The Fearful Rise of Markets: A Short View of Global Bubbles and Synchronised Meltdowns, by John Authers, Financial Times/Prentice Hall RRP£20, 232 pages
The financial world seems to turn faster on its axis every year. Inflated asset bubbles have burst in Japanese equities and real estate, in global tech stocks, and in US housing. Among the new bubbles forming in finance are books about what has just happened. Crowded on booksellers’ shelves are first-person accounts, bird’s eye views, and deep tomes challenging the foundations of economics.
Into this heavy traffic traverses John Authers, former investment editor for the FT and current global editor of its Lex column. With two decades of experience in successfully interpreting financial markets, Authers has the curriculum vitae and the confidence to go where no other author has thus far been. His goal in this slender volume is to make understandable why financial markets failed, how investors should protect themselves and what national authorities should do to correct some of the problems. His mission is happily met.
Authers’ effort is successful for two reasons. First, he recognises that the collective noun “we” is not particularly useful; he tailors his advice to different audiences – retail investors, professional money managers and national authorities. Second, he writes clearly, precisely, and without jargon. Each of the 27 chapters begins with an overview and ends with a summary of specific recommendations to investors and authorities.
The clarity of design makes it unlikely that Authers found inspiration in the economics shelf of the local bookshop. Rather, the volume most resembles EH Gombrich’s international bestseller A Little History of the World, published in 1935, in its ease of exposition and clarity of content.
Authers argues persuasively that good ideas for investors were taken to extremes over the past four decades. This process proved destructive to the information contained in financial market prices, the diversification benefits of some investment classes, and the stability of the financial system.
To take those stories in turn: first, the development of index funds followed logically from advances in finance theory. Researchers, led by Eugene Fama, argued persuasively that stock prices reflected all public information so that their future movements could not be predicted. Moreover, given this unpredictability, there is no reason to incur the costs associated with research into specific companies that informs active stock picking. Instead, passive investment in index funds that tracks a broad market index should be preferred. But this introduces a conundrum: if everyone opts to follow an index, who pays for the research that makes prices informative?
Second, Authers provides examples of financial investigators shining lights on hitherto obscure asset classes. These new gems, whether junk bonds, emerging market debt, hedge funds or commodities, provide a yield at least matching that of equities but varying little with the rest of investors’ portfolios. Once alerted to the benefits of such an asset, investors pile in and most of its attractive features are lost.
Third, Authers identifies various mechanisms that amplify price swings by inducing the mob to move en masse: for example, basing the compensation of fund managers on their performance relative to a market benchmark or the widespread copying of trading strategies across different funds. In both cases, success is measured by performing just like everyone else. These are co-ordinating schemes, easily envisioned as announcements telling passengers to rush together from port to stern on an ocean liner. The boat rocks. Indeed, perhaps the 1,000 point intraday movement in the Dow Jones Industrial Average of late reveals how violent the rocking can be.
Authers diagnoses the problems and often offers prescriptions for retail investors and policymakers. High on his list is to understand that the benefits of diversification apply across types of risk, not simply asset classes. In particular, at times of stress, seemingly disparate assets share similar risks. For their part, authorities, Authers says, have to be more holistic and recognise that each firm may individually be engaging in “crowded trades”. Risk management on a firm-by-firm basis, however sophisticated, does not prevent a lemming-like trip to the cliff’s edge.
The sureness of Authers’s grasp of the issues is no doubt due to writing about financial markets for two decades. But the book also suffers from drawbacks. Sometimes there is an insufficient appreciation of precedent and an over-emphasis on the role of policy authorities as drivers of events.
He offers a nostalgic view of the Bretton Woods era of 1944 to 1972, when the anchoring of fixed exchange rates fostered low and stable inflation and mitigated macroeconomic fluctuations. In fact, the stability associated with the Bretton Woods system owed as much, if not more, to restrictions on financial transactions – plainly put, capital controls. It was an era of multiple exchange rates within individual countries, lower and upper limits on the products of financial institutions and outright restrictions on some forms of financial trade. The beginning of the end of the era owed as much to the creation of the first offshore deposits, Eurodollars, as to the monetary profligacy of the United States.
This is an important distinction to keep in mind for the current policy debate. If the stability of financial markets in the immediate post-second world war period was owed exclusively to the maintenance of a fixed exchange rate system, then we are doomed to follow a rocky road. Policymakers will chafe under the discipline and speculators will be prone to attack. If, instead, the stability was owed to restrictions to financial trade, then the intelligent imposition of capital and leverage requirements, along with some sand in the gears of finance, might dampen extreme swings in markets.
Indeed, price movements in financial markets are often inexplicable when they are not driven by slowly changing and, therefore, un-newsworthy forces. When the news cycle otherwise grinds along, it is tempting to attribute decisive influence to individuals. On the dark side, former Federal Reserve chairman Alan Greenspan single-handedly put a floor to equity prices. We also read that enlightened New York Fed officials identified over-the-counter derivatives as a systemic risk and worked to limit their harmful effects.
Reality is less Manichean. Greenspan’s leverage on the economy worked through interest rates, which often necessitated easing policy to lean against the adverse effects of wealth losses in equity markets on the wider economy. Recent reinterpretations notwithstanding, the efforts of New York Fed officials prior to the crisis were to clean up bottlenecks in the trading of derivatives. That is, they were trying to get the engine to revolve faster, a thought to keep in mind after surveying the recent wreckage.
There are points to disagree with but far more to learn from The Fearful Rise of Markets. Anyone interested in financial markets would benefit from owning a copy.
Carmen M Reinhart is director of the Center for International Economics at the University of Maryland and co-author with Kenneth S Rogoff of ‘This Time is Different: Eight Centuries of Financial Folly’ (Princeton)