2012: The Financial Crisis and Economics

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Speculation and Market Efficiency

The primary purpose of capital markets is to bring together investors and businesses to serve their interests while promoting production, distribution and economic growth.  To me, an investor is someone, a person or institution, like Warren Buffet, who does a careful analysis of a business, invests for a long period and participates in its governance.  That may be a demanding definition that 6000 mutual funds and 4000 hedge funds do not meet.  They just buy and sell i.e. speculate, although they generally hold their investments for longer periods than “high frequency traders” (below).  Research shows that less than 1% of mutual funds beat the indexes over a long period.   While that may be a startling statistic, it makes sense.  Performance converges towards the mean (i.e. the index), but mutual funds have expenses and charge fees.  For that reason, they will tend to perform worse than indexes over a long period. A recent study of hedge fund performance (Economist, January 7th 2012) concludes that the return to their clients was 2.1% per annum between 1998 and 2010, a lower return than on Treasury bills.  Meanwhile, hedge fund managers took home $379 billion in fees during that period.

Worse than mutual and hedge funds is the trading by investment banks on their own account using at least some inside information, whether that is recognized or not.  Apparently, two-thirds of Goldman’s profits come from trading.  What is the point of trading a barrel of oil 37 times between extraction and use while its price deviates from fundamentals for long periods of time?  In a recent article in the New York Times, Gretchen Morgenson quoted research (a Stanford professor was one of the authors) that showed speculation results in significant increases in commodity prices.  Worse still are the high frequency traders that now account for 75% of daily trades.  They invest in all companies based just on stock price movements, without looking at fundamentals, and their trades have an average holding period of 22 seconds.   As a result, the weighted average holding period of all trades in the market is less than 4 months.

Speculation is supposed to facilitate price discovery.  Apparently it was successful in a managed process when, some time ago, the Department of Agriculture licensed a few well-capitalized and informed commodity speculators to stabilize prices.  But under current stock market trading conditions, where the majority of trades completely ignore fundamentals, the market conveys no useful information about the value of shares.

Krugman in a NYT Book Review (Aug 8, 2009) said that the efficient market theory, often used to justify speculation, is a myth, although lucrative for many.  Prolonged periods of asset bubbles have burst the omniscience of markets.  Markets clearly do not know everything and do not discount correctly what they do know.  Even Greenspan had to admit that markets are not self-regulating.  Yet, the media ignores this evidence probably because the myth has subliminally seeped into public consciousness

The overall effect of speculation is to make capital markets an international casino.  Casinos are fine in Las Vegas and Macao, but not when they affect national sentiment, economic policy and the pensions of millions.  These markets have also had other deleterious effects such as to increase the focus on short-term performance and worsen the distribution of wealth and income, especially in developing countries.   Stiglitz mentions these issues in “Freefall”.

My greater concern is with the capital markets in developing countries.   Unfortunately, plying the “Washington Consensus”, many of us have promoted national casinos in developing countries where the information asymmetry is much greater than in the US. Given the lack of information infrastructure (auditors, analysts, etc.) in most if not all countries, I feel they have been prematurely established.  Take Indonesia as an example.  Until recently, it did not have an accounting profession.  In India, in the early 1990s, although an accounting profession existed, it could be easily bought to reflect management’s version of performance.

Caveat Emptor

“Buyer Beware” may have been a valid concept when financial instruments were simple and easy to understand.  But the world has moved on and complexity has increased to the point that even educated buyers have difficulty assessing financial instruments.  Information asymmetries have increased dramatically.  Indeed, virtually all informed institutional investors were not able to assess the risk of the derivatives that they bought.  This lacuna has been recognized in other areas such as food and medicine, but not in finance.

