In that case, there is no learning experience. Whichever case applies, what is certain is that the question of the permanence of the decline in equity premiums is of critical importance to risk managers. They cannot be agnostic on this question because any abrupt rise in equity premiums must inevitably produce declines in the values of most private financial obligations. I have called attention to this risk-management challenge in a different context when discussing the roots of the international financial crises of the past two and a half years. During a financial crisis, risk aversion rises dramatically, and deliberate trading strategies are replaced by rising fear-induced disengagement.
Yield spreads on relatively risky assets widen dramatically.
As I have indicated on previous occasions, history tells us that sharp reversals in confidence occur abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short period. Panic reactions in the market are characterized by dramatic shifts in behavior that are intended to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing, as I noted earlier, is that this type of behavior has characterized human interaction with little appreciable change over the generations.