Why the Stock Market Tumbled...

Posted by Evan Derkacz at 9:29 AM on March 1, 2007.

Guest post by Robert Reich.

As of right now (11:15 am Pacific time, Wednesday), it looks like Wall Street is putting a the best face possible on yesterday's "correction." (A "correction" is a Wall Street euphemism for "holy shit!") But it's way too early for a sigh of relief. When the stock market takes a big hit, as it did yesterday, ask yourself two questions: What underlying speculative trend has been getting out of control? And what was the wake-up call that alerted investors to it?

This time, the out-of-control trend has been excess liquidity - so much easy cash all over the world (excess petro-dollars, excess sino-dollars, excess saving in the rest of Asia) that investors have been overly optimistic in lending money and buying stocks. In other words, they've taken on way more risk than they've thought they took on.

The biggest speculative bubble has been in China - which isn't surprising given the growth of China's economy and the under-regulation of its financial markets. Because global financial markets are so intertwined, that bursting bubble has hurt investors all over the world. American mutual funds had been putting some capital into the Chinese stock market because, hey, that's where the action was.

There have been other excess-liquidity speculative bubbles right here in America, too. One prime example has been sub-prime loans - banks and mortgage lenders that have done risky lending to low-income people on terms borrowers often can't afford over the long haul. When the housing market started to tumble, some of these risky loans have revealed just how risky they are.

Another liquidity bubble has emerged in hedge funds and private-equity funds, which have so much money they're buying up whatever they see. When these bubbles burst, the noise will be loud enough to shake foundations from New York to San Francisco.

The wake-up call this time was Alan Greenspan, the Oracle of Ayn Rand, whose visage had been beamed by satellite to a group in Hong Kong on Monday (New York time). Greenspan warned the gathering of excess liquidity in global financial markets, leading to over-optimism, and he predicted a recession later this year.

Boom!

Too early yet to tell how big this explosion will be.

Tagged as: economy, stock market

Robert Reich is the nation's 22nd Secretary of Labor and a professor at the University of California at Berkeley. He blogs at RobertReich.com.