[Krugman] Why aren’t markets freaking out? | “My read of financial history is that markets almost never consider the possibility of huge, disruptive events, even when the strong possibility of such events is obvious. The usual pattern is one of market complacency until the last possible moment”

> So why aren’t markets freaking out? Nations in which central banks lose their independence sooner or later suffer high inflation, especially when they are taken over by autocrats who buy into crackpot economic doctrines. And Trump, who has been demanding large rate cuts because, he claims, the economy is running hot — which almost every economist would say is a reason to raise rates, not cut them — certainly fits that pattern. Yet although there have been small tremors in the bond and currency markets, there have been no significant upheavals in financial markets that reflect the severity of the situation we are in. Throughout this episode, the stock market has remained fairly flat and bond yields haven’t spiked.

> Why not? Do financial markets doubt that Trump will get his way? Or do they reject mainstream economics and the clear examples of countries like Turkey and Argentina?

> Neither. My read of economic and financial history is that market pricing almost never takes into account the possibility of huge, disruptive events, even when the strong possibility of such events should be obvious. The usual pattern, instead, is one of market complacency until the last possible moment. That is, markets act as if everything is normal until it’s blindingly obvious that it isn’t.

> The inimitable Nathan Tankus summarizes this by saying that the market is not, as stylized economic models would have us believe, a mechanism that pools the knowledge and informed judgment of millions of investors. It is, instead, a “conventional wisdom processor.” That is, it reflects views that seem safe to hold because many other people hold them — and the crowd only abandons those views when they become blatantly unsustainable.

> Can I document these assertions? Let’s look at a couple of relatively recent examples of market complacency and myopia in the midst of clear signals of an oncoming crisis.

# The GFC

> First, the subprime crisis of the 2000s. By 2005, at the latest, there were very good reasons to suspect that we were in the midst of a major housing bubble. Here’s a graph of one measure of housing overvaluation, the ratio of home prices to average rents:

> When home prices are very high compared with average rents, that indicates the likelihood of a bubble because, ultimately, the value of the house lies in its use as a place to live.

> The shaded area starting in late 2007 is the Great Recession. Now, one could try to rationalize the extremely high prices of houses relative to rents in 2006. But an honest assessment would at least have reflected the serious possibility — not the certainty — that there was a bubble in house prices during this period. It would also reflect the possibility of a flood of mortgage defaults when the bubble popped.

> Yet ABX indices, a measure of perceived default risk on securities backed by subprime mortgages, didn’t show any serious decline until well into 2007, when the housing bubble had already been deflating for more than a year:

# The 2009 Euro zone crisis

> Another example of market complacency is the euro area crisis that began in 2009. By the mid 2000s it was already obvious that huge sums of money were flowing into southern European nations like Spain, where they were being used largely to finance highly speculative real estate investment — very much like the US sub-prime bubble.

> Even if it was unclear that the flood of money would abruptly end — a nasty “sudden stop” – the possibility of such a stop should have been reflected in bond yields.

> Yet the spread between interest rates on Spanish and German bonds — a measure of the risk markets perceived that Spain would experience a crisis — stayed very low until the crisis was already underway:

> So if you want to know why markets aren’t reacting to the risk of very bad policy if Trump takes over the Fed, you should know that major market reactions to that kind of risk are rare. In fact, I can’t come up with a single example.