Wild-animal spirits
Why is finance so unstable?
Jan 22nd 2009 | from PRINT EDITION
Illustration by S. Kambayashi
WHEN people look back on a
bubble, they tend to blame the mess
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collective insanity of others. What
el but madness could explain all
tho overpriced Dutch tulips? With
hindsight, today’s mortgage
disaster ems ridiculously simple. Wasn’t it the fault of barely legal mortgage underwriting, overpaid investment bankers and the intoxication of easy credit? Yet there is an element of the madhou in that explanation too. Cupidity, fraud and delusion were obviously part of the great bust. But if they are the chief caus of bubbles—which have repeatedly plagued Western finance since its origins in the Italian Renaissance—you have to suppo that civilisation is bet by naivety and manic depression.
In fact, obrves Abhijit Banerjee, an economist at the Massachutts Institute of Technology, a little irrationality goes a long way. When reasonable, lf-interested people trade with each other, optimism tends to breed optimism—until it subsides into corrosive pessimism. In the words of Willem
Buiter, of the London School of Economics, “finance is a scary, inherently unstable, esntial activity.”
Financial rvices are different from other industries, if only becau so much of the business is writing bets. One side pays the other for a claim that comes good if, say, oil prices fall, or a company defaults on its bonds, or houholders make their mortgage payments on time. When people talk about loss in finance, they are often thinking about only one side of the contracts. In fact, for every lor on a credit-default swap, for example, there is a corresponding gainer. The are bets, remember: if the punters are down, the bookies are up by the same amount. In the jargon, the claims “net to zero”.
That sounds safe enough. Yet the winners and lors behave differently. The winners’ extra spending may not offt the lors’ retrenchment. And the lors may not be able to afford to pay out, either becau they do not have the money—they are insolvent—or becau they cannot easily rai the money—they are illiquid. This “counterparty risk”, which grows with the volume of bets, has been the outstanding feature of this crisis. American International Group (AIG), once the world’s biggest insurer, was bailed out by the American government when it became clear that it would not be able to honour its vast one-way bets on financial stability. Had AIG failed, the banks on the other
side would have been in trouble. Although the market netted to zero, it was poid for disaster.
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Infectious optimists
In a boom there is every chance that the betting will get out of hand. Expansion in most business is held in check by the need to build asmbly lines, rent retail space or hire workers. All that takes time and money. By contrast, financial contracts can be written almost instantaneously and without limit.
Whenever issuers compete for market share or buyers pile in becau they are afraid of missing the boat, a boom may be in the making. Investors herd together in this way becau, as John Maynard Keynes argued, they do not have a sure grasp of the future. Faced with uncertainty, they resort to whatever conventions they can find to cling to, from popular wisdom to new theories. In a boom, overconfident investors take on bets that they later find themlves unable to discharge.
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Conventions are one reason why the appetite
to buy financial asts tends to feed on itlf
(e chart 2). In textbook markets for goods,
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price increas lead to a fall in demand and to
substitution. By contrast, rising ast prices
tend to be en, within limits, as a cau to
buy. People take rising share prices as a sign
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of confidence and a reason to put money into
their retirement accounts or mutual funds. More recently, falling prices have been taken as a signal to flee, even though shares are much cheaper than they were not so long ago.
Ast prices pull themlves up by their own bootstraps. As hous become more valuable, hou owners feel richer. If they then spend more, companies make more money, which in turn increas the value of shares and bonds. Profitable companies invest and create jobs. As the economy thrives, there are fewer defaults. Lenders are therefore willing to lend more on easier terms. This extra credit makes ast markets liquid: if ever you need to ll something, there always ems to be a ready buyer. Ample credit also tends to feed into spending and ast prices. That makes people feel richer. And so it goes on.
For as long as people are optimistic, the creation of credit is hard to restrain. Although banks are usually happy to join in, they do not have to be involved, at least for a while. In the boom in Kuwait b
etween 1977 and 1982, people started to u post-dated cheques to pay for shares and property. According to Kindleberger, the value of the circulating IOUs peaked at some $100 billion, a far larger sum than was kept on deposit in the banks.
Similarly, when the economy does well, borrowers want to take on more debt. Not only are managers ambitious to expand, but shareholders tend to encourage them. That is partly becau in a boom they think it is a low-risk way to increa the return on equity. It is also becau the burden of larger interest payments leaves managers with less scope to fritter away cash on pet projects that may not benefit their shareholders.
学生漫画Things that go pop
Manifestly, this virtuous circle does not operate unchecked. Potential bubbles often collap early and harmlessly becau fundamental forces are pulling in the other direction. Investors, torn between being late and being wrong, are restrained by rules of thumb, such as historical analogies and price-earnings ratios for shares. Their optimism is continually buffeted by scares and speculators who test whether a rising market is robust. The authorities carry out their original duty, to watch over the banking system, and they can u their newer powers by raising interest rates to damp down spending and borrowing.
However, bubbles sometimes get out of hand, and if they do, at some point they will stop inflating and start deflating. The cau can be small or large. A failed airline buy-out finished the debt-fuelled boom at the end of the 1980s; the entire housing market went wrong in 2007.
