2008中金论坛 CICC Forum 2008
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Taped Speech To Be Presented On Friday, November 21 in Beijing, China
You have asked me to explain the crisis that has engulfed the global financial
system. I’ll do my best.
The salient feature of the crisis is that it was not caused by some extraneous event
such as the OPEC raising the price of oil; it was generated by the financial system
itself. This fact—that the defect was inherent in the system — discredits the
prevailing theory, which holds that financial markets tend toward equilibrium, and
that deviations from the equilibrium are caused by some sudden external shock
which markets have difficulty adjusting to. I have developed an alternative theory
that differs from the current one in two important respects. First, financial markets
don’t reflect the underlying conditions accurately. They provide a picture that is
always biased or distorted in some way or another. Second, the distorted views
held by market participants and expressed in market prices can, under certain
circumstances, affect the so-called fundamentals that market prices are supposed
to reflect. I call this two-way circular connection between market prices and the
underlying reality ‘reflexivity’.
I contend that financial markets are always reflexive and on occasion they can
veer quite far away from the so-called equilibrium. While markets are reflexive at
all times, financial crises occur only occasionally, and in very special
circumstances. Usually markets correct their own mistakes, but occasionally there
is a misconception or misinterpretation that finds a way to reinforce a trend that is
real and by doing so it also reinforces itself. Such self- reinforcing processes may
carry markets into far-from-equilibrium territory. Unless something happens to
abort the reflexive interaction sooner, it may persist until the misconception
becomes so glaring that it has to be recognized as such. When that happens the
trend becomes unsustainable and when it is reversed the self-reinforcing process
starts working in the opposite direction, causing a catastrophic downturn.
The typical sequence of boom and bust has an asymmetric shape. The boom
develops slowly and accelerates gradually. The bust, when it occurs, tends to be
short and sharp. The asymmetry is due to the role that credit plays. As prices rise,
the same collateral can support a greater amount of credit. And rising prices also
tend to generate optimism and encourage a greater use of credit. At the peak of the
boom both the value of the collateral and the degree of leverage are, by definition,
at a peak. When the price trend is reversed participants are vulnerable to margin
calls and, as we have seen recently, the forced liquidation of collateral leads to a
catastrophic acceleration on the downside.
Thus bubbles have two components: a trend that prevails in reality and a
misconception relating to that trend. The simplest and most common example is to
be found in real estate. The trend consists of an increased willingness to lend and a
rise in the price of real estate. The misconception is that the price of real estate is
somehow independent of the willingness to lend. That misconception encourages
bankers to become more lax in their lending practices as prices rise and defaults
on mortgage payments diminish. That is how real estate bubbles, including the
recent housing bubble in the United States, are born. It is remarkable how the
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misconception continues to recur in various guises in spite of a long history of real
estate bubbles bursting.
Bubbles are not the only manifestations of reflexivity in financial markets, but
they are the most spectacular. Bubbles always involve the expansion and
contraction of credit and they tend to have catastrophic consequences. Since
financial markets are prone to produce bubbles and bubbles cause trouble,
financial markets have become regulated by the financial authorities. In the United
States they include the Federal Reserve, the Treasury, the Securities and Exchange
Commission, and many other agencies.
It’s important to recognize that regulators base their decisions on a distorted view
of reality just as much as market participants—perhaps even more so because
regulators are not only human but also bureaucratic and subject to political
influences. So the interplay between regulators and market participants is also
reflexive in character. In contrast to bubbles, which occur only infrequently, the
cat-and-mouse game between markets and regulators goes on continuously. As a
consequence reflexivity is at work at all times and it is a mistake to ignore its
influence. Yet that is exactly what the prevailing theory of financial markets has
done and that mistake is ultimately responsible for the severity of the current crisis.
I have originally proposed my theory of financial markets in my first book, The
Alchemy of Finance, published in 1987 and I brought it up to date in my latest
book The New Paradigm for Financial Markets: The Credit Crisis of 2008 and
What It Means. In that book, I argue that the current crisis differs from the
various financial crises that have preceded it. I base that assertion on the
hypothesis that the explosion of the US housing bubble acted as a detonator of a
much larger "super-bubble" that has been developing since the 1980s.
The housing bubble is simple; the super-bubble is much more complicated. The
underlying trend in the super-bubble has been the ever-increasing use of credit and
leverage. In the United States, credit has been growing at a much faster rate than
the gross national product ever since the end of World War II. But the rate of
growth accelerated and took on the characteristics of a bubble in the 1980s when it
was reinforced by a misconception that became dominant when Ronald Reagan
became president and Margaret Thatcher was prime minister in the United
Kingdom.
