Sometimes the markets just get things wrong. It doesn't happen very often.
Usually the market's collective wisdom is more perceptive than the
individual opinions of the investors who comprise it. But every now and then
- about twice every decade - markets make spectacular blunders, completely
losing touch with the real economy of consumption, investment, employment
and world trade. The markets' behaviour last week suggested that such a time
has arrived.
On Friday, share prices around the world collapsed as Wall Street was gripped
by rumours about the bankruptcy of the two largest financial institutions in
the world: the US Government-backed mortgage insurers Fannie Mae and Freddie
Mac, whose combined debts are almost $6 trillion, equivalent to roughly
double Britain's entire GDP. Yet what has been happening in the world of
real economic activity to explain such extreme market action?
While Wall Street has gone into meltdown since the beginning of June,
conditions in the real economy have been unambiguously improving. The latest
employment figures, published two weeks ago, confirmed that economic
conditions had stabilised after their sharp deterioration in the winter,
while purchasing managers' surveys, the most reliable indicator of very
recent economic trends, suggested a continuation of the modest but clear
improvement that began in April. Sales figures from leading retailers were
much stronger than expected, showing that tax rebates designed to provide a
shot of financial adrenaline to all but the richest US households were doing
exactly what the doctor ordered - offsetting the depressing effect on
consumption of the credit crunch and the housing slump.
As a result, consumer confidence, although an unreliable and lagging
indicator, showed its first improvement for six months. Even the figures on
home sales have now been near-stable for four consecutive months, after
almost a year of vertiginous falls. Most important of all, the monthly trade
figures, published on Friday in the midst of the Wall Street meltdown,
proved that the remarkably adaptable US economy was responding to the credit
crunch exactly as the optimists had hoped - by undertaking an immense
structural shift from consumer and housing-led growth to growth powered by
exports.
The narrowing of the US trade deficit, despite the biggest monthly increase on
record in the cost of oil imports, almost guarantees that the second-quarter
GDP figures, due to be published two weeks from now, will show the US
economy accelerating from the stagnant conditions of the past two quarters
to a near-normal rate of 2.5 or even 3 per cent growth.
Why, then, are share prices collapsing and the dollar hitting new lows? There
are three possible explanations. First, financial markets may “know
something” dreadful about America's economic prospects that is not yet
apparent in any statistics. Secondly, investors may be reacting to
specifically financial problems that have relatively little impact on the
non-financial economy outside Wall Street. Thirdly, the markets may simply
be wrong about the economic outlook and about the value of financial assets,
as they have been many times in the past. Hence the adage that “Wall Street
is a great economic forecaster - it has predicted six of the last three
recessions”.
The first explanation - the skeleton in the cupboard - is the one naturally
favoured on Wall Street itself. The financial community's self-regarding
faith in the foresight of financial analysts and investors seems never to be
shaken by the total lack of foresight revealed by these same analysts and
investors in the past.
For example, one of the “events” that triggered last week's collapse of
confidence was a privately circulated paper from a leading hedge fund group,
which estimated that total losses in the global credit crunch might be as
high as $1.6 trillion, rather than the $400 billion recently suggested by
the IMF, the Bank of England and other serious researchers. These new
estimates contained no new “information”, apart from some simple
extrapolations of the losses already suffered by the hardest-hit segments of
the credit markets on to other parts of the economy that so far had shown
few signs of trouble.
This was, in other words, a perfect example of the self-justifying
“reflexivity” identified by George Soros as the main cause of boom-bust
cycles in financial markets. But how much impact on the real economy are
these self-justifying expectations likely to have? Thus far, it seems that
the answer is “mercifully little”, which raises the second possible reason
for the divergence between financial and economic realities these days.
It is perfectly possible for financial conditions to keep deteriorating and
for bank shareholders to keep losing money, while real economic activity
stabilises and then improves. Even if institutions such as Fannie Mae are
“technically insolvent”, as suggested last week by Bill Poole, a famously
outspoken former governor of the Federal Reserve, this does not necessarily
mean that the real economy will suffer or that these “insolvent”
institutions either need to or ought to stop lending money, a point that Mr
Poole himself made.
