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From The Times

November 29, 2007

Ignore Wall Street's tantrums

Is the financial world about to collapse? You'd think so if you listened to the financiers

Anatole Kaletsky

What on earth is happening in the financial markets? Last week Northern Rock was going bust, stock markets were collapsing and the world banking system seemed to be going down the tubes. Now everything has reversed. Markets are soaring. Northern Rock shareholders, instead of losing everything, as expected a week ago are threatening to sue the Government unless they double their money. The Abu Dhabi Investment Authority (ADIA), the world's biggest investment institution, suddenly launched a dawn raid on Tuesday to snap up $7.5 billion worth of shares in Citicorp, the world's biggest and most troubled bank. So is the financial world about to collapse or are all the crises over?

The answer, of course, is neither. Markets always go up and down and these short-term fluctuations tell us nothing about the world outside the City and Wall Street. This is particularly true today because the markets' recent gyrations are caused mainly by short-term factors that will soon ebb away.

Investors are obviously still worried, as they have been since August, about the weakness of the US housing market and the exposure of banks to defaulting low-income mortgage borrowers, but these risks have not changed since mid-October, when stock markets all over the world were hitting record highs. What has changed is the emotional response of investors to these risks.

In a nutshell, investors feel betrayed. The banks told investors and regulators before the summer that they had learnt lessons from previous crises and had found new ways of making profits without exposing their capital to old-fashioned lending risks. Instead, these risks had been transferred, through clever financial engineering, to pension funds, insurance companies, Asian governments and other long-term investors with deep pockets. This has now been exposed as a myth. As a result, the share prices of banks are collapsing and their managers are being fired — though, being bankers, their reward for incompetence and deception is a multimillion golden handshake from the shareholders and taxpayers whom they abused.

This naturally makes people angry and, to make matters worse, the full extent of the deceptions has yet to be revealed, so that only the bravest investors, such as ADIA, can contemplate buying bank shares, however far they fall. Most of this uncertainty, however, will soon be resolved as the banks close their books for the year-end results — with directors and accountants aware that any significant mis-statements could land them in jail.

Will these results produce further shocks, triggering another stock market collapse? I have no idea and neither does anyone else, which is why the markets are so twitchy. What I do know is that market gyrations in response to these disclosures will matter much less than most financiers believe.

Financiers naturally think that they are the world's most important people, so when their own jobs and bonuses are threatened they assume that the global economy must be under threat. Most of the time this is simply not true.

Meaningful economic indicators come out only rarely but stock markets trade every day, so in periods of uncertainty they start reacting to their own daily fluctuations as if these provided “new” information. When bank shares fall sharply, investors treat this as evidence that the financial system must be in trouble and analysts who were saying “buy” only a few weeks ago begin to scream “sell”. This, in turn, causes shares to fall farther and proves the sagacity, and maybe even inside knowledge, of those who sold. As bankers see their share prices falling, they threaten to cut lending to the real economy of jobs, investment and housing. The fear of a weakening economy then makes bank stocks fall again.

This self-reinforcing process was defined as “reflexivity” by George Soros, in his classic treatise, The Alchemy of Finance. A substantial academic literature has now confirmed that Mr Soros's “theory of reflexivity” is a big driving force of boom-bust cycles in financial markets. But the question is whether these financial boom-bust cycles are as significant for the non-financial economy as he believes. The big mistake made by Mr Soros as an economic analyst, though not as an investor, was to exaggerate the power of his insight about reflexivity and therefore to conclude that capitalism is an inherently unstable system.

In reality, a modern mixed economy, especially one with a central bank actively managing demand, is protected by self-stabilising mechanisms that are much more powerful than the reflexive boom-bust behaviour of financial markets. In the present financial panic, for example, the dollar is falling sharply and this is boosting US exports. The acceleration of export growth is easily offsetting the slowdown in construction and consumer finance — at least so far. Another stabilising offset comes from long-term interest rates, which have now fallen back to the levels that triggered the global credit boom in 2004. As a result of such self-stabilising feedbacks, financial cycles tend to reverse of their own accord and almost never produce outright economic disasters. The 1930s Depression and Japan's recent stagnation are often cited as counter-examples but these were caused mainly by central bank policy errors that were amplified by unstable financial markets, not the other way round.

Which brings me to the most important stabilising mechanism: the central banks. The true reason for this month's grim mood in global stock markets has been disappointment with the US Federal Reserve Board. The Fed cut interest rates by a quarter point on October 31, believing (probably rightly) that this would be enough to avert a recession, but Wall Street wanted more. Since many investors think Wall Street is the economy, they believe the Fed has a duty to protect stock markets and banks against excessive losses — similar to the attitude displayed by the shareholders of Northern Rock. They therefore felt righteous anger when the Fed refused to promise another rate cut after October 31.

Wall Street in the months since the August panic has been like a spoilt child who has grazed her knee. As long as the Fed offered attention and sweeties, investors stopped screaming. But the moment the sweeties ran out, the screaming resumed. Like a weak parent, Ben Bernanke, the Fed Chairman, encouraged this naughty behaviour with indecisive policy flip-flops. In the next two weeks, however, the screaming will probably stop. On December 11, at the next Fed meeting, Mr Bernanke will doubtless back down and give Wall Street its extra rate cut. The tantrum will then be over and it will be cuddles all round in the City and Wall Street — at least until the next grazed knee.

