Contaminated Vegetables and Toxic Assets

Filed Under (Finance, U.S. Fiscal Policy) by Charles Kahn on Jun 8, 2011

The e coli scare in Europe right now has thrown governments and their health services into crisis, devastated Spanish agriculture and changed a continent’s eating habits overnight. And yet, the risks, viewed in any objective sense, of eating a cucumber in Germany are minuscule: there are, in that country at this moment, thousands of intrepid cigarette smokers who are shying away from the salad course in the name of health safety. Not that I would behave any differently: the slight chance of a devastating outcome is enough to make me boil my vegetables as well.

But it is noteworthy how news of such a low probability event can cause such enormous economic dislocation. There are millions and millions of cucumbers out there; the odds of any particular cucumber being toxic are vanishingly small, and yet since we can’t know which is the lethal cucumber, we avoid them all. Result: localized disaster leading to economy wide disruption. The situation is familiar to all the souvenir salesmen in Cairo–reports of a dramatic incident of tourists’ deaths in a terrorist incident lead to decline in foreign visitors for months or years.

In both of these cases the fundamental problem is contamination: the inability to sort out the good apples from the bad apples means all must be regarded as tainted. The same situation arose in the recent financial crisis. Somewhere out there lurked toxic assets–mortgage backed securities where the underlying loans were badly supervised or fraudulently arranged or insufficiently diversified. While the pile of toxic assets was enormous, it was still a very small part of the entire financial sector. But for the average investor–even for the expert investor–the problem was that there was no way to tell which financial institution was actually contaminated–so all are tainted. (This phenomenon is not particular to the recent crisis: observers of earlier banking crises in the U.S., back into the nineteenth century, also noted similar problems.)

In the case of the financial crisis, there is a potential strategy, for those of strong constitution. After all you can tell the magnitude of the problem at the outside–calculate the number of troubled mortgages. The total fall in the value of the financial assets at the height of the crisis is much greater than this underlying amount of damage. So there are profits to be had if you can just figure out which financial assets to buy. But you don’t know which. The solution: you just buy a little of every one of them, hold on to them all, and hope your stomach is up to the challenge.

Will People Work Longer Due to the Great Recession?

Filed Under (Retirement Policy) by Jeffrey Brown on Jul 27, 2010

When the financial crisis hit last year, a lot of news sources started speculating that people would be forced to work longer to make up for the losses in their 401(k) plans.  Yet there seemed to be some puzzlement when data started indicating that more people were retiring earlier.  What happened here?

Some new research sheds a bit of light on this.  The answer to the puzzle is essentially that there are different groups out there who were affected differently.  Higher income individuals with large 401(k) balances were indeed likely to postpone retirement as a result of the negative wealth shock.

However, the financial crisis was also accompanied by a deep and prolonged recession that significantly increased unemployment, or more broadly, joblessness.  A study by Courtney Coile and Phil Levine of Wellesley College shows that a rise in unemployment during a recession leads to earlier retirement.  In essence, older individuals choose to retire rather than try to find another job. 

In aggregate, it appears that the unemployment-induced increase in retirement outweighs the 401(k)-loss-induced delay in retirement.  The net result is the average person retiring earlier, not working longer.

Of course, the most important point of all is that both effects are likely to reduce retirement security.  Whether forced out of the labor force early due to job loss or forced to stay in the labor force longer due to a negative wealth shock, individuals are made worse off.  And that, ultimately, is the real story.