Last Updated Sep 26, 2011 10:39 AM EDT
I used this equation about a year ago and I'm trotting it out again to explain why stocks slumped this week. A year ago, the same two issues that we face today were casting a pall over global stock markets: slow global growth and the European debt crisis. This year, it's time to add a "twist" -- investors have lost the confidence that either central banks or governments can address either of those issues effectively, which has thrown everyone into a full-fledged tizzy. I discussed the trading on CBS Evening News with Russ Mitchell:
The summer of our discontent started with the debt ceiling debacle in Congress. Investors watched with dismay, as politicians appeared to be driving the U.S. economy off the cliff. The resolution came just in time, but not without draining investors' nerves.
As the U.S. soap opera was playing out, the Greek drama continued to unfold, as European leaders promised action (it was serious enough to interrupt the beloved European summer vacation for all of the leaders!), but seemed incapable of coming together and creating a real plan of action. The EU, ECB and IMF are loathe to say this, but here's the deal: Greece is flat-broke and the country itself, as well as the European banks that lent it money, will bear the costs together. The constant delay in speaking the truth is only making matters worse and ratcheting up investor anxiety.
Here's how this all plays into the latest round of stock-selling around the globe: coming into the week, investors drove up stocks by five percent, buoyed by hopes that the Fed would throw the economy a lifeline and that European leaders were starting to get nervous enough to actually do something meaningful.
Unfortunately, the Fed's acknowledgment that the economy is slow and Europe is a mess was far more powerful than the introduction of a new policy that will swap $400 billion of short-term bonds for long-term ones. In Europe, the inaction among government leaders trumped this week's announcement by the EU, ECB and IMF that they were working together on a solution to the Greek debt crisis.
Investors and citizens are tiring of the words. Who cares if finance ministers from the G-20 leading economies pledge to take "all necessary actions to preserve the stability of the banking systems and financial markets"? We need specific actions to assuage us because neither global central banks nor government leaders have addressed slow growth or the European debt crisis in a meaningful way.
Maybe the answer is that leaders think we mere mortals can't handle the truth about where the global economy stands. History tells us that when economies experience asset booms (think housing 2000-2006) that are financed with lots of easy lending, the subsequent bust is deep and the recovery is long and painful. How long? According Carmen Reinhart and Ken Rogoff, authors of "This Time is Different: Eight Centuries of Financial Folly", usually 7 to 10 years.
The Oregon Office of Economic Analysis has recently updated the Reinhart/Rogoff thesis and has a sobering conclusion: "the recent U.S. financial crisis looks very similar to the historical crises as detailed by Reinhart and Rogoff - your "garden variety, severe financial crisis."
If we are simply repeating history, then it looks like the next 3-5 years are going to be muddle-along ones. Until investors accept this potential outcome, they will continue to be driven by bouts of buying of selling, as they swing between their two basic emotions: fear and greed.