We have long believed in free markets as the best method for creating economic growth and improving the standards of living. Economic success creates wealth, and power. In some cases, political power that is born from free market success can give the powerful the confidence to engage in high-level risk taking with the knowledge that if they win, they keep the profits; and if they lose, a government taxpayer sponsored bailout will come to their aid. This is the situation in which we find ourselves today, and why we would like to share an article from this week’s Economist.
A special case
The demand for financial assets is not like the demand for iPods
Aug 12th 2010 – MARKETS work. A government would never have made a success of an iPod, iPhone or iPad whereas Steve Jobs at Apple was able to anticipate demand for such hand-held devices. Other companies quickly noted Apple’s success and produced rival devices, thereby driving down prices and widening their appeal to consumers.
Friedrich Hayek argued that markets were the most efficient mechanism for allocating resources because they represented the individual decisions of millions of consumers and thousands of producers—the wisdom of crowds, if you like. Bureaucrats and politicians would never have enough information to allocate resources as efficiently.
This newspaper believes passionately in the principle of free markets. But in recent years it has also argued that central banks should do more to counteract bubbles, even though asset prices are also set through the market mechanism.
This apparent contradiction can be resolved. Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.
Why the difference? The reason is surely that goods and services are bought with a specific use in mind. Our desire for them may be driven by fashion or a desire to enhance our status. But those potential qualities are inherent in the goods themselves—the sports car, the designer sunglasses, the fitted kitchen. Such goods may be means to an end but the nature of the means is still important.
Financial assets appeal for one reason only: their ability to enhance, or conserve, the buyer’s wealth. There is nothing that so induces a change in attitude as seeing a friend get rich. People learn through anecdote and example—the friend who sold his house for a million, the colleague who made a fortune buying dotcom stocks.
When goods prices are rising, manufacturers make more of them. The same is true of financial assets and it does not take long or cost much to create new shares. But if the underlying value of the businesses has not changed, then the creation of new shares simply dilutes the wealth of existing investors. The dotcom boom transferred the wealth of pension funds to 20-somethings in Silicon Valley.
If rising prices create euphoria, falling prices induce paralysis. Trading volume in the market tends to dry up as investors wish neither to realise losses nor to hunt for bargains. In other words the attitude of investors towards the stockmarket is the complete opposite of their attitude towards a department store. They will not rush to take advantage of a sale.
Surely there are rational investors who can profit from market booms and panics? There are some but not enough. Such rational beings are simply overwhelmed by the force of the herd. It does not help that many countries impose restrictions on short-selling (the ability to bet on falling prices). There is also, as Paul Woolley of the London School of Economics has pointed out, an “agency” problem. Many investors have their money managed by professionals, whom they select on the basis of past returns. Given that managers usually have a bias toward a particular style of investing, this causes even more money to flow to the most popular stocks.
After so many financial crises in the past 40 years most reasonable people would now accept that bubbles in asset markets can exist. The feedback mechanism described by Hyman Minsky, an American economist, seems pretty clear. A period of rising markets and steady economic growth creates the incentive for investors to speculate with borrowed money. This speculation drives prices even higher, until some shock (or the desire to take profits) causes the boom to implode.
Why not just let the markets rip? Some would say that bubbles tend to coincide with periods of great economic change, such as the development of the railways or the internet. Individual speculators may lose from the resulting busts but society gains from their overoptimistic investments. However, this argument is harder to sustain after the recent bubble in which society “gained” some empty condos in Miami and holiday homes in Spain.
The evidence is clear that the clean-up costs after debt-financed bubbles are too high. Central banks and governments do have to intervene when credit growth and asset prices (particularly in property) start dancing their toxic two-step. Asset markets do not work as well as those for consumer goods.
MORE ON INDIA
India is making an effort to open its markets to the many foreign retail and institutional investors who have not taken the considerable time, expense, and administrative difficulty involved in acquiring Foreign Institutional Investor [FII] status. At Guild, we went through this process twice, and we can assure you it was an expensive, time-consuming, and frustrating experience dealing with the Indian bureaucracy.
The fact that India is simplifying, and further opening themselves to foreign capital, especially the capital of non-resident Indians who know the country, yet have had a very hard time investing in India directly from abroad is very positive.
Eventually, retail investors abroad will have access to Indian stocks and to Chinese stocks [We will discuss China ’s market reforms in more detail in future letters]. This initiative can only be salutary long-term, for stock prices and P/E ratios in India .
CHINA NOW #2
You may have seen the headlines recently that China ’s economy surpassed Japan ’s in the second quarter to become the world’s #2 economy. Some believe that China will be #1 by 2030.
Two weeks ago we discussed the recently published research by a renowned Chinese professor discussing that China ’s “grey income”, or unreported income, understates the size of their economy. Clearly, if China ’s unreported income is really 67% higher than reported in their GDP numbers, then China actually surpassed Japan some time ago as Japan ’s unreported income is considerably lower than China ’s.
CHINA ACCELERATES MOVE OUT OF DOLLAR INTO YEN AND EURO
In recent weeks, the dollar has turned lower amid reports that China is continuing to further diversify its huge foreign exchange reserves away from the U.S. Dollar.
The Federal Reserve’s statement last week confirms its intention to keep U.S. interest rates very low. Meanwhile, European Central Bank President Jean-Claude Trichet and Bank of Japan chief Toshihiko Fukui have suggested that they may raise interest rates. Peoples Bank of China Governor, Zhou Xiaochuan, said that China will maintain its policy of diversifying the world’s largest foreign exchange reserves for “safety, efficiency, and liquidity”.
We expect to see rising gold and oil prices in the near term. We continue to look for opportunities in some of the faster growing Asian economies that we have discussed, as fast economic growth will lead to corporate profit growth. We prefer to wait for pullbacks in the markets to take positions. At present, the portfolios are holding large cash reserves as the markets are digesting many economic, political, and monetary cross currents.
Thanks for listening. We hope you are enjoying the summer season, and we encourage you to contact us with questions, suggestions and criticisms or if we may be of service.
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