Economics Debrief: Continued Fallout from the Crisis and the Challenges Ahead

Categories: Economics, Equity Investments, Fixed Income, Portfolio Management, Risk Management
Current Thinking

Among the abnormalities of the Great Depression in the 1930s were the brutal violence of the economic cycle and the grim persistence of unemployment — which resonates with us today. Of course, mechanistic comparisons to the past can lead to unhelpful caricatures especially if applying contemporary terminologies that don’t work outside of context. This time around very different economic dimensions have emerged, including excessive public debt made worse by bank bailouts, income inequality, and intergenerational warfare.

One study contends that when the Baby Boomers generation liquidate their savings through retirement, asset prices will depreciate, which will be somewhat inconvenient for the savings of the younger generation. Worse still, when the Boomers extract retirement benefits from the state, a large intergenerational wealth transfer will occur compared to what they have actually contributed. Seemingly though, economic growth is spurred when inequality of income distribution in a country is accompanied by equality of opportunity. In such situations, lower-income individuals have an incentive to work harder to improve their quality of life. No need for a revolution just yet then.

A careful new historical analysis by Carmen M. Reinhart, Vincent R. Reinhart, and Kenneth S. Rogoff shows that public debt overhang that has lasted for a minimum of five years is likely to continue for at least 10 years and on average for 23 years. Not exactly good news, but perhaps a silver lining to the crisis is the finding in another paper that abundant bank liquidity levels, as measured by bank deposits, plays a role in credit booms and asset price bubbles. If we know where the puncture is, maybe we can fix it.

Hopefully the quality of the response from today’s regulators is superior to that of the 1930s. A recent study highlights that long-term investors face economic consequences from short-term regulatory horizons, meaning that regulators and investors are working to different and conflicting timescales. Yet another paper suggest that the Dodd–Frank Act will actually make things worse, because the interaction among the act’s various rules will have a chilling effect on credit availability.

Let’s hope banks don’t make the same mistakes over again, especially since they invest so much in financial expertise by employing well qualified staff. Alas, even that happy outcome is not assured. Research shows that overinvestment in financial expertise can have a destabilizing effect. During times of high volatility, financial expertise causes more trades to break down as a result of adverse selection, partly due to asymmetric information. Even firms with the most experts are surprised and mystified along with other firms when financial crises unfold.

Our team of abstractors from CFA Digest takes a look beneath the surface of economic complexities:


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©iStockphoto.com/JLGutierrez

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