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Scary Thought: A Bear Market That Lasts Forever?
"Negative feedback loop" between economy and the markets -- true or false?

By Vadim Pokhlebkin
Wed, 20 Aug 2008 20:45:00 ET
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In late July, the International Monetary Fund issued the following statement (emphasis added):
 
"Global financial markets continue to be fragile and indicators of systemic risks remain elevated. The downside risks…[are] leading to a negative feedback loop between the financial system and the broader economy."
 
To paraphrase, "The credit crisis stemming from the U.S. housing slump has triggered a 'negative feedback loop' in the global economy that poses risks for growth." (Thomson Financial)
 
At first glance, it sounds like a typical statement from one of the world's financial authorities. But let's look closer at this "negative feedback loop" idea.
 
By claiming that there is a "negative feedback loop between the financial system and the broader economy," the IMF is essentially saying that we will be stuck in this bear market forever – literally.
 
Think about it. The crisis in the financial system is dragging down the economy, says the IMF. In turn, bad economy is dragging down the financial system – and they are doing it in a "loop"! Each step lower creates an even lower one – all the way down into the hazy, dark, bottomless economic hell.
 
What's more, if you continue this logic, not only will this bear market last forever – it will also get progressively worse as the economy and financial markets push each other further and further down.
 
Scary thought, isn't it?
 
Fortunately for all of us, this "loop" idea is completely bogus. There are no "feedback loops" between the economy and the financial markets. If there were, both the bull and the bear markets would last forever – but they don't. We have manias and crashes, economic booms and busts. Clearly, good times don't perpetuate everlasting euphoria, just as bad times don't propagate eternal pessimism.
 
Bob Prechter, EWI's founder and CEO, made this logical conclusion years ago in his brilliant Pioneering Studies in Socionomics (Chapter 27):
 
"I used to think that mood formed a feedback loop with events, which in turn reinforced the mood. I have since seen that this idea is erroneous. … If events formed a feedback loop with mood, then social trends would never end. Each new extreme in mood in a particular direction would cause more reinforcing actions, and those actions would reinforce that same mood, and so on forever. This is an untenable idea."
 
Untenable, yes – but so seductive in its conventional logic.
 
On second thought, I'm not that surprised to hear the IMF make that statement. After all, these are the same people who about four years ago told the British Guardian this:
 
"It would take a major and long-lasting shock to upset a financial system [that is] now capable of riding out the collapse of a hedge fund or even a leading bank. It is hard to see where systemic threats could come from…"
 
That "systemic threat" appeared out of the clear blue sky in July 2007, in the form of the now proverbial "liquidity crisis." And if you want real answers about its causes and when it may end, don't turn to the conventional economic wisdom: It has more holes in it than the late Bear Stearns' balance sheet.
 
We at EWI have been forecasting the markets and the economy for 30 years. From that experience, we know that is that it's not "loops" that create booms and busts – people's collective emotions do, in predictable Elliott wave patterns. That's why there is a light at the end of this tunnel.
 

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