“The child is father of the man:
And I could wish my days to be
Bound each to each by natural piety.”
– William Wordsworth
The ebbs and flows of economic fortunes of nations and companies have a direct correlation with the social and psychological ”health” of the people who inhabit those nations and corporations.
It is common knowledge that dysfunctional societies (where crime rates, divorce rates, teenage pregnancy rates, suicide rates, high-school dropout rates, illiteracy rates, etc. are high) also have low levels of productive economic growth (GDP per capita); high levels of unemployment and under-employment rates; low, flat or negative real wage growth rates, etc. It would be interesting to explore whether the psycho-social indicators precede economic indicators or vice versa.
We know, as a self-evident truth, that psycho-social maladies result in economic stagnation and even decay for a vast majority of the population whose economic fortunes are tied to the geographies or corporations under consideration. We also know that individual or family financial stress leads to many mental and psychological health conditions such as insomnia, depression, hypertension, heart disease, diabetes, low self-esteem, etc. We know that national economic malaise leads to several social problems such as increased destitution, drug use, prostitution, suicides, and so forth.
What comes first and what follows? What is the cause and what is the effect?
Perhaps, George Soros’ “Theory of Reflexivity” applies to this situation. Psycho-social turmoil leads to economic instability — which in turn — leads to more psycho-social turmoil with an ever greater pitch and velocity in a continuous downward spiral that can be stopped and reversed only by significant, firm and far-reaching policy mechanisms such as Keynesian-style deficit-spending economic stimuli to jump-start productive activity within an economy.
There is a certain ecosystem in which humans thrive, grow, and prosper. Such an ecosystem is defined by the opportunity to the entrepreneurial, the clever, the industrious, the agile, the innovative, the adaptive, the meritorious individual or company to reap the rewards of their labor in a relatively safe, fair and equitable society. Conversely, in an environment antithetical to promoting merit — innovation, entrepreneurship, value creation and the capitalist ideal are more or less suffocated and frustrated.
There are numerous examples of the above stated phenomena:
Just one such example is:
Over several years, Colombia’s decline across a wide gamut of economic indicators can largely be attributed to the descent of Colombian society into a brutal and unrelenting civil war. Or was it the other way: Did civil strife drive away investors and the profit motive for sharp, industrious, capitalist-minded individuals?
Question is: Does a strong moral fabric predict positive economic performance — both for the individual and for the society. In effect, does it pay to be good – not just in the hereafter — but also in the here and now?
More concretely, can one develop profitable trading strategies based on the psycho-social “performance” indicators of economies, and even, companies. Can we, for example, see a conclusive and positive correlation for a specific company where strong corporate social responsibility “performance” results predict strong corporate earnings and subsequent stock performance…over the long-term…factoring out any potential short-term “noise” or “bump” that comes from the PR-spawned corporate announcements about CSR initiatives?
There are numerous quantitative analyses that can be run to track asset (stocks, bonds, derivatives, currencies, real estate, etc.) performance vis-à-vis psycho-social indicators. Infact, if proprietary traders and hedge funds are not doing this already, a new school of investment philosophy could be developed where the study of psycho-social indicators across various economies and companies would inform investment and trading decisions.
…to be continued and detailed out further.
The Great Financial Squeeze: An Economic Policy Perspective
What are some of the underlying economic policies that have resulted in the current global financial crisis? ______________________________________________________________________
Monday, September 15, 2008: Lehman Brothers files for the largest bankruptcy protection in US history. The US government refrains to intervene from saving the failing investment bank.
Tuesday, September 16, 2008: U.S. Federal Reserve presents $85 billion rescue package to the insurance behemoth: AIG. The move is made in order to avert larger, systemic shocks to the global financial system. The same day, Merrill Lynch, the third largest investment bank in the world is sold to Bank of America in a fire sale.
Sunday, September 21, 2008: In order to shore up their toxic balance sheets, two of the most venerable names in the investment banking world: Goldman Sachs and Morgan Stanley dropped their much vaunted investment banking status to become bank holding companies.
October 6-10, 2008: The Dow Jones Industrial Index falls 1874 points (18%) to record the steepest weekly fall in its history of 120 years.
Friday, October 31, 2008: UK’s second largest bank: Barclays announces a £7.3 billion investment from Middle East sovereign fund investors for roughly a third of its ownership.
