Tuesday, December 07, 2010

Three Stages of Delusion

The first item of John Mauldin's latest (and free) outside the box newsletter does a very nice job of showing the mentality of failure, and gives us even more reason to doubt government officials when they either say "there's nothing to worry about" or "it's someone else's fault". Here's a brief excerpt to give you a sense of it, but the whole first item is worth reading:
The dawning of reality hurts. Prodded and bullied along a tortuous emotional path by events unforeseen and beyond our control, we descend through three phases: the first is denial that there is a problem; the second is denial that there is a big problem; the third is denial that the problem was anything to do with us.

US policymakers’ three steps during the housing crash fit the template well. Asked in 2005 about the danger posed to the economy by the housing bubble, Bernanke responded: “I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.” Here was the denial that there was a problem. But as sub-prime issues arose, Ben Bernanke reassured the world that they would be “contained.” And when Bear Stearns collapsed, Hank Paulson promised “The worst is likely to be behind us.” Here was denial that there was a big problem.

Soon the financial system was on the brink of collapse. There could no longer be any credible denial of the problem, so the locus of delusions shifted: there was a problem, but it was someone else’s fault. Thus a ban on naked short selling of financials was implemented in Sept/Oct 2008, as though the crisis was somehow short-sellers’ fault. (It certainly wasn’t the Fed’s fault, according to the Fed. Ben Bernanke argued this year “Economists … have found that only a small portion of the increase in house prices … can be attributed to the stance of US monetary policy.”)

What’s interesting is that the journey Bernanke and Co. took fits the journeys of policymakers presiding over crises past very closely, as I’ll show inside. What’s worrying is that taken in this context, eurozone policymakers’ denials/reassurances sound eerily familiar. And if these past crises are any guide, the euro crisis is still in its early stages.

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