China's credit growth worries...

China stood out this year as the one economy apparently not stalled by the global economic crisis, but their continued growth was brought about by rapid credit extension - always a worrisome aspect. FT.com reported the following story how Chinese banks will have to seek additional capital to prop up their capital adequacy ratios:

China’s banks are preparing to raise tens of billions of dollars in additional capital to meet regulatory requirements following an unprecedented expansion of new loans this year, according to people familiar with the matter.

China’s 11 largest listed banks will have to raise at least Rmb300bn ($43bn) to meet more stringent capital adequacy requirements and maintain loan growth and business expansion, according to estimates from BNP Paribas.

China’s banking regulator has warned it would refuse approvals for expansion and limit banking operations if lenders did not meet new capital adequacy requirements, a move that has prompted the country’s largest state-owned banks to prepare capital-raising plans for next year and beyond.

China’s banking regulator is definitely aware of potential asset quality issues and is pushing for higher capital adequacy requirements to offset deterioration in asset quality.

Following government orders to prop up the domestic economy in the face of the global crisis, Chinese banks extended a record Rmb8,920bn in loans in the first 10 months of the year, up by Rmb5,260bn from the same period a year earlier.

This unprecedented loan expansion resulted in a record fall in their core capital adequacy rates from just over 10 per cent at the end of last year to 8.89 per cent by the end of September, a drop that worries regulators.

A spokesman from the banking regulator said the vast majority of Chinese commercial banks met current capital adequacy requirements but lenders were expected to conduct reviews of their asset quality and ensure they continue to meet regulatory requirements.

The advent of the Efficient Market Hypothesis

Richard Thaler, professor of economics and behavioral science at the University of Chicago commented in a FT.com article about how the theory of Efficient Markets (otherwise known as EMH) led many to believe that the market should always be right. Hence, we have witnessed in recent years some gross policy errors and mistaken beliefs.

The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.

The EMH has two components that I call "The Price is Right" and "No Free Lunch". The price is right principle says asset prices will "fully reflect" available information, and thus "provide accurate signals for resource allocation". The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.

For many years the EMH was "taken as a fact of life" by economists. However, as early as 1984 Robert Shiller, the economist, correctly and boldly called this "one of the most remarkable errors in the history of economic thought". The reason this is an error is that prices can be unpredictable and still wrong; the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable.

Simply put, it is hard to reject the claim that prices are right unless you have a theory of how prices are supposed to behave. For example, stock market observers - as early as Benjamin Graham in the 1930s - noted the odd fact that the prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own. This violates the basic building block of finance - the law of one price - and does not depend on any pricing model.

Compared to the price is right component, the no free lunch aspect of the EMH has fared better. Mr Michael Jensen's doctoral thesis published in 1968 set the right tone when he found that, as a group, mutual fund managers could not outperform the market. There have been dozens of studies since then, but the basic conclusion is the same. Although there are some anomalies, the market seems hard to beat. That does not prevent people from trying. For years people predictedfees paid to money managers would fall as investors switched to index funds or cheaper passive strategies, but instead assets were directed to hedge funds that charge very high fees.

Now, a year into the crisis, where has it left the advocates of the EMH? On the free lunch component there are two lessons. The first is that many investments have risks that are more correlated than they appear. The second is that high returns that are based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist.

So where does this leave us? Counting the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be "right", then these bubbles would not occur.

While imperfect, financial markets are still the best way to allocate capital.

Not-so-efficient markets...

John Kay, author and columnist for Financial Times, wrote an article about the existing views on efficient markets. Here follows some excerpts:

Warren Buffett said most of what you need to know about efficient markets. “Observing correctly that the market was frequently efficient, they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.”

Mr Buffett has made his money not from the part that is frequently efficient, but from the part that is infrequently inefficient.

The efficient market hypothesis has been the bedrock of financial economics for almost 50 years. Market efficiency is a hypothesis about the way markets react to information and does not necessarily imply that markets promote economic efficiency in a wider sense. But there is a relationship between the two concepts of efficiency.

There are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.

These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.

Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.

The weak efficient market theory tells us that past prices are no guide to what will happen to security prices in future. There is a good deal of evidence for this claim: you would be as well employed studying the patterns on your palm as patterns on charts. But there is also evidence of a tendency for short-term price movements to continue in the same direction – momentum is real. If you know precisely when the short term becomes the long term, this would make you very rich. It is possible to make money – or policy – through reading boom-and-bust cycles. But most participants do not.

The semi-strong version of the theory claims that markets reflect all publicly available information about securities. What is general knowledge will be in the price. But inside information, or original analysis, might add value.

The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies.

False ideas don't survive...

Martin Wolf, chief economics reporter for the Financial Times, recently reviewed a new book by Andrew Smithers: Wall Street Revalued: Imperfect Markets and Inept Central Bankers.

The big points of the book are four: first, asset markets are only "imperfectly efficient"; second, it is possible to value markets; third, huge positive deviations from fair value - bubbles - are economically devastating, particularly if associated with credit surges and underpricing of liquidity; and, finally, central banks should try to prick such bubbles. "We must be prepared to consider the possibility that periodic mild recessions are a necessary price for avoiding major ones." I have been unwilling to accept this view. That is no longer true.

The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a "random walk". Mr Smithers shows that this conclusion is empirically false: stock markets exhibit "negative serial correlation". More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. "Markets rotate around fair value." There is, Mr Smithers also shows, reason to believe this is true of other markets in real assets - including housing.

A standard objection is that if markets deviate from fair value, they must present chances for arbitrage. Mr Smithers demonstrates that the length of time over which markets deviate is so long (decades) and their movement so unpredictable that this opportunity cannot be exploited. A short seller will go broke long before the value ship comes in. Similarly, someone who borrows to buy shares when they are cheap has an excellent chance of losing everything before the gamble pays off. The difficulty of exploiting such opportunities is large for professional managers, who will lose clients. The graveyard of finance contains those who were right too soon.

Mr Smithers proposes two fundamental measures of value - "Q" or the valuation ratio, which relates the market value of stocks to the net worth of companies and the cyclically adjusted price-earnings ratio, which relates current market value to a 10-year moving average of past real earnings. Professional managers use many other valuation methods, all of them false. As Mr Smithers remarks sardonically: "Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth."

Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back. Trees do not grow to the sky and markets do not attain infinite value. When stocks reach absurd valuations, investors will stop buying and start to sell. In the end, the value of stocks will move back into line with (or below) the value - and underlying earnings - of companies. House prices will, in the long term, also relate to incomes.

The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. "Leaning against the wind" requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned.

Not all bubbles are the same...

Frederic Mishkin, author and professor of finance at Columbia University and a former member of the Fed Board, believes not all asset-price bubbles are dangerous and one has to understand the underlying drivers before panicking about the effects of very accommodating monetary policies. Excerpts from an article that was published on FT.com follows:

There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no.

Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.

Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker.

Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture.