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.
