Deep funk in Financeland: Wall Street investors are gripped with fear, uncertainty, and pessimism about the future - since September 11th

International Economy, The, Nov-Dec, 2001 by Christopher Whalen

In the months since September 11th, two things have become clear to investors: First, the U.S. economy has been in a recession during 2001. Second, the once glib rhetoric about "free markets" so fashionable on Wall Street during the height of the Internet hype has been in favor of calls for speedy salvation from Washington in the form of government loan guarantees, tax cuts, and lower interest rates.

The idea that Washington can "stimulate" the economy is a neo-Keynesian illusion, the sort of socialist claptrap that passes for mainstream economics on Wall Street. Most Wall Street folk are politically left of center, meaning that they privatize the profits and socialize any losses. This fact is demonstrated by Senator John Corzine (D-NJ), the one member of Congress smart enough to ask U.S. airlines for equity warrants in return for government loan guarantees. When things get rough in the "free markets" Wall Street leaders grab for cheap money from the Fed followed by tax cuts, preferably on capital gains. The goal of current policy moves by the Fed is to make investors think the economy is improving, as illustrated by the Street's effort to convince investors that corporate earnings will improve in 2002. Once confidence is restored, the folks at CNBC tell us, the U.S. equity markets will rebound.

The year 2001 was one of the worst in generations for both stocks and bonds. Acknowledging that the U.S. economy is far weaker than Wall Street supposed even six months ago is the beginning of the process toward true recovery. But accepting that neither the Congress nor Federal Reserve Board can do much in the short run to affect an economy fueled by a speculative bubble on Wall Street is the real lesson of 2001. If there had been no terrorist attacks on September 11th, the U.S. financial markets might have taken longer to reach the lows achieved during 2001, but the result would have been the same.

In a strange way, the attacks on the World Trade Center ripped away the last remnants of the once infectious optimism created by the Technology-Media-Telecom investment bubble. The reality of death that touched so many average citizens also sobered up many traders, bankers and fund managers, ending the illusion of an economic rebound at the end of 2001. While investors once paid heed to such indicators as earnings estimates from sell-side analysts at major brokerage firms, the emphasis now is on preserving capital as pessimism spreads from Wall Street to Main Street.

"Market participants may not have considered the logical progression of the current severe U.S. economic contraction," says financial analyst Michael Belkin. "The World Trade Center attack accelerated the velocity of the downturn created by the collapse of the Greenspan speculative bubble. The shock of the WTC attack will pass, but the fundamental imbalances of the U.S. economy will take longer to liquidate. Greenspan sent deceptive signals with all those bailouts and smoothings of the business cycle in the 1990's. Businesses that believed those false signals from the Fed now find themselves overextended and overstaffed. Investors still relying on Greenspan smoke signals and looking for a V-economic bottom and equity market rebound need a reality check."

The biggest problem facing the U.S. economy and the financials markets is not the level of risk, but the large degree of uncertainty about the future. As Belkin and others suggest, the markets know that things are bad now. What they are looking for is an indication that the economy is going to improve tomorrow, whereupon the buying frenzy will begin anew. It is relatively easy to calculate the risks and returns on U.S. securities at current levels. But what investors cannot discern is whether another random, external event like the suicide attacks on the World Trade Center and the Pentagon will throw all of the financial analysis down the dumper.

In an essay published by Kudlow & Co., William Kucewicz, editor of Geolnvestor and a former editorial board member of The Wall Street Journal, reminds us of the work of the late Frank Knight of the University of Chicago. He writes:

   "Knight was the first to draw a clear distinction between risk and
   uncertainty. He defined `risk' as measurable uncertainty that can be
   determined by objective analysis based on prior experience and
   `uncertainty' as unmeasurable uncertainty that is of a more subjective
   nature because it is without precedent. Risk is dealt with ever day by
   weighing probabilities and surveying options, but uncertainty can be
   debilitating, even paralyzing, because so much is new and unknown."

Because Americans doubt Washington's ability to control the future, both regarding economic policy and the broader U.S. response to the threat of terrorist attacks, investors and consumers are less willing to take risks. Whether this involves a decision to buy stock, order new equipment for the plant, or purchase a new car, for many people the future is on hold. The attack on September 11th has not only amplified the recession that was already underway, but it makes a quick recovery less likely because uncertainty has become the dominant factor in people's minds.