Pavlovian Reflex

Jean-Marie Eveillard made some fascinating and insightful (at least in my mind) comments in the October 24 First Eagle Funds conference call. He made these comments right before the NASDAQ made a multi year high coming off the August lows.

The second thing that strikes me is that over the past 20 years there have been six financial crises: October '97, 1990, which already was somewhat real estate related, late 1994, the Mexican crisis, '97 to '98, the Asian Crisis, the Russian Crisis and then the failure of long-term capital management, the hedge fund, where the Fed had to organize a bail out, not of a bank, but this time, of a hedge fund. Then, in 2000, there was the bursting of the technology/media/telecomm bubble. And the sixth one, two months ago, was the sub-prime crisis, sub-prime housing crisis.

Now, the first five crises were handled by Greenspan, who flooded the system with liquidity and the crises passed fairly quickly. The last crisis was handled by Mr. Bernanke and he took the same attitude, flooded the system with liquidity. And, the consensus today I believe, among investors, since we are almost—we are back to all time highs in the American equity market then—it’s the consensus of other investors as well, since foreign equity markets are also back to their highs. So the consensus is that the crisis has come and gone, the crisis of two months ago has come and gone.

Now, it’s almost a Pavlovian reflex because if five financial crises were handled relatively quickly with no major negative economic consequences, then the assumption has to be that the sixth one will also be handled relatively quickly and with no major economic slow down or recession. And that may very well happen and maybe the odds are pretty good that it will happen. At the same time, it seems to me that the Fed is walking a fine line. On one side of the line, cutting short some interest rates to the point where the decline in the US dollar gets disorderly, although, it’s in nobody's interest admittedly that the decline get disorderly, and/or that domestic inflation perks up.

On the other side of the line, the risk is that cuts in short-term interest rates—because the housing bubble was so gigantic—that cuts in short-term interest rates would not be enough to prevent the economy from, the American economy, from going into a major slow down or even a recession. Now again, the odds may be good that both risks will be avoided. But at the same time, you know, as Peter Bernstein says, sometimes what matters is not necessarily how low the odds are that something will happen. What matters sometimes more is what the consequences would be if that something were to happen.

I had not thought of the the Pavlovian reflex point. It had me thinking all last night.