Putting the Current Market Turmoil in Context

It is easy to get swept away by the drama of the credit crisis as portrayed in newspapers and other media outlets each day, every day, over and over again. Are the problems real? Absolutely. Do they pose a risk to the US economy and those of other Western nations if not taken seriously? Without a doubt. But are we heading into the abyss of depression and stagnation arising from inflated real estate values and a debt bubble of historic proportions? Unlikely, IMHO.

But regardless of how I might portray today's circumstance in rational, thoughtful, pragmatic terms, Robert Steel (Undersecretary of Domestic Finance) and David McCormick (Undersecretary of International Affairs) over at the US Treasury have already done so in an editorial carried in last week's Financial Times. And they have somewhat more credibility and influence than yours truly. Here are some particularly interesting excerpts:

Despite understandable anxiety over current market turmoil, recent events are unfolding against the backdrop of very robust economic fundamentals. The global economy continues to grow at about 5 per cent annually; overall worldwide growth in recent years has been the strongest in three decades, with emerging markets as a key driver. US economic fundamentals remain strong: unemployment is low, wages are rising, core inflation is contained and our financial system remains well-capitalised.

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Benign market conditions bred complacency and credit discipline deteriorated, particularly in leveraged loans, US subprime mortgages and other, related asset classes. Recent volatility in the credit and mortgage markets reflects a reassessment and a re-pricing of risk, as well as retrenchment from lower-quality and less-liquid assets. This readjustment is a painful reminder of the importance of robust risk management and of the need for investors to properly understand, evaluate and examine risk.

We have also been reminded that when capital markets are globally integrated, disturbances and uncertainty, like capital, also flow across borders. We have seen some improvement in recent weeks, but it will take more time for the impact of these financial market dislocations to play out and for their impact on the global economy to be completely clear.

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...Mr Paulson and his counterparts in the Group of Seven leading industrial nations will ask the Financial Stability Forum (FSF) – a body of finance ministries, central banks and regulatory bodies from leading financial centres created after the Asian financial crisis – for a timely examination of four issues.

First is financial institutions’ liquidity, market and credit risk practices, including treatment of complex credit products and conduits. The second is accounting and valuation procedures for financial derivative instruments, particularly for complex, narrowly traded products that become difficult to price in times of stress. Third is basic supervisory oversight principles for regulated financial entities, especially given exposures to off-balance sheet, contingent claims. And fourth is the role of credit rating agencies in evaluating structured finance products.

From my perspective, Messrs. Steel and McCormick, together with their boss Mr. Paulson, have got it right. Situation is serious. Must act with clear and decisive action. Must coordinate with other major market participants. But don't panic because the underlying backdrop is fundamentally sound. Maybe I'm being a pollyana, but I think this is the right path and the correct interpretation of the facts. Painful, yes. But we'll come out the other end hopefully just a little bit smarter than before.