Thursday, October 29, 2009

Central Banks, Arsonists and Playing with Fire

Andy Xie: Money supply growth has sparked an asset market boom that supports the economy, not the other way around. Don't get burned.

Oct 28

(Caijing Magazine) Is money demand efficient? The answer could help decide what's best for monetary policy. Moreover, as financial institutions have demanded more money to support their leverage, money demand efficiency has become equivalent to financial system efficiency.

I think the answer is no. Monetary authorities and central banks have a responsibility to take this reality into account. Their best approach would be to limit the deviation of monetary growth from nominal GDP growth. In particular, sustained deviation should be corrected -- even if the underlying economy suffers in the short term.

This is a serious academic topic these days. Some of the world's most prominent economists hold different views. Why discuss it here? First, it's important to everyone. After all, retail investors dominate China's asset markets, and most base their investments or speculation decisions on expectations that the government will not let asset prices fall. The credibility of this expectation depends on whether money available for government spending is limited. A discussion on monetary expansion's limits can help Chinese investors assess the risks of their investment decisions.

Second, money supplies worldwide are rising much faster than nominal GDP growth rates. That is, monetary growth is being used to support leverage, mostly in the financial sector. Of course, the reason is central banks have responded to the financial crisis by cutting interest rates and sometimes force-feeding banks with liquidity in hopes more lending will boost the economy. But instead, money has flowed into and led to buoyancy in asset markets (stocks and bonds in developed economies, and almost everything in emerging economies).

Buoyant asset prices have stabilized the global economy. Most analysts say buoyant asset markets reflect correct expectations of a buoyant global economy. I don't think this is true. As we saw in the past decade, the latest asset market boom is supporting the economy, not the other way around. In other words, it's a bubble.

Even though the global economy is staging a modest recovery, mainly on inventory restocking and fiscal stimuli, the overall economic situation is still difficult. Unemployment rates in OECD countries are at record highs. Global trade is still at one-fifth its peak level. The small- and medium-sized economies that employ most of the world's people are struggling. We see a contrast – unprecedented in modern times -- between the asset market boom and real economic difficulties.

The gap is creating social tension around the world. While workers and businesses struggle, asset players are reaping substantial paper profits again. As the central bank's monetary policy is behind the asset boom, we should ask whether the policy is achieving its goal by helping the real economy, or whether it is just helping speculators and hoping they have something left over for the real economy.

The financial crisis exposed gross inefficiencies in the massive amounts of money financial institutions received from central banks. Supplying so much money to the same people who caused the crisis -- and with the same incentives -- does not feel right. The argument in favor of this policy is that, when the house is on fire, you have to do whatever to extinguish the fire and find the culprit later. The problem is that, in this case, the arsonists have been asked to put out the fire. How can we be sure they won't start another fire?

Most argue that the answer is not to limit the money supply but to reform the financial system. In this way, future demand for money would be efficient. But so far, no corrective reforms have been implemented in response to the financial crisis. Why? Because the global financial system became so big over the past decade that it has co-opted central banks, legislators and entire governments. Any reforms that do come will not address the main factors leading to the current crisis.

Even the best reforms will never resolve a problem based on the fact that financial professionals generally risk other people's money: They get big rewards when bets go right and don't have to pay when bets go wrong. The problem with this incentive system suggests the global financial system is structurally biased toward taking on more risk than what would be taken in an efficient market.

The only way to counter this is for central banks to limit money supplies. Asset inflation over the past 10 years and the catastrophe incurred when it burst lend credibility to this argument.

Stagflation in the 1970s spurred economists to study why monetary stimulus, over time, loses its punch. Demand is stimulated, but that leads to inflation. And it's led to development of the rational expectation theory to explain the average Joe's response to monetary policy. Its conclusion, although obvious to the uneducated, is that policymakers cannot fool people again and again. For that observation, many have won Nobel prizes. Milton Friedman advocated money supply growth targets as a guiding principle for central banking. Such an approach would put central banking on autopilot with a target of money growth and leave the market to decide interest rates.

The rational expectation theory was extended further to explain investor behavior. This led to the efficient market theory, which posits that, under some conditions, rational investors will lead to efficient asset prices that correctly anticipate the future. Academic jargon for efficient asset price says that it includes all useful information about the future. That laid the foundation for tearing down the regulatory structure built from the lessons of the Great Depression.

Stagflation of the 1970s led to central banking to focus narrowly on short-term inflation. The efficient market theory prompted central banks to completely accommodate financial institutions that demanded money for leverage funding. This combination of policy steps laid the foundation for the big bubble in the past decade. As globalization kept inflation low, Wall Street could source an unlimited amount of liquidity from central banks for bubble making.

Even though globalization has maxed out, and the global economy has now entered an inflation age, the bursting of the last bubble is a negative demand shock that's keeping inflation low for the time being. This has created another window for bubble-making. A last-train psychology means this bubble is growing quickly, totally oblivious of economic fundamentals. In addition to the usual misinformation from market makers who want to sucker people, government officials, financial professionals and the media are also saying what speculators want to hear. This is yet another episode of an inefficient market adventure.

Institutional investors dominate financial markets in western countries, while retail or individual investors are the main players in the east. Neither group is thinking or behaving rationally. Most institutional investors are benchmarked against market indexes quarterly, and with cash-holding limits. These constraints obviously have disadvantaged them and made it extremely hard to outperform the indexes. This is why most institutional investors are closet indexers. Extra management costs guarantee that most institutional investors under-perform market indexes and don't add to market efficiency.

Absolute performance funds or hedge funds are the biggest development in financial market in the past 10 years. But they have been amplifying market volatility rather than improving efficiency. The hedge fund industry has made managers rich, not investors, because managers are remunerated with a cut on the upside, and don't pay up for the downside. So they are structurally incentivized to long volatility while playing something like the coin-flip game "heads I win, tails you lose."