Monday, November 24, 2008: US government and Citigroup together identify $306 billion in distressed assets on Citigroup’s balance sheet. Citigroup would absorb the first $29 billion in losses and various US government agencies would pick up most of the remaining tab.
Thursday, December 11, 2008: Former Chairman of NASDAQ, Bernard Madoff is arrested on a securities fraud charge that is estimated to be worth a historic $50 billion.
There’s plenty of other bad news to recount. But you get the picture.
So, what is happening to the world?
Globalization of Capital
“Globalization is a fact of life. But I believe we have underestimated its fragility.”
– Kofi Annan
Today, more than ever before, global capital markets are exactly that: global. They have ever greater access to information. They are ever more inter-connected and inter-dependent. And with the ubiquity and integration of financial data and transactional platforms, they have the ability to act across the globe on a real-time basis.
Furthermore, while some may argue that there has been a certain degree of “de-coupling” in trade flows between the West and the rest of the world, it is undeniable that there is an ever greater integration and fluidity in capital flows across the world. Globalization of capital across sovereign borders and economic blocs has broken down structural barriers that foster capital formation imbalances within economies. It is logical that when capital is given a free rein, then it will flow to fill up those gaps, i.e. geographies and industries which provide for the best risk-adjusted return on investment. However, one of the few unintended downsides to globalized unfettered capital flows is that such an environment precipitates the “hot money” phenomenon. In a world of liberalized national capital controls, a sophisticated and globalized financial system can swiftly spread a financial contagion. Today’s inter-connected financial markets can trigger higher and faster “wildfires” within and across discrete financial capitals of the world. As we have seen, from New York to London to Paris to Frankfurt to Dubai to Mumbai to Hong Kong to Shanghai to Singapore to Tokyo and to Sydney – the current contagion has spared no one.
The synchronized behavior of capital markets around the world also points to another theme: As emerging economies become more and more akin to “producer economies,” and mature economies transform themselves into “consumer economies,” there is rising affluence in the emerging, producer economies. Wealth that is being created in the emerging economies is still largely being deployed into seemingly safer and broader array of investable assets within mature, i.e. developed economies. For example, the “investor class” of the emerging economies has much more confidence in the stability and liquidity of US treasuries than the bonds issued by their respective emerging markets’ sovereign governments. To use New York Times columnist Thomas Friedman’s oft-cited notion, the “world is flat”…hot and crowded. To our collective chagrin – regardless of where we are on the planet: we are experiencing the transitional “growing pains” of a fundamental and systemic re-adjustment within the sphere of international finance. For now, a “flat” commercial world is giving rise to a “flattened” financial world.
Add to that, as the financial markets have become ever more global, inter-dependent, transparent, and in some ways, democratic, their ability to arbitrage information has declined. Therefore, the other actors within the financial markets have developed ever more inscrutable and esoteric financial instruments to generate profits.
Rising Market Volatility
“Nothing travels faster than light, with the possible exception of bad news…”
– Douglas Adams (British Author and Comic)
In today’s global markets, traditional “herd-like” emotional responses to market gyrations are magnified by the ever greater and quicker availability of information (fact, sentiment and rumor). This phenomenon acts as a self-fulfilling “feedback loop” that gathers momentum embroiling ever greater numbers of investors and amounts of capital as it builds up like a wave sweeping across the globe. In the past, it took longer to grow a short-term or a long-term bubble from one asset class, economic zone or geographic context before it spread to the next. Today, it is virtually instant, across different asset classes, and around the world.
One can hypothesize that there is a direct correlation between the rising numbers of market participants (with access to real-time market information) within an asset class across the globe to the rising price volatility of that asset class.
The recent months’ intra-day capital markets volatility may provide further evidence to suggest that faster and greater exchange of financial and economic data offers up a double-edged sword: on the one hand, faster and greater access to information (fact or fiction) reduces information asymmetries for market participants across the globe. On the other hand, this free flow of instantaneous market data affords market participants to act in real-time on both positive and negative market sentiments. The upside: quicker and bigger market corrections due to quicker and greater exchange of factual data. The downside: quicker and bigger market distortions due to quicker and greater exchange of speculative sentiment.
Furthermore, one can assert that there is also a strong correlation between the velocity and volume of capital outflows in one asset class impacting the velocity and volume of capital inflows in another asset class and vice versa. The correlation, of course, can be direct or inverse depending on which two asset classes are being considered. For example, let us imagine that there is a closed financial system where no new capital inflows into, or outflows occur out of, the system as a whole. In such a system, the velocity and volume of capital inflows in one asset class (say, real estate) may have a negative correlation with the velocity and volume of capital inflows in another asset class, say, commodities.
