By Anatole Kaletsky (THE TIMES, 29/11/07):
What on earth is happening in the financial markets? Last week Northern Rock was going bust, stock markets were collapsing and the world banking system seemed to be going down the tubes. Now everything has reversed. Markets are soaring. Northern Rock shareholders, instead of losing everything, as expected a week ago are threatening to sue the Government unless they double their money. The Abu Dhabi Investment Authority (ADIA), the world’s biggest investment institution, suddenly launched a dawn raid on Tuesday to snap up $7.5 billion worth of shares in Citicorp, the world’s biggest and most troubled bank. So is the financial world about to collapse or are all the crises over?
The answer, of course, is neither. Markets always go up and down and these short-term fluctuations tell us nothing about the world outside the City and Wall Street. This is particularly true today because the markets’ recent gyrations are caused mainly by short-term factors that will soon ebb away.
Investors are obviously still worried, as they have been since August, about the weakness of the US housing market and the exposure of banks to defaulting low-income mortgage borrowers, but these risks have not changed since mid-October, when stock markets all over the world were hitting record highs. What has changed is the emotional response of investors to these risks.
In a nutshell, investors feel betrayed. The banks told investors and regulators before the summer that they had learnt lessons from previous crises and had found new ways of making profits without exposing their capital to old-fashioned lending risks. Instead, these risks had been transferred, through clever financial engineering, to pension funds, insurance companies, Asian governments and other long-term investors with deep pockets. This has now been exposed as a myth. As a result, the share prices of banks are collapsing and their managers are being fired — though, being bankers, their reward for incompetence and deception is a multimillion golden handshake from the shareholders and taxpayers whom they abused.
This naturally makes people angry and, to make matters worse, the full extent of the deceptions has yet to be revealed, so that only the bravest investors, such as ADIA, can contemplate buying bank shares, however far they fall. Most of this uncertainty, however, will soon be resolved as the banks close their books for the year-end results — with directors and accountants aware that any significant mis-statements could land them in jail.
Will these results produce further shocks, triggering another stock market collapse? I have no idea and neither does anyone else, which is why the markets are so twitchy. What I do know is that market gyrations in response to these disclosures will matter much less than most financiers believe.
Financiers naturally think that they are the world’s most important people, so when their own jobs and bonuses are threatened they assume that the global economy must be under threat. Most of the time this is simply not true.
Meaningful economic indicators come out only rarely but stock markets trade every day, so in periods of uncertainty they start reacting to their own daily fluctuations as if these provided “new” information. When bank shares fall sharply, investors treat this as evidence that the financial system must be in trouble and analysts who were saying “buy” only a few weeks ago begin to scream “sell”. This, in turn, causes shares to fall farther and proves the sagacity, and maybe even inside knowledge, of those who sold. As bankers see their share prices falling, they threaten to cut lending to the real economy of jobs, investment and housing. The fear of a weakening economy then makes bank stocks fall again.
This self-reinforcing process was defined as “reflexivity” by George Soros, in his classic treatise, The Alchemy of Finance. A substantial academic literature has now confirmed that Mr Soros’s “theory of reflexivity” is a big driving force of boom-bust cycles in financial markets. But the question is whether these financial boom-bust cycles are as significant for the non-financial economy as he believes. The big mistake made by Mr Soros as an economic analyst, though not as an investor, was to exaggerate the power of his insight about reflexivity and therefore to conclude that capitalism is an inherently unstable system.
In reality, a modern mixed economy, especially one with a central bank actively managing demand, is protected by self-stabilising mechanisms that are much more powerful than the reflexive boom-bust behaviour of financial markets. In the present financial panic, for example, the dollar is falling sharply and this is boosting US exports. The acceleration of export growth is easily offsetting the slowdown in construction and consumer finance — at least so far. Another stabilising offset comes from long-term interest rates, which have now fallen back to the levels that triggered the global credit boom in 2004. As a result of such self-stabilising feedbacks, financial cycles tend to reverse of their own accord and almost never produce outright economic disasters. The 1930s Depression and Japan’s recent stagnation are often cited as counter-examples but these were caused mainly by central bank policy errors that were amplified by unstable financial markets, not the other way round.
Which brings me to the most important stabilising mechanism: the central banks. The true reason for this month’s grim mood in global stock markets has been disappointment with the US Federal Reserve Board. The Fed cut interest rates by a quarter point on October 31, believing (probably rightly) that this would be enough to avert a recession, but Wall Street wanted more. Since many investors think Wall Street is the economy, they believe the Fed has a duty to protect stock markets and banks against excessive losses — similar to the attitude displayed by the shareholders of Northern Rock. They therefore felt righteous anger when the Fed refused to promise another rate cut after October 31.
Wall Street in the months since the August panic has been like a spoilt child who has grazed her knee. As long as the Fed offered attention and sweeties, investors stopped screaming. But the moment the sweeties ran out, the screaming resumed. Like a weak parent, Ben Bernanke, the Fed Chairman, encouraged this naughty behaviour with indecisive policy flip-flops. In the next two weeks, however, the screaming will probably stop. On December 11, at the next Fed meeting, Mr Bernanke will doubtless back down and give Wall Street its extra rate cut. The tantrum will then be over and it will be cuddles all round in the City and Wall Street — at least until the next grazed knee.