muted optimism: better policy, small signs of economic revival, and a sense that we already have absorbed a punch of historic proportions

TO BE NOTED: From Business Week:

This Market Rally May Be for Real
Better policy and a shrinking trade deficit, in addition to clues from history, argue for muted optimism

By Michael Mandel

Predicting the stock market is a dicey game. Back in October 2008, when the Standard & Poor's 500-stock index was at 940, I announced on my blog Economics Unbound that I was moving some money back into equities. At the time, I wrote: "Even if the market and the economy keep going down for a while (including today!), this strikes me as a good time to invest."

After that ill-fated post, the market went into a tailspin, hitting a closing low of 677 on Mar. 9. Stock prices, adjusted for inflation, fell back to 1995 levels, wiping out almost 15 years of gains. Many investors wondered why they even bothered.

But now, with stock prices up 20% since the low, I'm ready to take another shot at calling the bottom. The reasons for muted optimism: better policy, small signs of economic revival, and a sense that we already have absorbed a punch of historic proportions. The downside: stubbornly high unemployment.

not as vulnerable

What are the arguments that this rally will not fizzle out soon? Since the low point, the Federal Reserve and the Treasury have unveiled plans to pour as much as $2 trillion into the financial markets. That's a lot even in an economy as big as America's. "I don't think anyone is doing backflips and saying 'mission accomplished,' " says Ethan Harris, co-head of U.S. economics for Barclays Capital (BCS). "But the basic difference is that policy has entered in full force."

Meanwhile, the economy has shown tentative signs of coming back to life. For example, on Mar. 25, the Census Bureau announced that new orders for durable goods, such as computers, rose by 3.4% in February, the first gain in seven months. Equally important, the trade deficit in January narrowed to an annual rate of $430 billion, or 3% of gross domestic product. That's down from 5% a year ago. As the trade deficit shrinks, the U.S. has to borrow less from China and elsewhere to finance imports. That, in turn, means America's financial markets become less vulnerable to turmoil in other parts of the world.

History also offers clues about the future. The positive news: The average financial crisis has resulted in a 55% real drop in stock prices, according to economists Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University. If U.S. stock prices stopped falling now, that's almost exactly what our decline would be, putting us in line with experience. The bad news from history: The U.S. equity slide is only 17 months old, while most equity downturns triggered by financial crises last three years or more. "I don't think we can take too much encouragement in the fact the S&P 500 reached the typical fall of 55% so quickly," Rogoff says.

what could go wrong

Plenty of things could still go wrong. The sudden insolvency of a few governments in Eastern Europe or elsewhere could snuff out investor optimism. Joblessness in the U.S. poses a challenge, too. According to Reinhart and Rogoff, the typical financial crisis pushes up unemployment by some seven percentage points over five years. If the U.S. follows that pattern this time, the jobless rate would rise until 2012, eventually reaching 12%. With so many people out of work, companies would struggle to make good profits.

For sure, stocks could suffer another downward lurch. But despite the collapse that lies behind us and the undeniable problems ahead, this might be the moment when the market begins its next sustained climb.

Mandel is chief economist for BusinessWeek."

increasing the amount spent on R&D and innovation does not lead to diversification and a reduction of uncertainty

From Business Week:

"The Reverse Black Swan, Part I

Posted by: Michael Mandel on April 01

I recently reread The Black Swan and came to a surprising conclusion: Once I looked beneath the snarkiness, Nassim Nicholas Taleb’s book is brilliant—and I don’t use that term lightly. Yes, it is still true that Taleb is a confirmed pessimist and I am a confirmed technological optimist. But he’s gotten hold of fundamental truths which have changed some of my views about innovation and growth.

In particular, Taleb has a persuasive argument for why the economy, the financial markets and technology are fundamentally unpredictable in both directions—up and down—and why we should care.

Let’s start with the small reasons to like Taleb. First, he does a great job of nailing the bankers. He writes that the bankers:

are not conservative; just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug.

(Remember that the book was published in 2007, before the crisis really took hold). In the same vein, Taleb writes that

people are often ashamed of losses, so they engage in strategies that produce very little volatility but contain the risk of a large loss—like collecting nickels in front of steamrollers.

Bingo—that’s exactly what the banks did.

But prescience about the crisis is not the only or even the most important reason to take Taleb seriously. His big innovation is that he has the best approach that I’ve seen for thinking about “fundamental unpredictability.”