The steep descent of oil from a peak of over $147 in July, 2008 to $47 in December, 2008, further reinforces the notion of dramatically greater volatility originating from the same “wildfire phenomenon.” It is a phenomenon where the velocity and volume of information and fund flows is directly impacting the price volatility of a particular commodity or asset class, in this case – oil. Of course, to state the obvious, the past eighteen months’ escalation of oil prices in particular, and commodity prices in general, have a distinct marker of significant governmental, institutional and trader speculation on futures contracts.
While such volatility in the markets ushers in interesting times for students of economics and finance, such uncertainty is profoundly de-stabilizing for the smooth functioning of economies across the mature and emerging economies alike.
After all, a certain degree of economic uncertainty generates a healthy band of risk-adjusted economic opportunity. It fuels somewhat prudent and efficient capital allocation – which results in value creation and a resultant healthy pace of growth in an economy. The current levels of financial markets volatility, on the other hand, are having insidious effects on the investment climate.
The reason is, in an environment of abnormal levels of volatility like the one right now, the band of possible economic outcomes widens to the point where the option of inaction becomes ever more attractive than the option of taking virtually any investment position. Of course, in such times, being on the right side of speculative positions would generate a lot of wealth for a few investors. For the markets as a whole, however, this level of volatility is harmful.
De-regulation – The panacea that never was
“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.” – Ernest Hemingway
With the collapse of the communistic model of Soviet Union and the Eastern Bloc countries in late 80’s, a dramatic unraveling of decades old power structures, bureaucracies, and regulations created massive vacuums in the social, political, and economic lives of these societies. One after another, these economies eagerly, and often all too impatiently, embraced various forms of free market capitalism with all its transformational opportunities and inherent dangers. Meanwhile, the West – particularly America – became triumphant and ever more assured that free market capitalism was the panacea for all social, political and economic evils. The question raised by the Western governments and intelligentsia was: How can we not de-regulate in a time when those diametrically opposed to our ideologies are in the midst of a de-regulation frenzy?
Hence, all throughout the 1990’s, financial de-regulation continued its slow and steady march – regardless of whether the Democrats were in the White House, or Republicans held the majority in the Congress, or whether it was the Conservative Party or the Labour Party that enjoyed a majority in the House of Commons. The 1999 repealing of the US Glass-Steagall Act – that had been first brought into law in the wake of The Great Depression of 1929 – became a watershed moment for the financial services sector. In essence, this change meant that the separation between commercial banks and investment banks was no longer necessary. In addition, what it also meant was that banks could not only sell insurance products but now could also underwrite insurance. The result: a spate of merger activity and industry consolidation that resulted in today’s massive, monolithic institutions such as Citigroup, Bank of America, JPMorgan Chase, Wells Fargo (Wachovia) – that sold everything from checking and savings accounts to individual and corporate loans to mortgages to credit cards to insurance to bonds to underwriting, and so on.
They became too complex, too unwieldy, and too big to fail.
“Money is not the most important thing in the world. Love is. Fortunately, I love money.”
– Jackie Mason (American Stand-up Comedian)
The 1990’s also saw former Chairman of US Federal Reserve, Alan Greenspan’s peaking of influence on the world economy. Thanks to Greenspan’s monetary policies, this period was marked by cheap and abundant liquidity that kept building up silently in the US and across the globe for years to come. This period is fondly remembered as the “long-run, secular bull market.” As time went by, Greenspan’s prophecies became the stuff of legend. Policy-makers, economists and bankers alike hung by every word he said as gospel. They tried to decipher every assertion Greenspan made as a prized clue or a signal for something deeper, more meaningful and more valuable than it often was. Meanwhile, all of the cheap liquidity began to show up as perverse spending and investment binges involving an ever-growing number of unsophisticated investors. This, in turn, directly gave rise to a burgeoning investor appetite for equities (particularly the “dot bomb” stocks) in the late 1990’s, real estate in the early 2000’s, commodities and securitized debt instruments in the second half of 2000’s. Unfortunately, because of the outrageously high stakes involved, the most recent “financial innovations,” i.e. derivatives were put together like a string of obfuscations by some of the brightest minds coming out of Harvard, Wharton, MIT, Stanford, Princeton, London School of Economics, and other hallowed academic institutions.