As Mr Poole indictated in the interview that triggered the Fannie Mae panic,
every leading bank in the world would have been technically insolvent by
today's accounting standards throughout the 1980s. The Latin American debt
crisis of 1982 triggered defaults on loans worth well over 100 per cent of
the total equity of banks such as Citicorp, Chase Manhattan, Midland, Lloyds
and Deutsche. These were far bigger hits than anything suggested by most
analyses of today's mortgage crisis. Yet despite these enormous credit
losses, the global banking system was able to trade its way through the
crisis and finance the strongest global expansion in history in the 25 years
after 1982.
If most of the global banking system was technically insolvent, at least by
today's accounting standards, throughout the 1980s, how was it able to
finance this record-breaking economic growth? The answer lies in the third
possible explanation for the decoupling between financial expectations and
economic reality: market prices are sometimes just wrong.
In the 1980s, investors and regulators acknowledged this and simply assumed
that the negative valuations of bank balance implied by asset prices set in
the markets would eventually improve - an assumption that turned out to be
right. The main difference between the banking problems of the past and
today's seemingly more catastrophic crisis lies not in the scale of the
likely credit losses - which is probably less serious today - but in the
dogmatic belief that a bank's ability to operate must depend on the values
that wildly fluctuating markets assign to the assets and liabilities on its
balance sheet.
This dogma, encapsulated in the concept of “mark-to-market accounting”,
asserts that for a bank to be considered solvent it should be able to
liquidate all its assets and liabilities overnight and still have money left
over for its shareholders.
If this test were applied with full rigour, every bank that has ever existed
since the Fuggers and the Medicis would have been insolvent, since the whole
point of a bank is to exchange short-term, liquid, fixed-value liabilities
for long-term, illiquid assets whose value is hard to gauge - this liquidity
and maturity transformation is, in fact, the main social function that a
banking system provides.
What regulators around the world must now do, if they want to prevent a purely
financial problem degenerating into a genuine economic crisis, is to stop
the lemming behaviour of financial markets. To do this, they must return to
the basic principles of banking - and set clear limits to the absurdity of
mark-to-market accounting. Investors can pay attention to accounting
standards and rating agencies if they want to, but it is time for regulators
and governments to recognise that market prices are sometimes plain wrong.
I disgree 100% with the writer. What the world needs now is some honesty, not the same optimistic cabbage we have been hearing since this economic crisis began. Mr. Kaletsky has been consistently wrong for the last 12 months at least. He will continue to be dead wrong for many years to come. Cheers
William Kent, Brandon, Canada
Bankers on bonuses have anything to do with it? The less they lose, the more likely they are to keep their jobs? Possibly more likely than the three limited ideas presented. Spooking is the new game for those who can profit from short selling.
Alistair Kipling, Birmingham,
Economic growth in the 1980s was "financed" by oil so cheap that energy was virtually free. Growth would have been even faster if the banks hadn't been in such poor shape. Now energy prices are getting real but the banks are again shot.
William Ress-Mogg 6: Anatole Kaletsky 0. Sorry.
Edmund, Bristol, uk
'Tax rebates designed to provide a shot of financial adrenaline ...' Chances of that happening here?
Chris, Sheffield,
Share prices should reflect future profits; growth of gdp is only one factor. Rising import prices through devaluation and oil and raw materials costs will squeeze profits badly. Reason enough for share prices to fall even if prospects for the economy as a whole are not bad.
Matthew Green, London, Uk
When looking for the silver lining, don't get blinded by the facts. Consumer confidence is down; -- not level, not up.
The Conference Board Consumer Confidence Index, which had declined in May, declined even further in June. The Index now stands at 50.4 (1985=100), down from 58.1 in May.
Walter, Washington DC, USA
I agree in a way.The US financial market is in a collapse. At the same time however, other sectors isn't doing so bad. Look at Apple for goodness sake. They just sold 1 million iphones in just 3 days.I don't see Google or Amazon,even Zappos struggling either. And biotech is still a growing industry.
Arlene, LA,
good article - what frightens me, as an American is the people have been conditioned for so long to beliefs contrary to common sense that the lessons taught must be brutal before they sink in - the laughing baboons are everywhere ridiculing others pain as moral degeneracy.
glenn schaefer, holbrook, ny/usa
This entire banking crisis has been organisized by a few clever dicks. The missing money is in someone's pocket. Chase the money trail and the answer of who is really responsible will be clear. The banks are just dummies following the leader. Governments are just another pawn in the game.
