Friday, October 25, 2013

Economists begin to wonder -- are financial markets inherently unstable?

Justin Fox has a nice piece in the Harvard Business Review looking at how economics and finance have changed in the years since the onset of the crisis. He offers several conclusions, but one is that financial economists are now, much more than before, coming to accept the notion that financial markets are by their nature inherently unstable. Can you imagine that? From the article:

Before the late 1950s, research on finance at business schools was practical, anecdotal, and not all that influential. Then a few economists began trying to impose order on the field, and in the early 1960s computers arrived on college campuses, enabling an explosion of quantitative, systematic research. The efficient market hypothesis (EMH) was finance’s equivalent of rational expectations; it grew out of the commonsense observation that if you figured out how to reliably beat the market, eventually enough people would imitate you so as to change the market’s behavior and render your predictions invalid. This soon evolved into a conviction that financial market prices were in some fundamental sense correct. Coupled with the capital asset pricing model, which linked the riskiness of investments to their return, the EMH became a unified and quite powerful theory of how financial markets work.

From these origins sprang useful if imperfect tools, ranging from cost-of-capital formulas for businesses to the options-pricing models that came to dominate financial risk management. Finance scholars also helped spread the idea (initially unpopular but widely accepted by the 1990s) that more power for financial markets had to be good for the economy.

By the late 1970s, though, scholars began collecting evidence that didn’t fit this framework. Financial markets were far more volatile than economic events seemed to justify. The link between “beta”—the risk measure at the heart of the capital asset pricing model—and stock returns proved tenuous. Some reliable patterns in market behavior (the value stock effect and the momentum effect) did not disappear even after finance journals published paper after paper about them. After the stock market crash of 1987, serious questions were raised about both the information content of prices and the stability of the risk measures used in finance. Researchers studying individual investing behavior found systematic violations of the premise that humans make decisions in a rational, forward-looking way. Those studying professional investors found that incentives cause them to court tail risks (that is, to follow strategies that are likely to generate positive returns most years but occasionally blow up) and to herd with other professionals (because their performance is judged against the same benchmarks). Those looking at banks found that even well-run institutions could be wiped out by panics.

But all this ferment failed to produce a coherent new story about how financial markets work and how they affect the economy. In 2005 Raghuram Rajan came close, in a now-famous presentation at the Federal Reserve Bank of Kansas City’s annual Jackson Hole conference. Rajan, a longtime University of Chicago finance professor who was then serving a stint as director of research at the International Monetary Fund (he is now the head of India’s central bank), brought together several of the strands above in a warning that the world’s vastly expanded financial markets, though they brought many benefits, might be bringing huge risks as well.

Since the crisis, research has exploded along the lines Rajan tentatively explored. The dynamics of liquidity crises and “fire sales” of financial assets have been examined in depth, as have the links between such financial phenomena and economic trouble. In contrast to the situation in macroeconomics, where it’s mostly younger scholars pushing ahead, some of the most interesting work being published in finance journals is by well-established professors out to connect the dots they didn’t connect before the crisis. The most impressive example is probably Gary Gorton, of Yale, who used to have a sideline building risk models for AIG Financial Products, one of the institutions at the heart of the financial crisis, and has since 2009 written two acclaimed books and two dozen academic papers exploring financial crises. But he’s far from alone.

What is all this research teaching us? Mainly that financial markets are prone to instability. This instability is inherent in assessing an uncertain future, and isn’t necessarily a bad thing in itself. But when paired with lots of debt, it can lead to grave economic pain. That realization has generated many calls to reduce the amount of debt in the financial system. If financial institutions funded themselves with more equity and less debt, instead of the 30-to-1 debt-to-equity ratio that prevailed on Wall Street before the crisis and still does at some European banks, they would be far less sensitive to declines in asset values. For a variety of reasons, bank executives don’t like issuing stock; when faced with higher capital requirements, they tend to reduce debt, not increase equity. Therefore, to make banks safer without shrinking financial activity overall, regulators must force them to sell more shares. Anat Admati, of Stanford, and Martin Hellwig, of the Max Planck Institute for Research on Collective Goods, have made this case most publicly, with their book The Bankers’ New Clothes, but their views are widely shared among those who study finance. (Not unanimously, though: The Brunnermeier-Sannikov paper mentioned above concludes that leverage restrictions “may do more harm than good.”)

This is an example of what’s been called macroprudential regulation. Before the crisis, both Bernanke and his immediate predecessor, Alan Greenspan, argued that although financial bubbles can wreak economic havoc, reliably identifying them ahead of time is impossible—so the Fed shouldn’t try to prick them with monetary policy. The new reasoning, most closely identified with Jeremy Stein, a Harvard economist who joined the Federal Reserve Board last year, is that even without perfect foresight the Fed and other banking agencies can use their regulatory powers to restrain bubbles and mitigate their consequences. Other macroprudential policies include requiring banks to issue debt that automatically converts to equity in times of crisis; adjusting capital requirements to the credit cycle (demanding more capital when times are good and less when they’re tough); and subjecting highly leveraged nonbanks to the sort of scrutiny that banks receive. Also, when viewed through a macroprudential lens, past regulatory pressure on banks to reduce their exposure to local, idiosyncratic risks turns out to have increased systemic risk by causing banks all over the country and even the world to stock up on the same securities and enter into similar derivatives contracts.

A few finance scholars, most persistently Thomas Philippon, of New York University, have also been looking into whether there’s a point at which the financial sector is simply too big and too rich—when it stops fueling economic growth and starts weighing on it. Others are beginning to consider whether some limits on financial innovation might not actually leave markets healthier. New kinds of securities sometimes “owe their very existence to neglected risks,” Nicola Gennaioli, of Universitat Pompeu Fabra; Andrei Shleifer, of Harvard; and Robert Vishny, of the University of Chicago, concluded in one 2012 paper. Such “false substitutes...lead to financial instability and could reduce welfare, even without the effects of excessive leverage.”

I shouldn’t overstate the intellectual shift here. Most day-to-day work in academic finance continues to involve solving small puzzles and documenting small anomalies. And some finance scholars would put far more emphasis than I do on the role that government has played in unbalancing the financial sector with guarantees and bailouts through the years. But it is nonetheless striking how widely accepted in the field is the idea that financial markets have a tendency to become unhinged, and that this tendency has economic consequences. One simple indicator: The word “bubble” appeared in 33 articles in the flagship Journal of Finance from its founding, in 1946, through the end of 1987. It has made 36 appearances in the journal just since November 2012.
Too bad this shift didn't take place 20 years ago, or maybe 40 years ago.

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