By Steven Pearlstein
Friday, July 18, 2008

Is this a dagger we see before us, hanging over the global financial system, or a dagger of the mind, a false creation proceeding from the heat-oppressed brains of frightened investors and depositors, greedy short-sellers, short-sighted auditors, and attention-seeking analysts and journalists?

Okay, so I'm no Shakespeare -- I never could get iambic pentameter. What I do know, however, is that Macbeth's famous question is relevant to the unfolding financial crisis. Are the markets reflecting the reality of economic fundamentals, or are we getting lots of false signals reflecting irrational herd behavior?

We confronted that two years ago when people who should have known better assured us that it wasn't a real estate bubble but a one-time repricing of assets reflecting a shift to a period of low interest rates and low inflation.

More recently, some of those same people have been saying that the big flow of investment capital into commodities futures had little, if anything, to do with the dramatic run-up in the price of oil and other commodities -- that it's really all about the growing gap between stagnant supply and surging demand from China, India and other developing countries.

This week, people are wondering whether IndyMac, Fannie Mae and Freddie Mac -- or, for that matter, Bear Stearns -- are really insolvent or just victims of old-fashioned, rumor-driven bank runs.

The answer, of course, is that it's always a bit of both -- rational and irrational, fundamental realities and emotionally driven herd behavior, reality and illusion. Which is why its so hard to figure out what's really going on and what to do about it.

Do market fundamentals usually prevail in the long run? Of course. But as John Maynard Keynes famously quipped, in the long run we are all dead. What Keynes understood, and too many keep forgetting, is that those fundamentals can take years to finally assert themselves -- on the way up as well as on the way down. It is during those periods of irrational exuberance and panic that so much damage is done, both by those participating in the markets and those who are supposed to regulate them.

There is a certain pattern to all this. Those who deny a bubble is developing invariably hail from the industry that is profiting most from the bubble, aided and abetted by economists whose mental models assume away the very irrationality they claim they cannot see in the data before them. When anyone suggests that maybe government should cool things down, these bubble-deniers unleash a furious lobbying effort warning of all manner of economic calamity if anything is done to tamper with free markets.

And yet when the bubble bursts and prices begin to plummet, invariably they are first to complain that markets are acting irrationally and demand that government step in to calm the waters.

Those who are clever enough to see the bubble aren't immune to the same syndrome. Because they had so much investment, emotional as well as financial, in their against-the-grain stance, when the bubble finally bursts they see confirmation that they were right in every piece of bad news, forgetting all about what they once said about the irrationality of the herd. As they see it, the market has suddenly come to its senses.

So how do we apply this wisdom to the current crisis?

First, we might suspect that investors have become overly pessimistic about financial institutions as a class -- in particular, Fannie Mae and Freddie Mac. The mortgage giants have plenty of cash coming in, continued access to the bond market and newly approved access to the Federal Reserve's discount window.

More significantly, there's been no new information that could justify the dramatic decline in their stock prices -- nothing, that is, other than a news leak that the Treasury was preparing some contingency plans in case things started to unwind. That's the kind of news that quickly becomes self-fulfilling in a volatile market. But contrary to what you've heard from gleeful critics, it hardly constitutes proof that Fan and Fred are insolvent or that the public-private model on which they are based is fatally flawed.

The lessons of bubbleology also suggest that speculation is a significant factor in the run-up in commodities prices. Yes, we should have expected to see commodities prices rise steadily over a several-year period until supplies could catch up with the increase in demand from emerging countries. But no changes in the fundamentals can possibly explain the sudden and dramatic price increases over the past year. It's also rather suspicious that these price spikes coincide with a big influx of money into commodities futures from pension, endowment and mutual funds.

This has all the markings of a self-reinforcing process in which higher prices beget higher prices, a.k.a. a bubble. Suppliers stop worrying about price declines and decide not to sell their commodities forward, while buyers of commodities feel even greater need to buy futures contracts to hedge against price increases. And the more futures prices rise, the more financial speculators pile in.

The good news is that Washington has finally acknowledged the serious damage to the real economy that can happen when markets turn irrational. Over the past two days, the mere threat that Congress may authorize regulators to raise margin requirements on futures contracts has triggered the biggest decline in oil prices in more than three years. And the emergency order by the Securities and Exchange Commission outlawing "naked" short-selling of key financial stocks sparked a huge rally in those stocks, as shorts scrambled to buy the shares they never owned but had promised to sell.

Don't get me wrong -- there's plenty of bad news ahead, as we learned yesterday from those bubble deniers at Merrill Lynch. But remember that, in economics as on the Shakespearean stage, the only thing more dangerous than assuming the best is for everyone to assume the worst.

Steven Pearlstein will host a Web discussion at 11 a.m. today at washingtonpost.com. He can be reached atpearlsteins@washpost.com.