Jim Wills, Brisbane, Australia
Anatole, what about the extraordinary personal indebtedness of the UK population? And that in the US? Not just mortgages based on thin air, but unsecured loans, too. I fear that the only way out of this mess is some sort of debt forgiveness. One way or another that will be hugely painful.
Colin, shrewsbury,
Consumer confidence an unreliable lagging indicator for the real economy? Clutching at straws aren't you? In any business I have been involved with, monetary conditions affected consumer confidence, then consumer confidence affected demand. The real economy has hardly started to take the hit yet.
David Goldsby, Cheltenham,
Anatole's optimism has never ceased to amaze me despite that he has been proven wrong so many times. Whenever his predictions turn out to be wrong, he blames the market for making spectaculor mistakes. If the mark to market accounting gives rise to banks' losses, it also produced their past gains.
Charles, Hong Kong,
"Market prices are wrong" - doesn’t make sense. It is like saying the football score is wrong because the "best" team didn’t win. The score is the score. Market prices are the prices in the market at which transactions are happening; there is no right or wrong about it.
OJ, Frant, UK
Everytime i read an article by Mister Kaletsky a new contradiction to what was said previously by him emerges. So it's either all doom and gloom one week and next week it isn't so bad, really !. Sooner rather than later hopefully, he will collapse under the weight of his own contradictions.
Mark, London,
If you are a bank/hedge fund gearing to excess or are an average householder re-mortgaging every year to release "equity" to fund an unafordable lifestyle, eventually, robbing Peter to pay Paul will catch up with you. Classic bubble that is now going pop. Nothing to do with the markets being wrong.
J. R, Salisbury,
I think that the MTM problem that the author is trying to address is MTM-assuming-I-hold-for the-expected-life vs MTM if-I-have-to-dump-it-all-now.
US accounting regs can be interpreted to almost require the latter which can force valuations to accelerate downwards.
Rod, NYC, USA
The market is a indicator, and no more, of human sentiment at any one given moment in time. It is human sentiment that is changing not the markets - out on the street the common man is having a change of plan. If you get in the way you go under - if you figure what has changed you profit. Easy?
kevin, Lincoln, UK
Debt my dear, debt!
If the accountants were real about it there would not be the trickle of sub-prime losses.
In the real world (journalists get paid to make a story-good or bad) debt would be acknowledged.
Triple A bonds that are grade D in the real world -thats accountancy for you!!
Sean McGlinchey, London, London
People always have - and always will - behave irrationally in markets.
On the way up they cause bubbles, on the way down they create/over-emphasise any "crash".
Is this news to Mr Kaletsky ?
Clive, Surrey,
I admire Anatole, he really is the boy on the burning deck. he sticks to his guns no matter what. Read the US press from LA to New York and there's hardly any support for Anatole's optimism. As for a US export driven recovery - just flying in the face of reality. No way are US exports big enough.
John Walter, Bonn, germany
Anatole is off the mark in this article. Without MTM the world would have been a much poorer place. One example is we would not have mortgages that you could pay off early without a huge penalty. There are more. Problem is of control, not MTM in itself.
Dan, London,
They're not wrong. You can't keep adding to debt with no downside. This is a bubble and bubbles burst. You can bury your head in the sand and claim everything will be alright but it will not until people realise they cannot keep remortgaging to maintain their standard of living.
P Wilson, Brighton,
Eddie - It's bad for the husband's bank account but they do it for the greater good!
Paul, London, UK
US and European consumer confidence is at a multi-decade low. Unemployment is rising across the OECD. Globally, industrial production is starting to contract. This is not some mirage manufactured by the financial sector.
It is somewhat disingenuous to argue that Wall St. is, alone, crying wolf.
Joe Roseman, Tenbury, UK
Actually the entire mess has been created by the greed of the investors who are always seeking higher profits. If they think they can get a better return from another bank they then move millions and tell their buddies who in turn move millions leading to a Cash Shortage at the bank they hit.
Gene, Gebüg, Germany
Yes if Freddie and Fannie were to value their assets without reference to the market they could appear to be solvent and not require a taxpayer bailout - perfect. Mark to model made market assumptions that worked well for securitised debt - until it didn't.
Stephen, Cambridge,
The suppressed premise in Kaletsky's argument is that ultimate prices will be higher than present "mark to market" prices. Why assume that? Inflation could all-but guarantee this, but the consequences of unchecked inflation would be ugly. If Kaletsky is right why have the Japanese suffered?
