Wednesday, 5 February 2014
Wednesday, 28 August 2013
An article in today's FT (August 28, 2013) contains the following gloomy assessment of the tone at the Jackson Hole summit of central bankers.
The world is doomed to an endless cycle of bubble, financial crisis and currency collapse. Get used to it. At least, that is what the world’s central bankers – who gathered in all their wonky majesty last week for the Federal Reserve Bank of Kansas City’s annual conference in Jackson Hole, Wyoming – seem to expect.
Why would such an erudite gathering have reached such a conclusion and why are they right? It is a reflection of the fundamentally misguided view of financial economics which still largely prevails in academia and among policy makers and the financial elite.
Mainstream (neoclassical) economists see economic and financial behavior as manifesting, at the macro level, economically stable equilibria which are the outcome of a utility optimizing function by a collection of rational economic agents. Under this framework, financial crashes are due to exogenous factors. That is, within the modeling tools that they use to explain system wide economic circumstances, there is no explanation, other than abnormal shocks, which are “outside” the scope of their models, to explain why bubbles become unsustainable and eventually burst resulting in very damaging financial crashes. Mainly because they lack a proper framework for explaining the role of money and credit within financial capitalism they can only resort to something extraneous to account for the disequilibrium crash events which have punctuated economic history.
In more general terms, the neoclassical school is unable to explain the nature of credit and its role in the development of asset bubbles precisely because it fails to offer a satisfactory account for endogenous credit creation and the role of credit/debt in financing investments which can and will lead to unsustainable bubbles. Hyman Minsky outlined his intention to remedy this critical defect in the neoclassical tradition right at the beginning of his book Stabilizing an Unstable Economy .
“We will develop a theory explaining why our economy fluctuates, showing that the instability and incoherence exhibited from time to time is related to the development of fragile financial structures that occur normally within capitalist economies in the course of financing capital asset ownership and investment.”
A pithy statement of the opposition to the neoclassical tradition and its marginalization of the insights which Hyman Minsky had with respect to the role of financing in a modern economy – and its associated instability - is also revealed in this quote from Steve Keen during a US television interview. It also alludes to the dispute between himself, Randall Wray and several other economists not within the mainstream (yet), and Paul Krugman which has been ongoing:
You can’t model the economy without including the role of banks, debt, and money. And Krugman’s part of the economic establishment, which for thirty or forty years has got away with arguing that you can model a capitalist economy as if it had no banks in it, no money, and no debt… You just don’t have a model of capitalism if you don’t include those components.
While this cursory discussion may seem abstruse and theoretical a lot hinges on the endogenous/exogenous dichotomy. By situating the "causes" of financial bubbles and their ensuing crashes as due to exogenous factors, the central bankers and policy makers can absolve themselves of the ultimate accountability for creating such bubbles. If the assumptions of the endogenous money creation view were to be fully integrated into mainstream financial economics we might eventually be on a path to ridding ourselves of the recurring nasty shocks that, it is usually claimed from a self-serving perspective, no-one could possibly have foreseen, and which are largely the "unintended consequences" of wilful ignorance.
Sunday, 25 August 2013
How can investors that, in the latter part of 2008, were so traumatized by the complete absence of normal liquidity conditions that they were unable to engage even in short term arbitrage opportunities, where the interval spanned is just a matter of hours or days, be persuaded (or persuade themselves) to become confident again and to engage in long term capital commitments?
Understanding the psychological processes involved in the recovery from a crisis – both in the obvious sense of the emotions experienced directly as a result of a financial crash and the more subtle sense of the trust in inter-temporal commitments, goes to the heart of the “animal spirits” which Keynes wisely decided to leave as vaguely defined. In the early stages of rebuilding confidence it is most likely to be incremental and a gradual process and there can then be abrupt and dramatic shifts in the willingness to embrace risks and make enduring capital commitments in the face of the residual scars of anxiety and uncertainty. In essence this highly compressed description encapsulates the current financial environment where, to the dismay of many policy makers, the dynamics required for a re-emergence of the boom phase to follow on from the 2008 bust are still very fragile.
While there is ambiguity in the information being supplied to markets – those who are predisposed to seeing a certain “fact” such as a glass which has been filled to the 50% level with a liquid as half full can take an alternative position to those who perceive the same fact as showing that the glass is half empty. Because politicians, regulators and central bankers have a deep fear of illiquidity, for valid reasons that have only been too well exemplified by the financial meltdown of late 2008, the imperative to promote the right conditions in the financial economy as well as the cultural world (including the media/blogosphere) which will enhance and sustain market liquidity, will drive financial policy measures as well as political debate. This needs to be seen as a major determinant of posturing by policy-makers and entrepreneurs as it ensures the proper functioning of the capital markets.
