DeLong on the $20 trillion dollar mystery

Brad can't understand how a $2 trillion mortgage loss can destroy $20 trillion in value in the world's capital markets. He does a good job of laying out the mystery here:

[First list 5 factors that affect market value of capital stock:]

(1) Savings and Investment
(2) News
(3) Default Discount
(4) Liquidity Discount
(5) Risk Discount

...In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values.

The problem is made bigger by the fact that for (4), the Federal Reserve, the European Central Bank, and the Bank of England have flooded the market with massive amounts of high-quality liquid claims on governments’ treasuries, and so have reduced the liquidity discount — not increased it — by an amount that I estimate to be roughly $3 trillion. Thus (3) and (4) together can only account for a $3 trillion decrease in market value. The rest of that decline in the value of global capital — all $17 trillion of it — thus comes by arithmetic from (5): a rise in the risk discount. There has been a massive crash in the risk tolerance of the globe’s investors.

Thus we have an impulse — a $2 trillion increase in the default discount from the problems in the mortgage market — but the thing deserving attention is the extraordinary financial accelerator that amplified $2 trillion in actual on-the-ground losses in terms of mortgage payments that will not be made into an extra $17 trillion of lost value because global investors now want to hold less risky portfolios than they wanted two years ago.

From my standpoint, the puzzle is multiplied by the fact that we economists have what we regard as pretty good theories about (4) and (5), and yet those theories do not seem to work at all....

...Things are even worse as far as the risk discount is concerned. Our models predict that in normal times, with the ability to diversify portfolios that exists today, the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times — and more like 10% per year today. And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level but that has led to ten times the total losses in financial wealth of the impulse.

Short answer for physicists: phase transition in investor sentiment. People woke up one day and realized that the black box utility called "finance" (on which society relies so heavily) may not actually work properly. So they lost confidence, which is hard to regain. The importance of confidence is clear once we admit that most of the workings of financial markets are indeed a black box -- few people understand what is really going on. The same is true for individual companies -- we assume management knows what it is doing, until we realize otherwise. We might have a similar sudden shift in societal risk attitudes if, for instance, it were suddenly revealed (e.g., by the explosion of a submarine taking San Diego with it) that nuclear reactor and weapon designs were faulty and that random megaton explosions should be expected every decade or so.***

(Oh, and there's also the matter of CDS markets, a big amplifier of uncertainty and systemic risk which Brad doesn't mention at all.)

Some of this is explained in my talk. See also this paper for references to agent-based simulations which exhibit phase transitions in sentiment (bubbles and crashes). The intellectual toolkit of neoclassicals like Brad tends to focus on equilibrium ideas, which are unable to explain such phenomena. More discussion here on Arnold King's blog. I also recommend Bill Janeway.

Final technical point: it is very wrong to back out the implied total market capitalization from trades executed by a minority of distressed agents. A market cap extracted this way will inevitably exhibit wild fluctuations. Confidence in this quantity relies on particularly unwarranted efficient market assumptions: that markets (even in periods of dislocation) are the best forecasters of real economic value (discounted future cash flows).

*** You might try to accommodate events into a story of weakly efficient markets -- we received a shock or infusion of information (news) that caused a sudden revaluation. But the story doesn't work so when well the actual news is "financial markets are highly unreliable" or "nobody really understands this system as it is too complex" -- if that's the news, how efficient are / were markets? :-/