The question of economic and technological unpredictability has been a top concern of mine for many years. In my 1996 book, The High Risk Society, I argued that “economic growth is disruptive and unpredictable”. In my 2000 book, The Coming Internet Depression, I stressed the increasingly violent nature of the lurches in the economy:

…the process of technological and business innovation amplifies the normal rhythms of the overall economy….The result is that the Old Economy business cycle has been replaced by the New Economy tech cycle: longer expansions, followed by deeper and harsher recessions.

Since then, I’ve repeatedly made the point that technological progress is fundamentally unpredictable (see here and here)

But Taleb has gone far beyond anything that I did—I’m envious and appreciative. His main point is that the world is consistently capable of generating “Black Swans”—outlier events which have an extreme impact, and “retrospective (though not prospective) predictability.” Obviously the current financial crisis is a Black Swan from the perspective of many people.

There are several important implications. First, Black Swans don’t have to be purely negative events—we can have positive or what I would call ‘reverse’ Black Swans as well. The invention of the Internet was a reverse Black Swan—unexpected, extreme impact, and inevitable in retrospect. More generally, the positive Black Swans are the technological innovations which could not have been anticipated ahead of time, and which work so well that we have experienced 200 years of rising living standards, despite the downward Malthusian pressure.

Taleb acknowledges the possibility of positive or reverse Black Swans, though he doesn’t spend much time on them. On the subject of technology, Taleb writes:

Prediction requires knowing about technologies that will be discovered in the future. But that very knowledge would almost automatically allow us to start developing those technologies right away. Ergo, we do not know what we will know.

As a result, going forward, we can view the world as able to produce unexpected positive technological innovations. There is no potential ceiling for growth. In addition, we could easily see a reverse Black Swan—a technological breakthrough that helps pull us out of the downturn.

However—and this is an enormous however—a Taleb-type analysis tells us something else. Because technological innovation really is fundamentally unpredictable, increasing the amount spent on R&D and innovation does not lead to diversification and a reduction of uncertainty. Taleb writes:

In spite of our progress and the growth in knowledge, or perhaps because of such progress and growth, the future will be increasingly less predictable.

This is especially true in the U.S. The way that the global economy developed in recent years, the U.S. has outsourced production to other countries, and kept the high-end task of design and innovation. As Taleb puts it:

The American economy has leveraged itself heavily on the idea generation.

This is precisely the point that I missed in my 2004 book, Rational Exuberance. In that book, I argued that a “hot” financial system—one with lots of highly mobile capital —would boost growth by seeking out and funding the development of the most promising innovations. I also argued that this growth-enhancing effect was worth the added possibility of financial crises. This is what I wrote then:

During boom times, the U.S. is able to fund innovative and growing new businesses with financial instruments--venture capital and junk bonds--that barely exist anywhere else. And then when the inevitable bust comes, the U.S. financial system is highly liquid and far more diversified than elsewhere, able to cope with sharp plunges without freezing up.

Har de har har. How stupid could I have been...

In my (weak) defense, I acknowledged in that book the possibility that the pace of innovation would slow, leading to lower real wages for college-educated workers. What's more, I pointed out that in the absence of innovation:

...it will become a lot harder to service all the debt that companies and people took on during the 1990s. Housing prices will slump and perhaps even plummet.

But despite this nod to the potential Black Swan of the financial crisis, I didn't really wrap my mind around the possibility that all this money out there might not get results. The fundamental unpredictability of technology means exactly that--we could summon up all this capital, and not get the big innovation. The big potential innovations such as biotech didn't take off in the post-2000 era, as was expected. As a result, that big pot of hungry money had no outlet except for housing. The innovations didn't happen.

What did happen was a big negative Black Swan--the financial crisis. And a Taleb-type analysis tells us that such negative unexpected events--a sudden acceleration of global warming, global war, a breakdown of the Internet, you name it--are almost guaranteed over a long enough time span.

So here's the thing. What reading Taleb tells me is that as a technological optimist, I need to accept three statements.

1) Unexpected technological breakthroughs are possible. That's good

2) The timing and nature of the breakthroughs cannot be controlled. That's bad

3) Unexpected large bad events are possible as well. That's bad. In fact, we can get bad events which have as big an impact, in the negative direction, as the technological innovations.

Whew. That's it for this post. In my next post on Taleb, I will talk about the implications of these three statements for financial and innovation policy."