Ambiguous signals are those which may have intentionally been framed as open to two (at least) interpretations, or that is the way that they are received and interpreted by a consumer of that information. On the one hand it may be simply that two different individuals will find alternate meanings in the same message or, more stressfully, that an individual will perceive that the information is pregnant with alternate meanings. This will give rise to the kind of cognitive dissonance that has the capacity to lead to a breakdown in interval confidence that is manifested in liquidity crises.
Suppose that one reads a headline to the effect that unemployment has declined by a certain percentage point or that 120,000 new jobs were created how is one to interpret that “fact”? What if the participation rate has declined by 250,000 during the same month – does that mean that the fact that the new jobs created has to be adjusted to reflect the fact that more workers have become discouraged from actually looking for work? These are questions that can be, and are, debated by most economic commentators. The essential point is that even the data is open to such widely different interpretations that it could justifiably be claimed to be inherently ambiguous, and that is before the various analysts and commentators add their own “spin” to the data.
Spin is actually the deliberate introduction of ambiguity and a narrative bias to “facts” or “hard” data. Any data, whether it is unemployment data or earnings announcements by companies can be construed as being fundamentally positive or negative, as bullish or bearish. When markets are functioning normally the bulls will run with a positive interpretation, and the bears with a negative interpretation. It is precisely their disagreement that will be reflected in an adversarial contest or battle regarding prices. The resulting battle of wills will be a sign that the market is functioning in a healthy, normal and liquid manner (it is noteworthy that these separate adjectives are more or less synonyms)
When markets are unwilling or unable to accept ambiguous signals – because for example there are questions about solvency – the markets lack the prerequisite degree of fractiousness. Market participants become much more coherent and uniform in their views and, somewhat counter-intuitively this uniformity of opinion gives rise to macro illiquidity which is the instigator and defining characteristic of systemic crises, fire sales of assets and the onset of deflationary spirals.
In the wake of extreme evaporations of systemic liquidity markets need to be provided with ambiguous information from central bankers/policy makers in order to lubricate the adversarial dialectic of the bulls and the bears. This lubrication of fractiousness and the presence of disagreements between those who want to sell at the current price and those who would rather buy at the current price are vital requirements for two-way, liquid markets.
In the fall of 2008, after the collapse of several blue chip names in global finance, there was a period during which the investor community suffered from a complete lack of information asymmetry, which provides a fertile environment for constructive ambiguity. The state of the collective mind (which can act as a metaphor for the markets) was one of a symmetry of fear and ignorance. It would not be unreasonable to say that there was almost unanimous opinion about how to value risk on securities and assets. That unanimity or uniformity expressed itself, in essence, in the stance that these securities were over-valued, unattractively risky and that this was not the time to be an heroic buyer of distressed assets for which there was no liquid market – why step forward to catch a falling knife? The coherent and almost unanimous decision to step aside created a liquidity trap in which those forced to sell kept selling into a declining market, and when selling begets more selling the financial system stares over the precipice to contemplate freefall into total collapse.
WHY QE HAS NOT BEEN THE ANSWER
Emerging from a liquidity trap is not primarily about having central banks injecting limitless amounts of liquidity into the financial system. This mistaken belief lies at the root of the ineffective measures that central bankers have been trying with very little success since 2008. Moving beyond the scarring left by a systemic liquidity crisis is principally a matter of restoring interval confidence from which there will be a willingness to engage in inter-temporal commitments (initially of the short to medium term variety) of resources and emotions. Eventually these inter-temporal commitments must become longer term and involve large scale commitments of risk capital and this is ultimately how the economy emerges from the bust phase and a credit demand band wagon gets started leading to the next investment boom.
From the evidence of abrupt switches in investor sentiment that have become entrenched in the macro behavior of market participants during the last five years, it is more than tempting to conclude that there is a bipolar quality driving the collective consciousness which manifests itself in financial markets The financial markets can be seen metaphorically at least as a collective mind and the kind of behavior which is well described as one of increasing bipolarity. When considering the difficulties presented by some of the almost impossible dilemmas confronting policy makers, central bankers and investors this may well be a lot more than just a transient form of investor behavior.
HOW WE REACT TO HAVING TO CHOOSE ONLY AMONGST BAD OPTIONS
It is highly plausible that a bipolar financial market is the appropriate response to a deeply conflicted matrix of economic circumstances and policy initiatives. Binary risk on/risk off trading, so prevalent in the first three or four years following the Lehman collapse and still immanent in mid-2013, arises precisely because the dilemmas facing policy makers and strategically placed decision makers, and the messages that are being communicated from them, are inherently conflict laden and contradictory and create an irresolvable cognitive and emotional environment for investors in financial markets. In this perverse sense a binary, bipolar pattern of market activity is a legitimate and pragmatic response to capital markets, especially debt markets, which are perceived to be either already in, or fast approaching, a no win predicament.