It is reassuring to know that opportunity is created when investors are forced into liquidating assets, even assets with good fundamentals.
THE FINANCIAL TIMES-Published: August 15 2007 03:00
In a world of overconfidence, fear makes a welcome return – by Martin Wolf
"At particular times a great deal of stupid people have a great deal of stupid money . . . At intervals . . . the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is ‘speculation’; it is devoured, and there is ‘panic’."Walter Bagehot.*
Panic follows mania as night follows day. The great 19th-century economist and journalist, Walter Bagehot, knew this better than anybody. Lombard Street, his masterpiece, is dedicated to the phenomenon. It is devoted, too, to how central banks should deal with its results.
Ours has been a world of the "no income, no job, no assets" 100 per cent mortgage; of the "do what you like with our money, as long as you pay the fees" covenant-light loan; and of the "in go poor credits and out comes a triple A-rated security" financial alchemist. It has been a world of confidence, cleverness and too much cheap credit.
This is not new. It is as old as financial capitalism itself. The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with "displacement", some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.
The fourth stage is over-trading, when markets depend on a fresh supply of "greater fools". The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry "bubble" are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.
In the latest cycle, displacement began with the huge cuts in interest rates in the early 2000s, which drove up prices in housing. The easy credit was stimulated by innovations that allowed those making the loans to regard their service as somebody else’s problem. Then people started to buy dwellings to resell them, not live in them. Subprime lending was a symptom of euphoria. So, in a different way, was the rush of bankers into hedge funds and of the wealthy and big institutions into financing them. Then came profit-taking, falling prices and, last week, true revulsion.
This was what George Magnus of UBS bank calls a "Minsky moment". It was the moment when credit dried up even to sound borrowers. Panic had arrived.
The correct policy response is also well known. It was laid down by Bagehot himself from his observation of the evolution of the Bank of England. The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.
In providing money to the markets last week and this, the European Central Bank, the Federal Reserve, the Bank of Japan and other central banks have been doing their jobs. Whether the terms on which they have done this were sufficiently penal is another matter.
Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust.
When William Poole, chairman of the St Louis Federal Reserve, said that "the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves", I gave a cheer.
Not so Jim Cramer, hedge fund manager and television pundit, who declared last Friday that chairman of the Federal Reserve, Ben Bernanke, "is being an academic!…My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing! . . . The Fed is asleep."
So capitalism is for poor people and socialism is for capitalists. This view is not just offensive. It is catastrophic.
The world has witnessed four great bubbles over the past two decades – in Japanese stocks in the late 1980s, in east Asia’s stocks and property in the mid-1990s, in the US (and European) stock markets in the late 1990s and, finally, in the housing markets of much of the advanced world in the 2000s. There has been too much imprudent finance worldwide, with central bankers and ministries of finance providing rescue at virtually every stage.
Unfortunately, there is every chance of repeating mistakes. A bail-out has already occurred in Germany, far from the epicentre. More are likely. US legislators want Fannie Mae and Freddie Mac to bail out the mortgage markets.
The pressure on the Federal Reserve to cut interest rates will also grow. As Larry Hathaway and Mr Magnus of UBS note, this looks a much more significant event than the implosion of Long-Term Capital Management in the aftermath of the Russian default of August 1998. The consequences cannot be "ring-fenced", as those of LTCM were. Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging.
Such a period, desirable in itself, will lead to strong pressure for swift declines in interest rates, at least in the US, and so for another partial bail-out of a crisis-prone system. This pressure should be resisted as long as possible.
Yet the underlying challenge confronting the world’s central banks remains: huge surplus savings in important parts of the world; corporate sectors that do not need to borrow and so limited categories of creditworthy and willing borrowers, households in rich countries foremost among them. The epoch of the US housing bubble is over. The pressure for repeated injections of cheap finance is not.
*Cited in Manias, Panics and Crashes: a History of Financial Crises, fifth edition. Charles P. Kindleberger and Robert Z. Aliber (Basingstoke: Palgrave Macmillan, 2005)
Copyright The Financial Times Limited 2007
These articles are for informational purposes only and are not intended to be a solicitation, offering or recommendation of any security. Guild Investment Management does not represent that the securities, products, or services discussed in this web site are suitable or appropriate for all investors. Any market analysis constitutes an opinion that may not be correct. Readers must make their own independent investment decisions.
The information in this article is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation, or which would subject Guild Investment Management to any registration requirement within such jurisdiction or country.
Any opinions expressed herein, are subject to change without notice. In addition, there are many market, currency, economic, political, business, technological and other risks that are beyond our control. We make reasonable efforts to provide accurate content in these articles; however, some content and some of the assumptions, formulas, algorithms and other data that impact the content may be inaccurate, outdated, or otherwise inappropriate. In addition, we may have conflicts of interest with respect to any investments mentioned. Our principals and our clients may hold positions in investments mentioned on the site or we may take positions contrary to investments mentioned.
Guild’s current and past market commentaries are protected by copyright. Apart from any use permitted under the Copyright Act, you must not copy, frame, modify, transmit or distribute the market commentaries, without seeking the prior consent of Guild.