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Three laws of gravity

Three laws of gravity
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First Published: Mon, Jan 12 2009. 08 48 PM IST
Updated: Mon, Jan 12 2009. 08 48 PM IST
Prof. Emanuel Derman, affiliated to the department of industrial engineering and operations research at Columbia University, is a man of substance. He spent considerable time at Goldman Sachs. His experience convinced him that finance was a social science and subject to the caprices of human whims and emotions. His recently released Financial Modelers’ Manifesto is a good read. In his blog post on 28 November, he recommended the book, The Origin of Financial Crises by George Cooper.
Persuaded by his recommendation, I caught up with it over the weekend. The book deserves to be on the reading list for any course in finance and economics. Indeed, the time will come when teachers have to decide on how much and for how long they will teach efficient markets to their students, without their conscience pricking them. When it does sufficiently hard, they have an alternative at hand. The book is written so lucidly that even non-economists and non-financial industry participants should be able to get through it without much difficulty.
The crux of the book by Cooper is that efficient market theory is as muddled as the law of gravity would be if Isaac Newton had written three versions of it: one for the apple going up, one for the apple coming down and one which states that the apple does not move at all.
Unlike in the market for normal goods and services, “demand for financial assets does not stimulate supply; rather a lack of supply stimulates demand. Equally price rises can signal a lack of supply thereby generating additional demand or, conversely, price falls can signal a glut of supply triggering reduced demand”. Experienced and discerning investors would find themselves agreeing with this crucial differentiation stated right upfront on page 8 of the book. Based on this foundation, Cooper is able to build his entire thesis of why financial markets are inherently unstable and how stability can be achieved by targeting credit creation.
This important difference with how laws of supply and demand work in normal product markets need not hold if there are enough investors who view rising and high prices as signals to sell rather than to demand more of that asset—then financial markets need not be inherently unstable. Well, investors behave irrationally. While that may be true and there is considerable evidence of herding and irrational behaviour among investors, Cooper is not tempted to build his case on investor irrationality.
Instead, he argues that the financial and credit system is geared to inflating prices or stoking asset price bubbles as investors are lent more based on higher asset prices serving as enhanced collaterals. In other words, banks tempt and investors succumb to higher leverage and take on more funding obligations just when the expected return on assets is at its lowest.
Thus, rising asset prices stoke more credit creation that for a while feed into economic growth, raise profits and stock prices for a while so that the decision to borrow appears vindicated. This self-reinforcing cycle creates a scramble or more demand for assets whose prices rise and less demand for it when they slump because that is when banks are busy tightening credit and recalling loans!
The author concludes his diagnosis by proposing both medium-term and short-term solutions. The medium-term solution is for central banks to focus on credit creation and drop their conventional inflation targeting. Goods markets can take care of themselves and they did over the last 20 years, contrary to the widely propagated myth that central banks tamed inflation. Further, they are told to target asset prices via credit creation and be less transparent about their interventions in order to be effective. He advocates central banks setting off mini-contractions to avoid a mega-contraction such as the one we are facing. The analogy is similar to ski patrols setting off mini-avalanches on mountain slopes to avoid a major one killing skiers. James Rickards made this point in a 2 October article in The Washington Post that explained the conceptual errors that risk managers have made in modelling risk in financial markets.
In the short term, he agrees that two well-known approaches—Austrian creative destruction and Keynesian intervention—are inadvisable. The first one could be too unpalatable and make depression a full-blown reality and the second one risks causing long-term damage and may even be unsustainable. The third solution is to default on debt by unleashing the inflation monster. To him, it is the least inadvisable of the three although it too is deeply unpalatable for it is a pardon for imprudent borrowers and punishment for savers.
It appears that the US is engaging in the second solution (“delaying the inevitable”, as the author puts it) now as a prelude to the third. Smart investors know what to expect and do when the supply of a financial asset is set to rise massively. If they don’t, it is time to pick up a copy of Cooper’s book.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer and Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at baretalk@livemint.com
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First Published: Mon, Jan 12 2009. 08 48 PM IST