. The only way for the US to get that money is that everyone continues to believe in the US.

With huge foreign holdings of US debt and US investments, if people suddenly started to doubt the US and started to disinvest, then the US economy could, in theory, collapse. The problem is that unlike the mean reverting view, in this view, the new equilibrium would leave the faith in the US economy so damaged that it would permanently destroy the US economy's value, and the US would never completely recover.

The Fed's experiment with Lehman caused a crash that has everyone spooked. They won't try it again. No other large US brand name can be allowed to fail. What the US government, Fed and all those illustrious economists are hoping is that if they can just hold on long enough, things will get better. They are banking on the assumption that it's in no one's interest to let the US fail. The alternative is a complete collapse of the US economy.

Are we really at such a cliff? Who knows? But you don't really want to find out by stepping off the ledge, do you?

However, note that all these interventions maintain a fiction. They keep you on the right side of the ledge. They don;t get you further away from the ledge. In fact, in some ways, they lift you up a bit, making the fall, if it comes, all the worse. So long as there is no catastrophic collapse of the economy, you could say these measures are working. But you are still at the edge.

To fix things, we still need to fix the underlying problem - asset price inflation. There are only two solutions. Either let the asset prices deflate. Or, let them stagnate until the value increases to the price. Neither is attractive. Both take time, maybe years. And, remember the second lesson from Enron is that ultimately the fiction can only maintained for so long. Let's hope the creditors of the US economy are more patient.