The Wisdom of the Markets

"Because crises can be self-fulfilling, sound economic policy is not sufficient to market confidence - one must cater to the perceptions, the prejudices, the whims of the market. Or rather, one must cater to what one hopes will be the perceptions of the market. And that is how the Keynesian compact [my words: the logical and proven understanding that recessions are managed by decreasing interest rates or increasing budget deficits - less taxes more spending] got broken: international economic policy ended up having very little to do with economics. It became an exercise in amateur psychology, in which the IMF, and the Treasury Department tried to persuade countries to do things they hoped would be perceived by the market as favorable."

The quote is from Paul Krugman's "The Return of Depression Economics", which outlines the lessons that should have been learned from countless previous crises, mainly, in Latin America and Asia and that should have been applied to the now largely gone subprime mortgage crisis and the increasingly looming threat of the fiscal crises in debt-burdened economies around the Western world.

While the economic soundness of the decisions that the Euro zone is making as a response to Greece's dire financial state can and should be debated by those with more knowledge of the field of economics than myself, the fact remains that there is a very real sense that the value of any decision taken is measured by the market's reactions rather than by its potential to remedy the situation at hand. People may point out that the market's reactions should depend on whether a particular course of action is beneficial or not. Yes, the reaction should depend on the validity of a decision; however, it does not because of differing time horizons and incentives.

The role of policy makers is to ensure that the long-term prospects of the country are favorable while investors are motivated by the same thing that most other business people are motivated by - short-term profits. Why have we entrusted so-called investors with deciding what a good company and a good country look like? Surely, a good company is defined as a well run organization with a clear and sustainable strategy, not necessarily one with high stock valuation - more often than not a reflection of a company's balance sheet than of its strategy. Likewise, a good country is surely defined as one in which its citizens live in peace and harmony, have access to basic necessities and have the possibility to make an honest living, not necessarily one which can convince the markets that it will not default on its debt obligations.

Regardless of whether the current market-led system is ideal or not, the fact remains that it is what we have to contend with nowadays and largely because of its self-fulfilling ways, we are now looking at a fiscal budget crisis as we begin to emerge from the worst recession in a life-time.