Sunday, September 06, 2009
Blame bankers and regulators, not the market
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


As we approach the first anniversary of the great meltdown (having passed the second anniversary of the start of the credit crisis), many questions are unanswered.

Financial markets are calming now. The gap between money-market interest rates and Bank rate is returning to something like normal levels and stock-market volatility (the surges and slumps in prices) has also subsided. But the questions, and challenges, remain.

Some go to the heart of economics. Not only did conventional economic models fail to predict the crisis, it is said, they failed because they were based on a flawed view about markets.

The idea that markets work, on this view, has been seriously challenged. Free financial markets led us into this mess and therefore should be more controlled. Once you accept this for financial markets, maybe others markets should be reined in too.

At the heart of these criticisms of markets is the efficient-market hypothesis. This emerged four decades ago, in a seminal 1970 paper by Eugene Fama, a financial economist at Chicago University.

What it said, simply enough, was that prices in financial markets, say a company’s share price, reflect all known information at the time. There were plenty of embellishments of the hypothesis, but that, in a nutshell, was that.

Markets were the most efficient way of taking all available information and distilling it into a single measure: the price. Anybody claiming to consistently beat the market or predict with certainty where that price would be tomorrow should be treated with the deepest suspicion.

Yet that idea has apparently got us into trouble. Lord Turner, chairman of the Financial Services Authority (FSA), in his now famous Prospect interview, said: “We have had a very fundamental shock to the efficient-market hypothesis, which has been in the DNA of the FSA and securities and banking regulators throughout the world.” It had become, he said, like a religion.

Paul Woolley, the fund manager and academic, said the theory of efficient markets had been discredited. Lord Skidelsky, who has produced a new book, Keynes: The Return of the Master, and who has probably written more Keynes’ books than the man himself, weighed in with an article in the Financial Times. The theory of efficient markets had, he wrote, “led bankers into blind faith in their mathematical forecasting models. It led governments and regulators to discount the possibility that financial markets could implode”.

Willem Buiter, a maverick former member of the Bank of England’s monetary policy committee (MPC), said economics had swallowed efficient markets “hook, line and sinker” and so come unstuck.

You challenge such people at your peril. They have enough intellectual power to light up a small town. I am no market fundamentalist and do not know of many people who are. The kind of people who tell you “the market is always right” are either that type of City trader who wears white socks or the oddballs you occasionally meet at some think tanks.

My view of markets is like Churchill’s view of democracy: their faults may be many but they are far superior to the alternatives. In particular, I think the efficient-market hypothesis — and Fama — have been unfairly castigated.

Let me explain. The rocket scientists on Wall Street and in London built the models that led to the creation of the complex securities and derivatives that caused the damage, but they did not simply plug in the efficient-market hypothesis and let the computers whirr away.

That may have been the approach that helped bring down Long-Term Capital Management, the big hedge fund that failed more than a decade ago. It believed it could profit from temporary market inefficiencies or, as one of its founders described it, picking up the nickels other investors ignored, on the assumption that these inefficiencies would be quickly corrected.

The more recent vintage of dodgy investments, toxic securities, mainly failed because of man-made assumptions. American sub-prime securities, and derivatives based on them, went wrong because their underlying assumptions were incorrect — it was believed that American house prices would not fall because they had not since the 1930s, and that default rates on mortgages would remain low.

As for economic forecasting models, their problem was not that they were fatally corrupted by the efficient-market hypothesis — it was that they assumed finance, like hot and cold water, would always be on tap. Modellers are furiously trying to incorporate a more sophisticated version of banking into their models.

Turner, who is always thought-provoking, was not trying to exempt the FSA from blame, merely pointing out that the culture of regulators had been to believe in efficient markets a little too much. I think he is being too kind to regulators. A proper interpretation of the efficient-market hypothesis should surely have told them that there were no free lunches as far as investment returns were concerned.

The period up to the crisis was one in which many fund managers and investment banks appeared able to achieve exceptional returns in a world that should have been characterised by low returns, with little inflation to flatter performance.

Exceptional returns were claimed by fraudsters such as Bernard Madoff, but also by plenty of non-criminal investment banks during the “search for yield” phase of a low-yield era. Regulators should have asked more questions about how risky such returns were. Markets can only be efficient if they know what is going on.

Andrew Haldane, Bank of England executive director for financial stability, estimated an investor doing due diligence on just one of the notorious CDO-squared instruments (collateralised debt obligations with knobs on) would have had to read a billion pages of documents.

These products were shadowy and mysterious, as was much of the shadow banking system. Information was kept from shareholders and, in many cases, was kept from bank boards. The blame for this lack of transparency must rest with bankers, and the way banks were run and regulated, not the market per se. It was starved of much of the essential information.

Markets are not perfect, and never will be. Nobody with sense thought the market was always right and could peer indefinitely into the future, or avoid occasional herd behaviour. Even this could be consistent with efficient markets, in that part of the information that establishes a market price is knowledge of what others are buying.

The danger is that an anti-market fundamentalism takes over, in which the market is seen to be always wrong. That would set financial markets back. It would also be a retrograde step for the economy.

PS: For this week at least, it looks like a case of All Quiet on Threadneedle Street. Mervyn King, the Bank governor, has long wanted to make monetary policy boring and this month he should succeed. Anything other than the MPC keeping Bank rate at 0.5% and leaving the existing programme of quantitative easing in place would be a shock. An even bigger one would be adoption of a Swedish-style negative interest rate on commercial bank reserves at the Bank.

The debate about quantitative easing continues. Net lending to companies and individuals is falling and there was only modest evidence in the latest money-supply numbers of a pick-up. The shadow MPC, which meets under the auspices of the Institute of Economic Affairs, believes for this reason that quantitative easing will have to go a lot further. In August the Bank extended its asset purchases to £175 billion, though King and two colleagues wanted £200 billion.

The shadow MPC says it should go well beyond £200 billion to achieve the necessary lift in the money supply and cement recovery. An important debate, but not one to be resolved this week.

From The Sunday Times, September 6 2009