in this light

here's larry summers:

"The new year will begin
with the greatest divergence
for a generation
between the general view of global risks
as reflected by conventional wisdom
and the risks as priced in financial markets.

the gap increased in 2006
as markets became more serene
and everyone else
grew more anxious.

record global trade imbalances
and
rising protectionist pressures;

on increased levels of public and private sector borrowing
combined with record low saving in the US;
on falling home prices
and middle class economic insecurity.

At the same time,
financial markets are pricing in
an expectation of tranquillity
as far as the eye can see.
Stock prices in the US
are at all-time highs.
The risk premiums
to cover the possibility of default
that corporations or developing countries
have to pay
to borrow money
are at or near historic lows.

In addition, estimates of the volatility
of the stock, bond and foreign exchange markets
inferred from the prices of options
are near record lows.

the world economy in aggregate
grew more during the last five years
than in any five-year period
since the second world war.

The US is enjoying a rare combination
of low inflation and 4.5 per cent unemployment
and has not suffered a deep recession
in a quarter of a century.

Given the natural tendency of markets
to extrapolate from experience
optimism is to be expected
and is to some extent justified

The great danger is that optimism
can become a self-denying prophecy
if it leads to excessive extension of credit
irrational capacity creation
and unsustainable levels of spending

A turn towards protectionism,
would be unlikely to affect
the ability
of companies or nations
to service their debt
next year

but history suggests that over time
such a turn would have profound effects
on the ability of businesses
to profit
and countries to pay off debts

changes in the structure of financial markets
have enhanced their ability
to handle risk in normal times.
The percentage of any loan
a given institution
has to hold
has been reduced
with increased securitisation
and syndication.
It is natural
that associated risk premiums
have also declined.

Greatly enlarged pools of speculative capital
can also reduce volatility
by pouncing any time
an asset price gets significantly
out of line

Financial innovation
through derivatives
has made the hedging of risk much easier
As institutions have become more sophisticated
in their approach to risk
they have felt comfortable
in taking positions
they might have been reluctant to hold
even a few years ago

We do not yet have enough experience
to judge what happens
in abnormal times
As we observed in 1987
and again in 1998
some of the same innovations
that contribute
to risk spreading
in normal times
can become sources of instability
following shocks to the system
as large-scale liquidations take place

How dramatic increases
in speculative capital
and the use of credit derivatives
and other hedging tools
will affect the system’s response
to the next large shock
is a profoundly important
but ultimately unanswerable question

it is fair to point out
to those who take comfort
from the markets’ comfort
that they hardly ever predict
serious disruption
and historically the moments of greatest complacency
have been the moments of greatest danger

Over the past 20 years
the world has confronted
the 1987 market meltdown
the banking crisis of the early 1990s,
the Mexican near-default in early 1995
the Asian financial crisis in 1997
Long Term Capital Management in 1998
and the Nasdaq decline
and September 11
in this decade

the record does suggest
that crises occur in about
in one out of every three years

At least as far as the markets are concerned
perhaps the main thing we have to fear
is lack of fear itself "