I just read a great post that may be a key to understanding both the course of the economy and the public sentiment about government policies.
David Merkel suggests that people are unhappy with the unfairness of government policies.
I would go even further. People have overwhelmingly come to the conclusion that they need to reduce their own debt. Many, many people are enduring what they think of as hardship (by ceasing to spend money that they do not have) to bring down their personal debt level. At the same time, they see the government adding to the public debt. People are not stupid. They think of the government debt as THEIR debt. So they are economizing for naught if for every dollar of debt that they reduce, the government adds a dollar of debt.
Perhaps some day someone will discover a Pelzman effect like mechanism at work with regard to debt. During the credit bubble that led up to the financial crisis, people where almost totally insensitive to the level of debt. But now there is a high degree of sensitivity. So if people feel that there is a right level of debt, then they will take actions to get to that level. If the government works against that effort, then they will adjust their personal targets so that the aggregate of personal and public debt comes into line with their perceived optimal level of debt. This may not be because they set a specific target, but because the rising level of public debt makes people uncomfortable and they express that discomfort in the way of looking for more security and less debt.
So maybe the extreme cutting of government spending that is happening in the UK is what is actually needed. Because the government actions do not exist in some “all things being equal” economics textbook argument. Government policy and the economy exist in and among the people of the world.
It is widely known that household consumption is a large fraction and major driver of the GDP in the US. So if we want the GDP to grow, we need to do the things that will get households spending again. Not in an all things being equal world, but in the real world with real people.
An interesting wrinkle to this is that the Keynesian ideas of using government spending to get out of the Great Depression did not work until the spending for WWII came along and the war spending did the trick. Some economists have suggested that showed that a larger amount of government spending was needed than was tried prior to WWII. But the ideas above – that the government spending will not be effective if the people want to save may have kept the earlier spending from working. The spending for WWII may have worked though BECAUSE people thought of that spending as having its own merits. WWII spending was necessary.
So perhaps government spending cannot go against the grain of public sentiment to overcome the Paradox of Thrift, unless the public believes that the spending is necessary.
And now to finally link this discussion to risk and risk management…
Perhaps Greenspan is right when he says that he did not know how to pop a bubble. Maybe that is because he did not believe that he could have changed public opinion about the value of an asset class. He could take actions that might temporarily hurt the value of an asset class, but it was quite possible that the public attitude would swing right back and keep inflating the bubble in spite of the actions of the Fed.
The same thing certainly has been true within firms. When the risk manager finds him/her self at odds with the prevailing idea in a firm about a risk, he/she is more likely to lose their job than to change the prevailing opinion.
So in all three cases, in the general economy in severe recession, in an asset bubble and in a company overconfident about a particular risk. the only actions that can be effective will be actions that are not obviously going against the grain. The actions will need to be designed so that they appear to go with the popular sentiment even when they are really intended to change the fundamentals with regard to that sentiment.
So, I now realize that I need to keep this secret. So please forget you ever read this.