Why should we believe the market this time? ECMI Commentary No. 22, 23 February 2009

During the decade preceding the eruption of the financial crisis in August 2007, rating agencies and market participants, gripped by euphoria, systematically underestimated the risk inherent in a wide range of financial assets. Today the panic that has gripped them leads to an equally distorted view of the risks involved. Private debt is dumped in favour of government debt of just a few countries. How these countries are selected is unclear. This selection mechanism is the result of an emotional reaction that leads market participants to believe that “it is inconceivable that serious countries like the US, Germany or France would ever default on their debt” while other countries are deemed to be to be capable of doing such a bad thing. These emotional reactions create distortions that affect economic activity in profound ways