According to Prof. Robert Shiller of the Case-Shiller Home Price Index fame, in the current crisis, the derivatives themselves were not so much of the problem as was the application of these instruments (meaning the enormous leverage the banks and hedge funds used to wager on these derivatives). Whether you agree with him or not, these instruments turned out to be built on untenable promises made by mortgage lenders to unsuspecting or over-optimistic homebuyers. Not-so-secure loans were sold by retail lenders as secured loans to merchant and investment bankers. Collateralized securities were rated much higher by ratings agencies than was prudent or responsible. Short sellers spread rumors of doom and gloom to line their pockets. And of course, high-risk, highly-leveraged derivatives often backed by sub-prime debt were sold by greedy investment bankers as low-to-medium risk investments to less-than-sophisticated or plain lazy buy-side investment community.
In fact, as of mid-November 2008, the asset-backed commercial paper market was valued at $845 billion. This value is post the 30% decline in their value since August, 2008.
An estimated $150 trillion (that’s right, trillion) of loans and derivative contracts are indexed to Libor across the world. Markets are now trying hard to asphyxiate the toxic monsters of sub-prime mortgages, Mortgage-backed Securities (MBS’), Collateralized Debt Obligations (CDO’s), Structured Investment Vehicles (SIV’s), Credit Default Swaps (CDS’) and other on and off-balance sheet instruments that in hindsight created little –if any – real value. And as part of this market exorcism, the global economy is being inflicted with wrenching pain and suffering.
Safety in Numbers
“We go by the major vote, and if the majority are insane, the sane must go to the hospital.”
– Horace Mann
The word on the street was: if a sufficiently high number of people would be on the wrong side of the issue, the rule of safety in numbers applied. Well, the numbers part did apply, and the safety part did not.
During the boom times, “free markets” were given as much a free rein to benefit from the growing “investor class” of wealthy high net worth individuals, investment bankers, hedge fund managers, asset managers, and private equity firms, among others. Millions of less than sophisticated investors got caught in the current financial crisis through one product or another – whether through an unrealistic home mortgage, or spiraling credit card debt, or a derivative investment, or a home equity line, or one of the other cheap credit-fuelled products. Now, tens of millions of average Joes and Janes through their savings, 401-K’s, IRA accounts, and mutual fund and common stock holdings are bleeding hundreds of billions of dollars. Somewhere along the way, the financial services sector (purveyors of easy credit-fuelled products) got too smart and too greedy for everyone’s good.
Ultimately, bad karma had to catch up.
And how has bad karma caught up?
Seemingly sophisticated financial market participants (investment banks, insurance companies, hedge funds, asset management firms, etc.) have suffered, and in certain instances, succumbed to what Warren Buffet calls, “weapons of mass financial destruction.” And now, expectedly, everyone – the perpetrators and the victims – are in that clichéd state of: fear, uncertainty and doubt.
Doesn’t history have a way of repeating itself?
In fact, there are several parallels between now and The Great Depression. On the back of years of easy credit, speculation was rampant across several asset classes such as equities, commodities and real estate then, just the way it was on this go around. There was a “trust” (investment firms that were publicly traded) securities bubble then just the way there was a derivatives (fixed income securities, commodities futures, etc.) bubble this time around. The role of investment banks in creating and selling new, arcane, and insidious financial instruments, was central then just as it has been in this crisis. And an unfettered financial markets regulatory environment and a damagingly loose monetary policy regime that spawned the market distortions then are strikingly similar to the “market fundamentalist” economic policy framework that has given rise to the current financial meltdown today.
Whether folks are aware of the parallels between now and the Great Depression or not, markets are spooked by the inability of the financial services sector to self-correct the excesses of its own offspring, i.e. products of financial engineering.
And therefore, markets find themselves underneath a cascade of events from housing price collapse, to home foreclosures, to personal and corporate bankruptcies, to the ever-growing sub-prime crisis, to millions of job losses, to an unrelenting colossal liquidity crunch, to historic stock market crashes, and to a potential US financial markets failure, and a global economic meltdown…and possibly the invocation of The D word?
About the Author: Sahil Alvi is a management consultant and a writer. He presently works with KPMG in Dubai. Previously, he has held management consulting roles with Ernst & Young and PricewaterhouseCoopers in the US. He can be reached at: email@example.com