Regulation

The usual answer for many of these issues is more and better regulation.  Sure, but the political economy of regulation can weaken its effectiveness.  The political power of the regulated, regulatory capture, under-funded and under-staffed regulators and corruption undercut the design of regulations and their enforcement.   As we have seen recently, developed democracies with evolved market economies and great professional capability failed to regulate their financial systems effectively and well-funded lobbying by the industry being regulated is stifling reforms.   How should developing countries without these critical advantages approach regulating their financial systems?  Generally, economists have fallen in-line to advise adopting the US/European approach.  The “Washington Consensus” strikes again.

If the spectrum of economic management ranges from a command economy to a free market economy with levels of control and regulation decreasing from one side to the other, where should a developing economy’s economic management be in that range?  Singapore (and China) manages just fine at the command end and Hong Kong (and who else?) at the market end.

Evidence suggests that a free market economy is better for economic and social development, which implies a need for effective regulation.  Stiglitz agrees with this while also recognizing the possibility of government failure.  Fine, but the pace of movement towards that objective depends on the country’s starting point, culture, political evolution, institutional and professional development, etc.  In other words, it’s complicated, and one size does not fit all; it requires a deep understanding of the country to design the speed and sequencing of reforms.   Each step in the process is fraught with pitfalls, requiring a sage government to manage the process successfully.

Profit Maximization

My guess is that almost everyone who works in the financial sector has taken Economics 101 at university and learned that pursuing self-interest and maximizing profits results in the best outcome for everyone.  Stiglitz says that the unrelenting pursuit of profits and self-interest and has helped create a “moral deficit” in business behavior.  I agree and believe that attitude has, unthinkingly, led to greed.  Indeed, “long-term greed” was Goldman Sachs’ mantra, but in the run up to the crisis it abandoned the “long-term” part and concentrated on “greed”, reminiscent of Gordon Gekko’s “Greed is Good”.   Goldman sold financial instruments to clients as good investments while betting against them in its own account.

People simply react to situations with the mindset of maximizing profits.   Thus, an elegant heuristic device has seeped into the public’s consciousness and affected behavior.  Some developed economies such as Japan and Germany that focus more on longer term results seem to have succeeded in business and innovation at least as well as the US.  A recent article  (New York Times, Sunday Jan 8, 2012) about Japan’s economy showed that it has not been in the doldrums for two decades, as most commentators have observed.  Instead, its indicators are better than the US despite the prolonged crisis it went through in the 1980s.  Its manufacturing sector is still among the best in the world.   Is it time come up with a new, more nuanced attitude to business development?

Ethics

Professions such as law, accounting, medicine and others have codes of ethics.   Although I am not sure, the documentary “Inside Job” suggested that economics does not.  Indeed, I don’t think ethics is discussed in economics except in one fundamental respect—individual freedom.  I believe this is a failing.  For example, speculation could in some circumstances stabilize commodity prices, but is the activity in itself ethical?  If the discipline does not have an ethical framework, it is unlikely that the profession will.  In the context of the documentary, economists that benefited from relationships with financial institutions, should have, at the very least, recused themselves from making policy for or bailing out institutions in the sector.

Conclusions

At the time of writing Freefall, Stiglitz estimated that the financial crisis had cost the world $20 trillion and caused suffering to hundreds of millions of people who have been pushed into poverty and tens of millions who had lost their jobs.  The waves (not just ripples) from that period continue to threaten the economies of Europe and the US and cast a shadow on the future.   The cost of the bankers’ folly will mount.  Catastrophe is the best word to describe what we are living through.  With a few exceptions like Schiller and Roubini, the economics profession did not see it coming.  Indeed, I got into an argument in June 2008 with a senior person in the economics profession who disdainfully brushed aside the possibility of a recession that I suggested could be approaching.  Not that I was prescient or looked at reams of numbers.  I had simply talked to a friend who was a director of a large mortgage bank who warned me that a housing market meltdown was approaching.

I do not read economics journals, but nothing published in the intelligent press such as the Economist and New York Times suggests that the economics profession has reflected on the validity of its paradigm or thought to develop an ethical foundation for the discipline or a code for the profession.