Regardless how one tries to improve the incentive structure for institutional investors, nothing could overcome the incentive distortions tied to the practice of managing other people's money. Institutionalization, once hailed as a great step forward in improving market efficiency, has proven to diminish efficiency. Developing countries that face highly volatile markets have been looking to institutionalization as a way to calm them. They should think twice. Institutionalization may decrease short-term volatility but make up for this advantage with a big crash.

Retail or individual investors routinely mistake volatility for trend. Their herd behavior creates self-fulfilling trends that are mainly temporary. From time to time, such herd behavior lasts a long time and leads to big bubbles, which in turn lead to major misallocations of resources.

To minimize chances of future financial crises, one could reform the financial system to make it less crisis-prone, or target both asset and CPI inflation when setting monetary policy. When the crisis began a year ago, policymakers around the world swore to reform the system while ridding it of corruption and excess leverage. After governments bailed out financial institutions with trillions of dollars, the impetus for reform waned. Reform bills in the U.S. Congress have been watered down so much that they would not prevent another major crisis.

Capital requirements and transparency are key elements to address in any effective financial reform. And unless reforms target problems in the derivatives market, they will not be effective. Over-the-counter derivatives carry hundreds of trillions of dollars in notional value, thriving in an opaque environment. Derivatives in theory help buyers decrease risk, but in practice they are merely tools for taking on more risk, hiding leverage through complex structuring. Market-makers can earn high profits by fooling buyers and regulators, overcharging while putting up little capital to warehouse such high-risk products. If the market is made transparent and capital requirements are reasonable, this business would shrink.

Every party ends sooner or later, and I see two scenarios for the next bust. First, every trader is borrowing dollars to buy something else. Most traders on Wall Street are Americans, British or Australians. They know the United States well. The Fed is keeping interest rates at zero, and the U.S. government is supporting a weak dollar to boost U.S. exports. You don't need to be a genius to know that the U.S. government is helping you borrow dollars for speculating in something else.

But these traders don't know much about other countries, particularly emerging economies. They go there once or twice a year, chaperoned by U.S. investment banks eager to sell something. They want to think everything other than the U.S. dollar will appreciate; Wall Street banks tell them so. Since there are so many of these traders, their predictions are self-fulfilling in the short-term. For example, since the Australian dollar has appreciated by 35 percent from the bottom, they now feel very smart while sitting on massive paper profits.

When a trade like this one becomes too crowded, a small shock is enough to trigger a hurricane. There must be massive leverage in many positions, but one just never knows where. When something happens, all these traders will run like mad for the exit, and that could lead to another crisis.

Surging oil prices could be another party crasher. This could trigger a surge in inflation expectation and crash the bond market. The resulting high bond yields might force central banks to raise interest rates to cool inflation fear. Another major downturn in asset prices would reignite fear over the balance sheets of major global financial institutions, resulting in more chaos.

Twice in recent years, oil prices surged into triple-digit territory, wreaking havoc on financial markets and the global economy. In 2006, surging oil prices toppled the U.S. property market, debunking the story that property prices never fall -- a premise upon which subprime lending was based. Oil prices fell sharply amid the subprime crisis period while the market feared collapse in demand. The Fed came to the rescue and, in summer 2007, began cutting interest rates aggressively in the name of combating the recessionary impact of the subprime crisis. Oil prices surged afterward on optimism that the Fed would rescue the economy and oil demand. It worked to offset the Fed's stimulus, accelerated the economic decline, and pulled the rug out from under the derivatives bubble. The ensuing fear of falling demand again caused oil prices to collapse.

Oil is a perfect ingredient for a bubble: Oil supplies cannot respond to a price surge quickly. It takes a long time to expand production capacity, and oil demand cannot decrease quickly due to lifestyle stickiness and production modes. Low-price sensitivities on both demand and supply sides make it an ideal product for bubble-making. When liquidity is cheap and easily obtained, oil speculators can pop up anywhere.

Oil speculators are no longer restricted to secretive hedge funds. Average Joes can buy exchange traded funds (ETFs) that let them own oil or anything else. Why not? Central banks have made clear their intentions to keep money supplies as high as possible, debasing the value of paper money to help debtors. It seems no good deed is unpunished in this world. If you speculate big, governments will offer a bailout when your bets go wrong and cut interest rates and guarantee your debts, allowing bigger bets. People who live within their means and save some for a rainy day see dreams shattered. Central banks can't wait to break their nest eggs.

It is better to be a speculator in this world. The powers that be are with you. Maybe everyone should be a hedge fund; ETFs give you this opportunity. As the masses are incentivized to avoid paper money while buying hard assets, the price of oil could surge to triple-digit territory again. Oil bubbles are easy to come and quick to go because the oxygen needed for its existence disappears after it kills other bubbles.

A word of caution for all would-be speculators: You'll want to run for your life as soon as the bond market takes a big fall. And the case for a double dip in 2010 is already strong. Inventory restocking and fiscal stimuli are behind the current economic recovery, and when these run out of steam next year, the odds are quite low that western consumers will take over. High unemployment rates will keep incomes too weak to support spending. And consumers are unlikely to borrow and spend again.

Many analysts argue that, as long as unemployment rates are high, more stimuli should be applied. As I have argued before, a supply-demand mismatch rather than demand weakness per se is the main reason for high unemployment. More stimuli would only trigger inflation and financial instability.

Stagflation in the 1970s discredited a generation of central bankers. They thought they could trade a bit more inflation for a lot more economic growth. Today's crisis will discredit a generation of central bankers who ignore asset inflation by sometimes trading asset inflation for a bit of economic growth. Those who play with fire often get burned, even when the arsonists don't.


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