Exogenous Shocks, Events, and Unknowns

Economists call them exogenous shocks. One-time British Prime Minister Harold Macmillan called them “Events, dear boy, events.” Former US secretary of defense Donald Rumsfeld called them “unknown unknowns.” Investors care less about the precise label than the fact that the world seems a scary place. Never mind that almost all of the economic news in America is good: the economy is growing again; corporate profits are up and mortgage rates are down; retailers’ first quarter profits are 26% above last year’s level, and bankers have had the best quarterly profit performance in two years; home building is up; inflation is at a 44-year low; and the Chinese are again buying US government IOUs.

But the happy economic news is accompanied by disturbing news on a variety of fronts. Israel seems to have botched an attempt to prevent Hamas from re-arming in Gaza, increasing tensions in the Middle East. South Korea has promised to block passage of North Korean ships through its waters. Only terrorists’ incompetence prevented disasters in New York and Detroit. Worst of all, America now seems so impotent that its former allies, Turkey and Brazil, have signed up with Iran in its fight with the US over sanctions.

In short, the world’s policeman has left the international beat. Worse still, that cop has decided to patrol the domestic beat, without too much regard for the consequences of his inability to distinguish the good guys from the baddies.

The financial overhaul bill wending its way to the president’s desk, whatever its virtues, and there are several, will likely lower bank profits and their credit ratings, forcing them to be even stingier with potential borrowers. The Securities and Exchange Commission has adopted new rules that will make it more difficult for US money market funds to continue providing wholesale funding to European banks

Congress is about to take up the cap-and-trade bill that will drive up energy costs, and is planning to impose new taxes on multinational businesses, investment managers, and hedge fund operators. No one can predict the consequences of these moves, adding to the uncertainty that markets loath.

Then there are the problems in Euroland, which threaten US banks that do business over there. We accept, reluctantly, that some institutions are too big to fail. When Greece was bailed out by its Eurofriends we found that there are countries too small to fail. With Spain experiencing difficulties, we are told that medium-size countries are, well, too medium-sized to fail. Allan Meltzer, economics professor at Carnegie Mellon University, famously said, “Capitalism without failure is like religion without sin.” He was right: there is now every reason for governments and big banks to believe they can spend and take risks, failure no longer being a possible penalty.

Of course, investors who value a good night’s sleep above all else can flee to the dollar, as many are doing. But as they nod off they just might have a nightmare or two. The Federal Deposit Insurance Corporation’s list of “problem” banks now runs to 775 institutions, some 10 percent of the US industry, compared with 252 at the end of 2008. These mostly smaller banks have taken on property loans that are unlikely to be repaid in full.

More important, there is no end in sight to the deficits the government is piling up. Indeed, earlier this week presidential adviser Larry Summers urged congress to pass a second stimulus package.

Which means that inflation is one of the nightmares that those fleeing to the safety of US government bonds will have. Some wake in a sweat and rush to buy $1,200 gold, or other commodities. Others give up, and decide that since they can’t really protect themselves against exogenous shocks, events or unknowns, all they can do is fret.

Dr. Stelzer, director of economic policy studies at the Hudson Institute, is a columnist for the Sunday Times of London. A former managing director of investment banking firm Rothschild, Inc., he earned his doctorate in economics from Cornell.