Seeing A Scary Movie For The Second Time

For the second time in four autumns, financial markets are dropping faster than the leaves as investors worry that unpaid debts could trigger a new recession, or even bring down the global financial system.

But this time there is a difference: We have seen this movie before, and we know the ending. Scary movies are never quite as terrifying the second time around. Let’s take a deep breath and watch the rest of the show.

Do you own a bank? Probably not, except maybe in little slices of your stock portfolio, most likely through index funds. Have you lent a lot of money to the government of Greece? I didn’t think so. Are you trying to find a job in Spain, where the unemployment rate is north of 21 percent? Thank your lucky stars that you are not.

If you do not fall into one of the above groups, chances are good that you will survive this adventure.

And if your biggest financial worry is the value of your stock portfolio, ask yourself what you are really worried about. Stock prices move every day for all sorts of reasons, but in the long run, the only thing that matters is profits. If a company consistently makes money, its stock price tends to rise.

Corporate profits are only loosely related to broader economic conditions like unemployment and output growth. Booming economies produce healthier earnings, of course, but businesses can cushion a downturn by reducing production and staffing. Managers have become quite adept at this. Many businesses have also socked away large cash cushions in order to survive a rough patch in the economy or a tightening of credit. We did not see a large wave of business failures even in the worst part of the severe slowdown three years ago. Companies that survive a recession often prosper when recovery comes. Today’s companies are, for the most part, battle-tested survivors.

Last time the problems started on this side of the Atlantic. This time, although our political gridlock is not helping matters, the worst problems are in Europe. Ask yourself another question: If you had to rank Asia, Europe and North America in their importance to the global economy and to U.S. financial health, where would you put Europe? I would put it last on that list. That’s another reason this episode will not be as bad as 2008.

The world really has two major financial problems. First, a lot of money has been borrowed that is not likely to be paid back. Some was borrowed to build and buy houses in the United States and elsewhere, and some was borrowed to finance unsustainable government spending in a lot of places. Fixing these problems requires a couple of steps that are obvious, but still difficult to take.

Step one: since someone is not going to get paid back the money that was lent to now-insolvent borrowers, we have to work out how much of a “haircut” lenders will take, and exactly which lenders will take it. As we showed in the United States a few years ago, if forcing banks to take those haircuts will put the financial system at risk of total shutdown, politicians will bite the bullet and put taxpayers on the hook instead. Voters will be mad, but not nearly as mad as they would be if perfectly healthy companies employing millions of people had to shut down because they couldn’t get credit. This is why Europe will eventually solve its sovereign debt problems without destroying its banks or seriously hurting ours.

Step two: profligate borrowers have to bring their spending in line with their income, because lenders are no longer willing to finance large ongoing deficits. This also makes a lot of voters unhappy, since it implies significant government spending cuts, tax increases and public employee layoffs.

Yet these things are happening right now, all over the world. We are intensely debating spending and taxes here in the United States. The same debates are playing out in the United Kingdom, Italy, Greece and elsewhere. We are still apportioning the costs of the U.S. mortgage meltdown among the various players in our housing market. In Europe, they are only in the early stages of apportioning the losses that will occur when governments fail to repay their debts in full and on time. But the process has begun over there as well.

It turns out that a lot of the global economic growth of the 1990s and 2000s was illusory. It was built on consumption that was paid for with money borrowed from suppliers like China and from future generations of taxpayers. Now we are in a lengthy process of settling the bills and re-setting expectations.

It’s painful, as anyone who can’t find a job or sell a house can attest. It’s scary, as anyone contemplating an investment statement already knows. But it’s transitory, and if it is part of a successful long-term adjustment, it will be worthwhile.

Don’t panic. You have seen this flick before.