Are markets experiencing a 'fear bubble'?

In the past 15 years, the U.S. economy has generated dot-com, Nasdaq, housing and commodity bubbles. Now it's being hurt by another type of bubble: a 'fear bubble,' at least in the analysis of energy trader Paul Schmidt.

Schmidt mentioned the concept during a conversation with DailyFinance Monday, and here's his argument: There's $45-65 trillion in investment capital in the United States, depending on the methodology one uses and what you classify as a 'liquid asset.' That's plenty of money to get the gears of commerce moving, in Schmidt's view. The trouble is that not nearly enough investment activity is actually occurring.

"There's capital to deploy, cash to invest and lend, but no one is deploying, investing, and lending," Schmidt said in exasperation. "That's the essence of the financial crisis and it's driven by fear. We now have a 'fear bubble.' "

By 'fear bubble,' Schmidt said that current economic fundamentals should dictate a higher level of investment and deal-making activity, even more stock and bond trading, "but it's not occurring, and fear has a lot to do with it."

Are lender and investor fear justified?

But couldn't one also argue that the fear represents rational caution, due to the large amount of toxic assets in the financial system, and the as-yet unknown shape of the U.S. Treasury's upcoming plan to remove them? In other words, investors large and small are sitting on their money, for a legitimate reason. "Toxic assets are the biggest negative, but they should not hold be holding back investment to the degree that they have," Schmidt said.

Schmidt also argued that the term 'credit crunch' is somewhat inaccurate, in his interpretation. "There's no 'credit' or 'money' shortage, because there's plenty of money around. There is a shortage regarding the use of that capital so I call it a 'deployment shortage.'

The danger, for investors and for just about everyone else, if the fear bubble continues, in Schmidt's view? We can run the risk of a massive paradox of thrift, he said.

For those unfamiliar, the paradox of thrift (or paradox of savings) was conceptualized by economist John Maynard Keynes, who correctly theorized that if everyone saves more money during a recession, aggregate demand would fall more, and the recession would worsen. This, Keynes added, would ultimately also lead, paradoxically, to a long-term decline in the savings rate societally, because of lay-offs associated with the deepening recession.

The above is the basis for Keynes' economic axiom: 'Saving money is a good thing, but if everyone saves everything, all the time, it would be a disaster.'

Schmidt is concerned that so many financial institutions are cutting back their lending and investing that "we may be entering a global paradox of thrift" that would slow the global economy even more -- below the 1.9% 2009 global GDP growth rate forecast by the International Monetary Fund -- and deepen recessions in the U.S., the European Union, and Japan.

Hence, in Schmidt's interpretation, if U.S. and global economic conditions continue to worsen, it won't be due to a lack of investment capital or credit, but due to a lack of deployment of that capital and credit.

"And, to me, that's a preventable economic slump," Schmidt added.

Economic Analysis: To be sure, the bears would point to toxic assets in the financial system -- and uncertainty regarding the health and status of key financial institutions, with Citigroup (C) and the Bank of America (BAC) high on that list -- as adding to non-deployment of capital sentiment.

The view from here argues that, while not diminishing the seriousness implied by the toxic asset situation, at least regarding the United States, the resources of the nation and common sense will win out. That conclusion is not intended to be solely an inspirational statement, but also an economic fundamentals evaluation: the United States has the resources to both solve the financial crisis and to get the economy growing again, and that strength, combined with the inherent fairness of the American people, will overcome fear, and lead the nation to better times and a stronger economy.

What's your view of the current state of things? Are toxic assets preventing institutions from lending and investing? Or is it irrational fear? Perhaps a combination? Let us know what you think.

Financial Editor Joseph Lazzaro is based in New York.
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