Understanding the 2008 Financial Crisis

Transcription

1 Understanding the 2008 Financial Crisis 3. Economic theories and the crisis Nicoli Nattrass Centre for Social Science Research University of Cape Town January 2015

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3 Generating the wrong incentives Bonuses and executive pay generated incentives to increase leverage and take on more risk (Raghuram Rajan). He proposed that executive pay should be managed. But this flew against the conventional wisdom of free-market ideology (and neoclassical economics). See How Markets Fail, pages (on the 2005 Rajan paper) and chapters 2-8 for a history of free-market economics)

4 Some economists like Nouriel Roubini and Paul Krugman had warned about the bubble but had been ignored by those believing in the invisible hand of the free market.

5 Alan Greenspan Chair of the US Federal Reserve from (previously served as a director of JP Morgan) Had great faith in the ability of markets to regulate themselves. After the 2008 crisis he admitted in a televised congressional hearing (chaired by Henry Waxman) that he had found a flaw in his ideology and had made a mistake in presuming that the selfinterests of organizations, especially banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firm (See Cassidy, How Markets Fail, Introduction)

6 Mistaking beauty for truth (Krugman) Assumption of free-market theory (perfect information, perfect competition) results in socially optimal outcomes (what Cassidy calls the illusion of harmony ). The idea that financial markets were so efficient that stock prices displayed a random walk, (Cassidy calls this the illusion of stability and the illusion of predictability ). This approach (pioneered by Eugene Fama) implies that looking at the fundamentals of stocks is unnecessary rather just invest in unit trusts.

7 In 1975 Stiglitz and Grossman critiqued the efficient market hypothesis on the grounds that it was based on a logical inconsistency: If stock prices at every moment reflected all of the available information about the economic outlook and other factors pertinent to individual companies, investors wouldn t have any incentive to search out information and process it. But if nobody finds and processes information, stock prices wont reflect that information and the market wont be efficient. For the market to work at all there must be some level of inefficiency. Grossman and Stiglitz entitled their paper On the impossibility of Informationally efficient markets. Other economic theorists admired its terse logic, but it didn t have much immediate impact on Wall Street (How Markets Fail, page 94).

8 Cassidy: How Markets Fail, page 91-2 on the mean variance approach (assuming a bell curve) and page 93.

9 Consider the following option: A December 2015 put on IBM with a strike of $150 gives you the right to sell a share in IBM for $150 in December If you write (i.e. sell) a put, you are insuring the buyer against the possibility that the value of the stock will fall below the strike price. How much do you charge? To compute the value of an option using the Black- Scholes formula, all you needed, in addition to the strike price, the current price, and the duration of the option, was the interest rate on government bonds, the standard deviation of the stock, and a table of the normal distribution. By the end of 1973, you did not even need a pen and paper to do the calculation: Texas Instruments had introduced a calculator to do it for you (How Markets Fail, page 93) A huge risk management industry was thus born assuming they now understood risk

10 Myron Scholes got a Nobel prize in 1997 the year before his own firm, Long Term Capital Management collapsed due to bad derivative bets.. The collapse resulted in a $3.6 billion recapitalization bailout by a group of 16 banks under the supervision of the Fed. It was liquidated and dissolved in early 2000 Why did this lesson not get learned?

11 Collateralised debt obligation (CDOs) rated AAA Mortgage bonds made up of pools of home loans BBB rated tranches Mortgage bonds made up of pools of home loans NB: CDOs made up of BBB tranches were still rated AAA because the model saw them as diversified CDSs were priced low according to Black Scholes

12 The market seemed to believe its own lie (The Big Short page 129) The genius of Cornwall Capital s bet: To pay 0.5% a year on a bet against the AAA rated CDOs because they were made up of BBB-rated underlying mortgage bonds (which had cost Michael Burry 2% to bet against). The Big Short page 129. But this still begs the question why anyone trusted the rating agencies, especially given their reputation on Wall Street (Big Short, pages 153-9)..

13 John Maynard Keynes on the stock market Keynes argued that as financial markets developed, the risk of speculation predominating over enterprise rises: Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.

14 Keynes argued that in the presence of uncertainty, people make judgements based on current prices and what others are saying and doing (a conventional judgement. This, being based on so flimsy a foundation, is subject to sudden and violent changes... New fears and hopes will, without warning, take charge of human conduct... All these pretty polite techniques made for a well-panelled Board Room, and a nicely regulated market are liable to collapse... I accuse the classical economic theory of being one of those pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future. Keynes, J. M The General Theory of Employment. In Quarterly Journal of Economics, vol.51, no.2:

15 Keynesians argue that financial sector turbulence directly affects the real economy through its impact on credit and demand. 9 million jobs were lost in the US as a result of the 2008 financial crisis (and it took until the end of 2014 to get them back) In 2008 there was a balance sheet recession. People saved more to reduce debt, which in turn reduced demand, caused problems for businesses, resulted in layoffs, and even lower demand.

16 Hyman Minsky Student of Joseph Schumpeter. Minsky argued that capitalism was inherently unstable because of the activities of the financial sector which resulted in periodic processes of increasing financial fragility. In an ironic reference to the efficient markets hypothesis, he called this the financial instability hypothesis See discussion of Minsky in Cassidy, How Markets Fail, Chapter 16

17 Minsky argued that rising debt levels were associated with increasingly risky lending and hence the possibility of a crash ending up in a downward spiral as households tried to increase their savings and reduce debt (the so-called Minsky moment )

18 Minsky not only took the incentives facing investment bankers seriously, but he assumed that they would necessarily innovate and seek ever riskier lending opportunities In contrast to the orthodox Quantity Theory of Money, the financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus bankers (using the term generically for all intermediaries in finance), whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market. He argued that capitalism had become money manager capitalism because most liabilities of corporations are held by financial institutions where the money is managed by these bankers

19 Minsky identified three types of finance: Hedge finance (anticipated revenues exceed running costs and debt and interest payments); Speculative finance (can meet their interest payments but can only repay the principle if the asset price rises) and; Ponzi finance (projected earnings cannot possibly meet obligations). If hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi financing, the greater the likelihood that the economy is a deviation amplifying system.. But he also argued that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for and unstable system.

20 Crashes caused by Ponzi finance are known as Minsky moments

21 ICELAND Banks privatized in 2002 From 2003 to 2007 the value of the US stock market doubled: the value of the Icelandic stock market rose 9 fold; and house prices tripled. In 2006 the average Icelandic family was three times wealthier than it had been in 2003 and virtually all of this wealth was linked to the financial sector. The banks created fake capital by borrowing money from a abroad, relending the money to themselves to by assets (many of them inflated by the boom). When the banks collapsed Iceland had $100 billion in banking losses (about $330,000 for every person in Iceland). The bubble was obvious, had been described by Robert Aliber in 2006 yet other economists white-washed it. Economists as corrupt: The Inside Job ( )