The more efficient the financial system, the faster fear will spread. As ast prices fall, people spend less and investors foreshadow lower profits and higher defaults by running from corporate bonds and shares. When investors lo confidence that other people will
honour the promis that underpin financial asts, they retreat to government bonds, cash or gold, which are more dependable. Liquidity and credit suddenly become scarce and a devastating, value-destroying uncertainty takes hold. In 2007 Dick Fuld, the former head of Lehman Brothers, obrved that whereas credit grows arithmetically, it shrinks geometrically. Much to his cost, he was later proved right.
Investors take all sorts of precautions to ensure that the people they deal with will honour their promis. They demand regulation and accurate accounts that price asts at market values; they want loans to be backed by collateral and covenants; they ask specialist agencies to rate borrowers’ creditworthiness; and so on. Such safeguards, esntial as they are in policing individual lenders, tend to feed greed in greedy times and fear in fearful ones.
Chart 3 shows how lenders to banks registered
alarm after Lehman collapd in September
last year. So worried were they about the risk
of being wiped out in a bankruptcy or a state
rescue that they suddenly started to demand
that banks hold much more capital against
their asts. For decades this ratio had been
stable, below 10% of book asts, though it
was over 50% in the 1840s, when banks were apt to fail more often.公子雍
Nobody can be sure how much capital shareholders now want banks to hold, but Alan Greenspan, a consultant the days, thinks the figure could have grown to 15% of their asts. If so, the banks will have to rai money and ll loans and curities even as politicians are asking them to lend more. Investors’ desire for extra protection has made the contraction of credit wor.
The same thing happened with collateral. As the number of defaults falls in the boom, borrowers’ credit ratings improve, asts are highly valued and lenders accept a broader range of them. In the bust many borrowers have had to find more collateral to offt falling ast prices. Some borrowers may have had to post cash or some other liquid ast. Precily when markets have turned down, forced ast sales have weakened them further. Borrowing has become harder and more expensive.
In the booming American housing market mortgage originators were happy to accept no curity at a
ll, lending 100% of the value of the hou—partly becau they thought hou prices would continue to ri, and partly becau they assumed the market would be liquid enough for them to palm the mortgages off on other investors. As it happened, the mortgage originators were wrong and the loans that were stuck on their books helped destroy their business.
Just say no
Some would ek to limit the ebb and flow of confidence with early warnings, as if financial busts were a hurricane or an outbreak of plague. Gordon Brown, Britain’s prime minister, would like to e the IMF cast in that role.
History suggests that such schemes do not work. People enjoy booms. Walter Bagehot, an editor of The Economist in the 19th century, obrved that “all people are most credulous when they are most happy.” Whatever Mr Brown says now, politicians like booms too. As chancellor of the exchequer, if the IMF dared critici the British economy he ud to be dismissive.
Seers like Henry Kaufman, a Wall Street veteran, and Nouriel Roubini, of the NYU Stern School of Business in Manhattan, pointed to the risks of a disaster, but were largely ignored. When Paul Warburg, a renowned banker, spoke about a possible Wall Street collap in 1929, he was accud
of “sandbagging American prosperity”. J.K. Galbraith, who recounts the story in “A Short History of Financial Euphoria”, detects a whiff of anti-Semitism in Warburg’s treatment.
If it is hard to stop booms once they are in full swing, it is no easier to prevent them from starting in the first place. Hyman Minksy, an unconventional economist who made it his life’s work to study cris, was convinced that they aro spontaneously. Financial stability itlf creates confidence and risk-taking, eventually leading to recklessness and instability. After the bust, stability will return and the cycle will begin again. Similarly, David Roche and Bob McKee, of Independent Strategy, an investment consultancy, among others, think credit started flowing more easily in the 1980s becau the rich economies conquered inflation and the large emerging markets embraced globalisation.
Relax and enjoy it
云朵怎么形容Some booms started with liberalisation. Japan created a huge share and property bubble in the 1980s by relaxing its strict banking regulation. The banks fell over each other to lend money as they jostled for market share. Extra credit found its way into stock and property prices. Kindleberger identified a similar pattern in Latin America and again in Poland and in parts of the former Soviet Union. Liberalisation brings many advantages, but unless it is carefully managed it can lead to trouble.
Some booms started with technological innovation. Carlota Perez, a Venezuelan economist, thinks that each new industrial technology favours its own sort of financing. Local banks grew up to rai capital for the small companies created in Britain’s industrial revolution; joint-stock companies thrived when businessmen needed to finance the railways in the 19th century; industrial banks backed new continental European industries; consumer finance helped Americans buy cars and fridges in the early 20th century. Ms Perez links each financial innovation to its own booms and busts.
That ems deterministic. But the internet revolution really did spill over into the rest of business and finance. Paul Krugman, the most recent Nobel laureate for economics, puts it with characteristic acerbity: the huge, strait-laced, bureaucratic corporations that ruled the roost before the dotcoms were, he says, like “socialism without the justice”. By contrast, internet business was full of optimism. And in finance, optimism is everything.
Powerful new computers also created a platform for a new sort of mathematical finance. In the hands of “quants”—the mathematicians and physicists expert in the arcana of quantitative analysis—this proved immenly versatile. Unfortunately, it also led financial rvices astray.