The misconception is derived from the prevailing theory of financial markets,
which, as I mentioned, holds that financial markets tend toward equilibrium and
deviations are random and can be attributed to external causes. This theory has
been used to justify the belief that the pursuit of self-interest should be given free
rein and markets should be deregulated. I call that belief market fundamentalism
and I contend that it is based on a false argument. Just because regulations and all
other forms of governmental interventions have proven to be faulty, it does not
follow that markets are perfect.
Although market fundamentalism is based on false premises, it has served the
interests of the owners and managers of financial capital very well. The
globalization of financial markets has allowed financial capital to move around
freely and made it difficult for individual states to tax it or regulate it.
Deregulation of financial transactions and the freedom to innovate have enhanced
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the profitability of financial enterprises. The financial industry grew to a point
where it produced about a third of all corporate profits both in the United States
and in the United Kingdom.
Since market fundamentalism is built on false assumptions, its adoption in the
1980s as the guiding principle of economic policy was bound to have adverse
consequences. Indeed, we have experienced a series of financial crises since then,
but the negative consequences were suffered principally by the countries that lie at
the periphery of the global financial system, not by those at the center. That’s
because the system is under the control of the developed countries, especially the
United States, which enjoys veto rights in the International Monetary Fund.
Whenever a crisis endangered the prosperity of the United States—as for example
the savings and loan crisis in the late 1980s, or the collapse of the hedge fund
Long Term Capital Management in 1998—the authorities intervened, finding
ways to bail out the failing institutions and providing monetary and fiscal stimulus
when the pace of economic activity was endangered. Thus the periodic crises
served, in effect, as successful tests that reinforced both the underlying trend of
ever-greater credit expansion and the prevailing misconception that financial
markets should be left to their own devices. It was of course the intervention of
the financial authorities that made the tests successful, not the ability of financial
markets to correct their own excesses. But it was convenient for investors and
governments to deceive themselves. The relative safety and stability of the United
States, compared to the countries at the periphery, allowed the United States to
suck up the savings of the rest of the world and run a current account deficit that
reached 7 percent of GNP at its peak in the first quarter of 2006.
Eventually even the Federal Reserve and other regulators succumbed to the
market fundamentalist ideology and abdicated their responsibility to regulate.
They ought to have known better since it was their actions that kept the United
States economy on an even keel. Alan Greenspan, in particular, believed that
giving financial innovations free rein brought such great benefits that having to
clean up behind the occasional financial mishap was a small price to pay for the
gain in productivity. And while the super-bubble lasted his analysis of the costs
and benefits of his permissive policies was not totally wrong. Only now has he
been forced to acknowledge that there was a flaw in his argument.
Financial engineering involved the creation of synthetic financial instruments for
leveraging credit with names like Collateral Debt Obligations and Credit Default
Swaps. It also involved increasingly sophisticated mathematical models for
calculating risks in order to maximize profits. This engineering reached such
heights of complexity that the regulators could no longer calculate the risks and
came to rely on the risk management models of the financial institutions
themselves. The rating agencies followed a similar path in rating synthetic
financial instruments, they relied on information provided by the issuing houses
and they derived considerable additional revenues from the increase in their
business. The esoteric financial instruments and sophisticated techniques for risk
management were based on the false premise that deviations from the equilibrium
occur in a random fashion. But the increased use of financial engineering
disturbed the so-called equilibrium by setting in motion a self-reinforcing process
of credit expansion. So eventually there was hell to pay. At first the occasional
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financial crises served as successful tests. But the subprime crisis came to play a
different role: it served as the culmination or reversal point of the super-bubble.
It should be emphasized that this interpretation of the current situation on the
bursting of the super-bubble does not necessarily follow from my theory of
reflexivity. Had the financial authorities succeeded in containing the subprime
crisis—as they thought at the time they would be able to do—this would have
been seen as just another successful test instead of the reversal point. My theory of
reflexivity can explain events better than it can predict them. It is less ambitious
than the previous theory. It doesn’t claim to determine the outcome as equilibrium
theory does. It can assert that a boom must eventually lead to a bust, but it cannot
determine the extent of or the duration of a boom. Indeed, those of us who
recognized that there was a housing bubble expected it to burst much sooner. Had
it done so, the damage would have been much smaller and authorities might have
been able to keep the super-bubble going. Most of the damage was caused by
mortgage-related securities issued in the last two years of the housing bubble.
The fact that the new paradigm doesn’t claim to predict the future explains why it
did not make any headway until now, but in light of the recent experience it can
no longer be ignored. We must come to terms with the fact that reflexivity
introduces an element of uncertainty into financial markets that the previous
theory left out of account. That theory was used to establish mathematical models
for calculating risk and converting bundles of subprime mortgages into tradable
securities. But the uncertainty connected with reflexivity can’t be quantified.
Excessive reliance on those mathematical models did untold harm. In my book, I
predicted that the current financial crisis would be the worst since the 1930s but
the actual course of events actually exceeded my worst expectations.
