Assessing the damage...

Cees Bruggemans, chief economist of FNB, gave his assessment of the costs of the financial crisis in one of his weekly commentaries published on the 24th November 2009. Here follows excerpts from the article:

The original focus was very much on financial asset losses, with estimates in the trillions of dollars, and equity markets tanking with losses in the tens of trillions.

But though the financial asset losses were painful and real (ultimately some $2.5 trillion worth, of which three-quarters by now written off, yet questions remaining whether global toxic assets really have been fully dealt with), the equity paper losses have already been mostly erased as markets bounced sharply in 2009.

The global output forever lost in 2008-2009 probably amounted to $3 trillion, with at least twice that opportunity loss still to be counted through 2015-2020.

The agonising pain deluged on bank shareholders and managements, hedge funds and insurers, especially in large parts of the West, has been on vivid display throughout. But this was ultimately only a small sliver of humanity facing the piper.

Much larger numbers of people ultimately paid a major price because of the financial failure of preceding years and the manner in which the financial crisis hit the global economy broadside.

The number of US housing foreclosures runs in the many millions. A much larger multiple lost their work and livelihood. So far, some 8 million private sector jobs have been lost in the US alone, a number that will still climb by another 1 million through Easter 2010. To this must be added another 1 to 2 million discouraged workers ceasing to look for work and falling from view. And we must then still incorporate the substantial shortening in US working time, going by temporary workers and reduced working hours. And then we must still allow for the 1-2 million youngsters newly added to the labour pool during 2008-2009 for whom there was little scope overall.

This amounts to a lot of pain in a 150 million workforce, where nominal wage increases are currently minimal and bonuses mostly reduced, heavily constraining household income. Together with tightened bank credit and terms, and consumer unwillingness to take up new debt, it paints a picture of a weakened colossus.

In the years ahead, policy action in the US and elsewhere is geared to get financial markets functioning normally again, extending credit to creditworthy customers, but also to support effective demand, thereby gradually restoring business confidence in the future and a willingness to take risk and resume investing (and hiring) more boldly again.

Yet it will be slow going. Not only are employers fiercely intend on improving productivity (and repairing their bottom lines), thereby allowing GDP and national income to expand, but they prefer doing so without rehiring of new labour, at least in the short term.

Then, in the case of the US, once employers finally start hiring again, the first 100 000 of new jobs created monthly will merely absorb newcomers to the labour force (population growth and migratory changes). Only thereafter will the economy start to rehire from the unemployment pool and possibly create new opportunities for currently discouraged individuals.

Absorbing the new additions to the labour pool, and reducing unemployment to acceptable levels could well take up to a decade, considering the relative slow cyclical take-off currently underway, the high emphasis on improving productivity, the lingering uncertainty in so many walks of life, and the consequent inhibition to start hiring normally again quite soon.

Instead, the hardship for many will be spread out over many years.

The senior leadership in the various major central banks (Fed, ECB, BOE) and in national governments (US, UK, Germany, France and others) seem highly aware of these realities and their possible political implications. Under these circumstances we don't encounter any early eagerness to withdraw support for their respective economies, rather the contrary as evidence multiplies of staying the course for longer, though trying to placate bond market vigilantes every step of the way.

Yet state finances are deteriorating, calling for early remedial action. Even so, governments seem intend on discovering how far they can go with their support actions to ensure that economic recovery truly vests. And though central banks are now actively signaling a gradual reduction in quantitative easing (bond buying) next year, they will do so warily, throughout cautiously examining whether the perceived normalization of financial markets proves genuine and can continue.

Meanwhile, with resource slack as large as it is, core inflation at 1% and likely still moving closer to zero next year, and inflation expectations subdued, the major central banks have every reason to keep their interest rates near zero for longer, probably throughout 2010, as ever so gently signaled by Fed, ECB and BOE.

The next crisis looming: Asset bubbles?

Robert Zoellick, president of the World Bank, recently aired his views on certain dangers arising from the massive monetary and fiscal stimuli governments have embarked upon to avoid the dire consequences of the financial crisis of 2008. Here are some excerpts from the article that was published on FT.com:

As the world begins to recover from the worst downturn since the Great Depression, the conventional wisdom is that we have employed lessons of the past effectively: a flood of money; a dose of fiscal stimulus; and an avoidance of the worst trade protectionism.

Of course, governments knew these dramatic actions would have consequences. Central banks have been watching carefully for early signs of the traditional danger – inflation. Yet in a new era of global competition, companies are unlikely to have the pricing power that led to “demand pull” inflation in decades past; nor are unions likely to be able to make wage demands that contributed to “cost-push” stagflation. Walmart and the developing world’s labour force have changed the paradigm.

Yet the revival of John Maynard Keynes should not lead us to ignore Milton Friedman: where will all that money go? For a hint of the future, look to Asia, where a new risk is emerging: asset bubbles.

Asia is now leading the world economy with increases in industrial production and trade, partly reflecting the growth in China and India. This welcome economic upswing is accompanied by rising equity and property prices.

The combination of loose money, volatile commodity markets and poor harvests – such as occurred recently in India – could make 2010 another dangerous year for food prices in poor countries. Asset bubbles could be the next fragility as the world recovers, threatening again to destroy livelihoods and trap millions more in poverty.

Unfortunately, the chapters in the history books about how to deal with asset bubbles usually precede tales of woe. Asset bubbles can be more insidious than traditional product inflation, because they seem to be a sign of health: higher values lift the real economy, which in turn can send the bubbles higher.

Waiting for bubbles to burst and then cleaning up the aftermath is now a new lesson of what not to do. But tightening interest rates too abruptly – especially where recoveries are weak, such as in the US and Europe – could trigger another downturn.

Australia, with its ties to the Asian economies, has already raised interest rates. Asian countries, which traditionally follow the US Fed’s monetary policy, will be under pressure to follow. But raising rates while the Fed keeps its rates close to zero would cause Asian currencies to appreciate. This would make their exports more expensive and decrease overseas sales, hurting recoveries based on exports. More­over, there is competition from China. The renminbi is tied to a declining US dollar that makes Chinese goods cheaper to buy than those of Asian rivals.

It would also help if North America and Europe took a closer look at the agenda that Australia and many Asian countries are starting to pursue. To build confidence and opportunity for the private sector, the Asia-Pacific countries are advancing structural reforms – including in service sectors – to boost productivity and potential growth. These reforms will help them to compete even if their currencies appreciate.

Perhaps the primary lesson from history is for countries to co-operate in making assessments that distinguish their situations, avoiding one-size-fits-all “exit strategies”, and cautioning against currency or trade protectionism.

These will be the challenges for the Group of 20 nations in 2010. The G20 had better put asset price bubbles and new growth strategies on its agenda. Otherwise, the solutions of 2008-09 could plant the seeds of trouble in 2010 and beyond.

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.