With the world’s attention turned to the financial crisis, a?strange?celestial occurrence went virtually unnoticed. For more than 200 days this year, the sun was devoid of sunspots. That historic run, the longest since 1954, ended last week when a small spot appeared and then disappeared.

That financial events and freakish sunspot behaviour are coinciding will doubtlessly encourage nonsensical speculation by astrologers. For the thoughtful, the coincidence provides an interesting parallel to circumstances in the late 1800s that ignited an economic theory based on sunspots. While the early work ended up being a dead end, it led to frontier theoretical work a century later that provides exactly the right framework for thinking about the philosophical implications of the current crisis.

The fact is, we are not, as a piece in The Washington Post recently suggested, at the end of American capitalism. Rather, we are in the middle of what economic theorists refer to as “sunspot equilibrium", or a state in which a completely random variable is driving the economy. Such a situation was long thought to be a rare possibility in a free market.

We now know that these economic sunspot theories are more valuable than we ever could have dreamed. If capitalism is to survive, it will be because its politicians better understand sunspots.

Theoretical triumph

Back in 1884, William Stanley Jevons proposed a link between sunspot cycles and business cycles. He provided data that suggested the link might be real, and he speculated that there was some connection between sunspots and the weather. While the sunspot theory of the business cycle has now been widely rejected, Jevons’s work did motivate a theoretical triumph by economists David Cass and Karl Shell.

High priests of the free market have long argued that government regulation should be minimal because the market will inevitably produce the most efficient outcomes, with prices fully and rationally reflecting the true fundamentals. If stock prices drop, it is always because some fundamental has worsened. Cass and Shell showed that an unregulated market is far from perfect in its outcomes. Their argument was based on sunspots.

Reinforcing beliefs

Suppose, they said, that sunspots are truly irrelevant, but everyone believes Jevons that they cause business cycles. Then firms might look at the sun, see a bad cycle coming, and begin laying off employees. Workers might look at the sun, see a bad cycle coming, and cut back expenditure.

The action of the firm would reinforce the belief of the worker that sunspots cause downturns. The actions of consumers would reinforce the belief of firms that sunspots cause downturns. After a few cycles, a dispassionate scientist could gather the economic data and find that sunspots drive business cycles. Beliefs could be self-fulfilling. So sunspots might be truly irrelevant only if 1) they are irrelevant, and 2) individuals believe that to be the case. Cass and Shell showed that sunspot equilibrium is possible, ending forever the view that free markets always lead to the ideal outcome.

Sunspot equilibrium

In the current crisis, we are doubtless experiencing sunspot equilibrium. Panic has caused financial institutions to stop lending to one another and to their clients. The absence of liquidity has reinforced the panic, as few firms can survive indefinitely without outside cash flow. As consumers watch financial institutions unwind, they, too, have panicked, reducing spending, driving down profits and inducing yet another round in the downward cycle. The end result is a state of the world that is far removed from the happy equilibrium a well-functioning free market promises.

The financial institutions themselves have failed because of their own bad decisions and because of the nuclear bomb set off in the housing industry by Fannie Mae and Freddie Mac. But how did that set off this unprecedented wholesale panic? Liberal pessimism, and the negative sunspot equilibrium it created, has likely been a key contributor. The US media have been in a sour mood ever since President George W. Bush took office. When times were good, the economy was covered as if we were in a Great Depression. For years, everything about the Bush economy has been “the worst since Herbert Hoover". When times actually turned bad, where was sentiment to go?

Losing faith

Economist Donald Luskin, one of the few bold enough to publicly stand up against the landslide of negativity, did a Google News search in mid-September of “since the Great Depression" and found 4,500 hits in the previous month.

The problem is, if you keep telling people that our system is fundamentally broken, they will lose faith in it and run for the exits when real distress occurs. The influence of the profoundly negative reporting and destructive partisan rhetoric is apparent in the numbers. Over the past three years, consumer sentiment has been lower relative to the state of the economy than it has ever been. In June, that sentiment was far below where it had been since the great stagflation of the early 1980s. And political bias is apparent in the data as well. During Bill Clinton’s presidency, even bad data were covered gloriously, and consumer sentiment was generally higher than it had ever been relative to the data.

All of which suggests we have two possible paths forward.

On the one hand, we can work to restore faith in markets and provide the government backbone needed to do that. On the other, we can decide we have learned that markets fundamentally don’t work. That belief, like one in the effect of sunspots, would be self-fulfilling.

The choice is ours.

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