When Lehman Brothers declared bankruptcy on September 15, the inconceivable
occurred: the financial system actually melted down. A large money market fund
that had invested in commercial paper issued by Lehman Brothers lost part of its
asset value, thereby breaking an implicit promise that deposits in such funds are
totally safe and liquid. This started a run on money market funds and forced the
funds to stop buying commercial paper. Since they were the largest buyers, the
commercial paper market ceased to function. The issuers of commercial paper,
which include the largest and most respected corporations, were forced to draw
down their credit lines, bringing interbank lending to a standstill. Credit spreads—
that is to say, the risk premium over and above the riskless rate of interest—
widened to unprecedented levels and eventually the stock market also was
overwhelmed by panic. All this happened in the space of a week.
The world economy is still reeling from the after effects. Resuscitating the
financial system then took precedence over all other considerations and the
authorities injected ever larger quantities of money. The balance sheet of the
Federal Reserve ballooned from $800 billion to $1.8 trillion in a couple of weeks.
When that was not enough, the American and European financial authorities
publicly pledged themselves, that they would not allow any other major financial
institution to fail.
These unprecedented measures began to have some effect: interbank lending
resumed and the London Interbank Offered Rate (LIBOR) improved. The
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financial crisis showed signs of abating. But guaranteeing that the banks at the
center of the global financial system will not fail has precipitated a new crisis that
caught the authorities unawares: countries at the periphery, whether in Eastern
Europe, Asia, or Latin America, couldn’t offer similar credible guarantees, and
financial capital started fleeing from the periphery to the center. All currencies fell
against the dollar and the yen, some of them precipitously. Commodity prices
dropped like a stone and interest rates in emerging markets soared. So did
premiums on insurance against credit default. Hedge funds and other leveraged
investors suffered enormous losses, precipitating margin calls and forced selling
that have also spread to the stock markets at the center. In recent days, the credit
markets have also started to deteriorate again.
Unfortunately the authorities are always lagging behind events. The International
Monetary Fund is establishing a new credit facility that allows financially sound
periphery countries to borrow without any conditions up to five times their annual
quota, but that is too little too late. A much larger pool of money is needed to
reassure markets. And if the top tier of periphery countries is saved, what happens
to the lower-tier countries? The race to save the international financial system is
still ongoing. Even if it is successful, consumers, investors, and businesses have
suffered a traumatic shock whose full impact on the global economic activity is
yet to be felt. A deep recession is now inevitable and the possibility of a
depression comparable to the 1930s cannot be ruled out.
What are the implications of this dire situation for China? In many ways China is
better situated than most other countries. It had been the main beneficiary of
globalization. It has amassed large currency reserves, its banking system is
relatively unscathed and the government enjoys a greater range of policy choices
than other governments. But China is not immune from the global recession.
Exports have dropped, inventories of iron ore and other commodities are
excessive, the stock market has declined further than in most other countries, and
the real estate boom has turned into a bust. Domestic demand needs to be
stimulated, but that is not enough. China must also play a constructive role in
stimulating the global economy, otherwise exports can’t recover.
The international financial institutions – the IMF and the World Bank – have a
new mission in life: To protect the countries at the periphery of the system from
the effects of a financial crisis that has originated at the center of that system, the
United States. They cannot carry out that mission without the active support of
China, exactly because China has accumulated tremendous currency reserves.
Fortunately the United States has a new President who fully recognizes the need
for greater international cooperation. Hopefully the Chinese leadership will also
recognize the need.
What is involved in such cooperation? The super-boom was fueled by the United
States consuming more than it produced. In 2006, the current account deficit of
the United States reached 7% of its GNP. The deficit was financed by China,
other Asian exporters and some oil-producing countries accumulating larger and
larger dollar surpluses. This symbiotic relationship has now ended; the American
consumer can no longer serve as the motor of the world economy. A new motor
has to be found. That means that China and the rest of the world must stimulate
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domestic demand by running fiscal deficits during the recession. China can afford
to do so but countries at the periphery of the global financial system can’t because
they are suffering from an exodus of financial capital. The exodus must be
stopped and a way must be found to finance fiscal deficits in periphery countries.
This can’t be done without the help of the surplus countries and the large-scale
commitment of sovereign wealth funds. Even that may not be enough because the
collapse of credit and the destruction of wealth are so severe that there may not be
enough money available. It may be necessary to create additional money by the
IMF issuing Special Drawing Rights or SDRs. In any case, stimulating consumer
demand may not be the right way to go because it involves credit expansion for
financing consumption. Credit ought to be used primarily for financing investment.
I believe the solution lies elsewhere. The world is confronting an urgent problem
in global warming. To bring it under control will require tremendous investments
in energy savings and alternative energy sources. That ought to provide the motor
for the world economy. To make that possible we need an international
agreement that would impose a price
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