Paul Volcker on the Financial Crisis

Cognitive Dissonance

Cognitive dissonance is a psychological state that describes the uncomfortable feeling when a person begins to understand that something the person believes to be true is, in fact, not true.

Is this a trigger effect for the change in expectations? It appears to be what's happening at the moment in the Irish market (evidenced by Prime Time last night).

Four mega-dangers international financial markets face

Article by Dennis J Snower

Four dangers

The first danger we have witnessed since August 2007: The subprime mortgage crisis gave rise to a liquidity crisis in the international banking system, due to uncertainty about who holds the losses. This is leading to reduced lending to firms and households. But that is not the end of the story, because the reduced lending will lead to reduced consumption and investment. With a lag, reduced sales of goods and services will reduce stock market valuations. And, with another lag, the lower stock market prices will – in the absence of any favourable fortuitous events – intensify the banks’ liquidity crisis.

The second danger lies in the dynamics of U.S. house prices. As more and more U.S. households find themselves unable to repay their mortgages, foreclosures are on the rise, more houses are put on the market, the price of houses falls further – with further lags – this leads to more foreclosures and declines in housing wealth. This dynamic process plays itself out only gradually, as households face progressively more stringent credit conditions and house sales gradually lead to lower house prices.

The third danger results from the interaction between wealth, spending and employment. As U.S. households’ wealth – in the housing market and the stock market – falls, their consumption is beginning to fall and will continue to do so, again with a lag. This decline in consumption is leading to a decline in profits, of which more is on the way, which in turn will lead to a decline in investment. The combined decline in consumption and investment spending will eventually lead to a decline in employment, as firms begin to recognise that their labour is insufficiently utilised. The decline in employment, in turn, means a drop in labour income, which, with a lag, leads to a further drop in consumption.

And that leaves the fourth (and possibly the nastiest) of the dangers, one that concerns the latitude for monetary policy intervention. As the Fed reduces interest rates to combat the crisis, the dollar is falling. This is leading to higher import prices and oil prices in the United States, putting upward pressure on inflation. The greater this inflationary pressure – which is currently in excess of 4 percent – the more difficult it will be for the Fed to reduce interest rates in the future, without running a serious risk of inflaming inflationary expectations and starting a wage-price spiral. U.S. firms and households will gradually recognise this dilemma and the bleak prospect of little future interest rate relief will further dampen consumption and investment spending.