Misunderstanding markets
Civitas, 30 November 2010
Yesterday the Irish government finalised a rescue deal worth €85 billion for the country’s beleaguered banks. With all such large financial decisions, the initial test of success was seen to be the reaction of the markets. Thus, we all had to wait until Monday before the markets opened to see how the Irish bailout was received by the financial sector.
To say that the markets were not convinced would be an understatement. The euro fell against the dollar and the London and German stock markets saw a drop in value. Perhaps more importantly the bond yields on Portuguese, Irish and Spanish government debt stayed worryingly high, as did the cost of insuring such bonds against default. French Finance Minister Christine Lagarde criticised the markets stating that the bailout was ‘sufficient’ and the markets ‘irrational’, in a similar vein Germany’s finance minister Wolfgang Schaeuble called the markets’ worries about Portugal ‘irrational’.
The problem with lambasting the markets is that by doing so politicians seem to suggest that the markets are treating Irish, Portuguese and Spanish debt unfairly and, more importantly, that they are aware they are doing so. However, both criticisms seem to conflate two mutually exclusive conceptions of the market. The first, that the market is a fair reflection of value, or that it can be. The second, that the market is simply the collectivisation of various subjective opinions, and that like any subjective opinion it can be, knowingly or unknowingly, incorrect. While the two are mutually exclusive, it would appear that some politicians would like to have it both ways.
One result of the recent financial turmoil is that markets were exposed as being particularly prone to ‘herd-behaviour’ and likely to underestimate the chance of one-off, ‘unique’ events occurring. In this sense the market is not a ‘fair’ indicator of value, but a subjective response based on a number of considerations. Thus the markets should not be lambasted for remaining sceptical about the financial state of some European countries’, or some banks’, finances. Markets also responded, negatively to indications that, rightly, bondholders will have to absorb some possible losses on European bonds in the future. Market opinion is not infallible; if politicians do not agree with it, then they should say so, but it is juvenile to label it ‘irrational’.
Importantly politicians have to be honest with themselves, and admit that the more they interfere with the free operation of markets the less markets can be trusted as a source of true value. Every time a bank is bailed out, every time debts are implicitly underwritten, market indicators become less accurate. That’s not to say that politicians should let countries default on their debts, or allow banks to fail to pay their creditors, but they must realise that when they do intervene, investors will take note, and adjust their behaviour accordingly. Thus decisions made by market participants will not only reflect their opinion of a good deal in light of the possible risk, but also in light of the possible action, or inaction, of government. If this is accepted, then maybe politicians will stop suggesting that market opinions are perfectly rational, but they’ll also have to stop labeling those opinions ‘irrational’ when they don’t like them.
Let’s split up this term “markets” a little….
“Investors” perceived that the value of stock, which had been inadequate at sustaining profits, was less attractive when this point was proved irrefutably by the need for a bail out.
“Corporates and companies” are so denied capital, to invest in resources and labour. Observation that other corporates and companies are experiencing similar insures the onus to raise such capital remains low (e.g. by sale or paying higher interest rates).
Wages do not rise. The purchasing power of “employees” (and so consumers) remains depressed and so does the outlook.
All sounds pretty rational to me.
I wonder if in the past the bail outs worked better when we were in less-perfect markets i.e. people had less access to this information and a clear insight into the market risks and failures…. There were less barriers to entry through regulation. Technology was not owned by a few mega sized companies.
In other words, when investors behaved irrationally.
And also, when investors, for one reason or another, were less able to turn attentions to other markets? Or were so wealthy, that they could afford not to invest for a while.
The bankers rang up huge bonuses on huge fictitious profits with the use of fictitious money. Now they want the tax payer to bail them out with real hard earned money so they can continue to rake in bonuses as we have seen with QE. The markets understand that this will collapse in the not too distant future.
Unfortunately, bail-outs will always distort the ‘free market’, however, as they have been an action taken by governments since market economies first developed, one can only try to analyse how the markets will react to them. In the recent financial and sovereign debt crises, it is particularly worrying that some financial institutions, or countries, have become so important that they will never be allowed to fail or default. The ramifications of this, for free market ideals, are particularly worrying.