On risk premiums, confidence, and institutional uncertainty

It seems to me, and apparently to many others smarter than me, that business cycles and apparent excess volatility in financial markets are related.  Sometimes (usually?) risk premiums appear too high, other times too low, and much of the fluctuation in asset prices appears to be fluctuations in these risk premia.

So my thought-of-the-moment is that much of what we loosely describe as "confidence" has to do with the amount of institutional uncertainty.  We learn only very slowly about the solidity of our business, financial and regulatory structures.  If everyone in the economy believes these institutions are working well then prices will reflect strongly defined property rights, so risk premia will be low and prices will be high.  If everyone loses faith in these institutions then prices will obviously crash.

All of this has a Chicago-like feel to it.  But there is still room for other important ideas, like sticky prices, which has strong empirical validity and many theoretical explanations.  And while institutional strength would seem to be something that would change slowly over time, market beliefs about it appear highly volatile.  There may be some psychology or animal spirits involved with this apparent disconnect.  The apparent disconnect may also stem from the fact that we don't know how strong our institutions really are, and information about this strength flows slowly and erratically over time.  As a result, a kernel of information (like Lehman's collapse?) can sharply influence beliefs, even if the underlying truth has hardly changed at all.


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