Craig Ross, Glasgow, UK
Thank goodness for Anatole Kaletsky's always thoughtful writing. I have wondered for many months about this market-to-market accounting, since many assets can surely be held onto and realised later for profit.
Ronald Millar, West Horsley, Surrey, UK
How do you value an asset? It is what a willing buyer is prepared to pay to buy an asset from a wiling seller.
In this lemming like bubble addicted world inhabited by humans there can be no 'fixed' price or value for anything.
If.... 'The music is still playing then we will still dance'......
David Nammory, Liverpool,
The system can only be made stable if there is a feedback loop, feeding the discrepancy between the achieved and expected back to the decision making process. With managers getting their bonuses here and now, moving solvency requirements further into the indefinite future is hardly the solution.
Alex, Dublin, Ireland
Yes mark to market accounting is absurd, but we haven't actually had it. Nobody agrees how to "value" mortgage backed securities assets, hence the extent of bank losses is unknown & undeclared, and the financial markets panic.
We need better valuations & accounting standards! Wake up regulators!
Alistair Nicholls, Manchester, UK
As long as women and credit cards exist any recession in a western economy will be short-lived.
Eddie Reader, birmingham, england
Soros has been worng in every one of his books - why should he be roght this time?
Don, Sinagpore,
The financial crisis is the mirror image of the past Asia banks' credit crisis. This then spreads into property and economic setbacks. Such recessions are deep and slow to fix - Japan is still trying to recover a decade later.
Ron, Oxford,
What "record-breaking economic growth"? Merely increasing the sums & number of dead-end service-sector jobs cannot substitute for real production of real goods. This Potemkin Economy of more money going at greater velocities disguises the lack of REAL savings & REAL expansion...!
Chris. Fulker, Jiji Township, Taiwan, R.O.C.
The financial markets and the real economy are not parallel worlds. Sophisticated financial instruments only make them look that way. Where asset prices run ahead of their economic value you get a boom. When they come back down again you get a bust.
Paul, Clear Water Bay, Hong Kong
Various averages were used to amortise losses on illiquid assets in financial institutions in the past before the introduction of mark to market accounting. This slow recognition of losses gave institutions the breathing room they needed to recapitaise if necessary.
patrick slattery, Dublin, Ireland
Banks make nothing except the bottom line. Central Banking is a communist idea that serves only the priveledged few. With the Nutters in charge of the Nuthouse anything is possible.
No economy no economic problems. Shop till you are maxed out and then shop some more.
Amero anyone?
Laurence Howell, Bridgend, UK
The real issue is that this is a bank credit problem almost identical to the Asia crisis, whatever the accounting technique. Credit crises take many years to get through and bring down property and economy. Japan is still suffering the after-effects a decade on.
Ron, Oxford,
This is the most sensible & balanced article i have seen on the evaluation of the economic situation to date, by any commentator!
Tonto, London,
So markets are wrong now they are down, and were not when high? All sorts of real mis-pricing (CDO's etc) is still outing, there is a link.
Mark to Market = wrong, Model = right - is it, comrade?
Participants have reached their conclusions, and won't be betting the farm that you are right - yet.
Michael, Bay of Plenty, New Zealand
Thank you for your contrarian analysis!
Eb, New York,
I have just read Soros's book on the credit crunch. Soros says that not just the housing bubble is bursting, but also the bubble created by the de-regulation of financial services in the 80s - which could mean we face the worst slowdown since 1929 - unless you live in India, China or parts of Asia.
Tom D, London,
The problem is that over the last 10 yrs banks have side stepped lending multiples by keeping lending off their balance sheets by using the CDO market. More on more money was created and lent in this way leading to large asset bubbles. The game is now up and the markets know it - they are not wrong.
Simon, London, UK
After the hysterical commentaries of last week this, and the comments from Kate barker,offer a much needed more sensible perspective. Armagedon is not nigh and UK house prices will reach a sensible level without destroying the economy in the process. Bank shareholders will blame their managers
Colin Grant, Montreal, Canada
Fantastic! The financial market live in a parrallel world to the rest of us - and sometimes their view of the realities of life lead them to behave like sheep (following the analyst-gurus) and they part company completely with what is really going on. Fabulous article - keep the flame alight!
Mike Armitage, Manchester, U.K.