Anatole misses the point. In todays financial markets the problem is not reflexive behavior of investors or the inherent strength of economies. The real danger are the balance sheets of our financial institutions and their capital reserves. In other words the economy will be fine one or two years down the road if banks do not go bankrupt.

Alfred, New York,

If you were to believe these scammers, you would believe the soft landing theory. I personaly don't believe a word, the reason the Fed is lowering rates is not due to the screams of banks i believe but due to the fact the USA is sinking fast, and inflation risks are high but the Fed belives a collapse is worst than inflation even though this is wrong. The equity market are scaming the small investors and the pension schemes that constantly buy shares. I mean what would you prefer inflation which irrodes debt( china's 1.3 trillion)or higher rates which protects the surpless China has. equities will sink as of 2002 and these upward movement are just shorters buy back to short again,scammer make money on the up as well as down.so it pays well to have such voitility. when you have Mr buffett saying get out of stocks and sell the dollar you know you must listen,who would you prefer to be your advisor buffet or bernanke, only buffett has the track record bernanke is a print press operator!

lee, Cardiff, UK

I agree with this article but it doesn't cover the whole story. The bankers have generally not managed their risk properly. They have no idea about correlated risk - i.e. how seemingly unlinked risks can aggregate together under certain circumstances. Insurers discovered this after the world trade centre disaster when aviation, terrorism, property and liability insurance teams were all hit at once! Banks now have a similar hit and having paid out massive bonuses have no reserves to cover these "one in a hundred year event" scenario's. Hence they look for central bank bailouts; not somthing that I recall insurers ever getting! Greed has indeed overcome prudence in certain finance companies and central banks are to a certain extent condoning this. Several bank failures need to be allowed to take place and some directors need to loose everything to ensure more prudent future management. As a result I consider that a recession is almost a requirement to cauterise this management failure.

C Rowley, London, England

This is one of the most rational and balanced article of this type I have read for some time. It is a welcomed respite from the hype and whinging from a lot of sore losers out there.

Ross, London,

The problem is that unlike the US, the UK has little manufacturing output and hence the increased exports will not happen.
The UK economy is largely based on London and house prices, which are reliant on the city and the financial sector as London is now the undisputed financial capital of the world.
A financial crisis in London would have serious consequences for the UK economy, consumption, house prices, and individuals' net worth.
Roll on the recession......

Mark B, London,

No word of controlling inflation, which should be the only criteria to act for central banks ; at least if you are preaching free capitalism.

a.hunten, Pfemice,

It always amuses me when people who are so passionate about the free market with all its attendant benefits are also so in awe of the Fed.

These people would scream blue murder if the government or the Fed tried to control the price of bread or the price of carrots...but seem to worship the Fed which is basically controlling the price of money.

This is all going to end badly as the Fed is printing ever larger quantities of money to bail out one sector or another. This may prevent an immediate problem or even recession...but it will simply make for a bigger problem down the road.

Nick, Montreal, Canada

Overheard on the deck of the Titanic:

"Iceberg? Oh, don't be such a fear monger! All that we can responsibly say at this stage is that we are approaching a large white object sticking out of the water. It could be anything really, and nobody can say for certain what. Anyway, even if does turn out to be an iceberg you must remember that this ship is designed to be unsinkable! Even in the worst case scenario, that it is indeed an iceberg and we do indeed develop a hole, one would be foolish to worry because the damage will surely be contained to one or two of the fifteen bulkheads, leaving plenty more to keep the ship afloat! And what, with global warming and all, I hear that icebergs are far softer than they used to be..."

We court disaster, don't we? What is even sadder is that it won't be the women and children who get the lifeboats because the crew has already jumped ship. The end is not nigh. It is here.

ludwig, vienna, austria

NIck, no pink butterflies here. From "The Money Masters " The success of the central banking scheme developed into a far-reaching plan described by President Clinton's mentor, Georgetown Professor Carroll Quigley, "to create a world system of financial control in private hands able to dominate the political system of each country and the economy of the world as a whole. This system was to be controlled in a feudalistic fashion by the central banks of the world acting in concert, by secret agreements arrived at in frequent meetings and conferences. The apex of the system was to be the Bank for International Settlements in Basel, Switzerland, a private bank owned and controlled by the world's central banks which were themselves private corporations. Each central bank....sought to dominate its government by its ability to control Treasury loans, to manipulate foreign exchanges, to influence the levels of economic activity in the country, and to influence cooperative politicians.

Victor Compton, Cherbourg, France

I am not sure this is a complete analysis. It's not just the US housing market that is moving backwards, for example, the UK, Spain and Ireland are too. A world wide reduction in house prices will negatively affect consumer confidence and spending everywhere - particularly when personal debt levels are high.

Don't many governments e.g. the US and the UK have large and growing debt levels as well ? Wouldn't a forced balancing of the books have a big impact on government spending ?

So won't the current credit crunch make the above more likely ?

And what about $100 oil and the continued feed through of rising commodity prices and labour costs into Chinese and other countries' manufacturing costs. This will surely impact world wide inflation.

So while I agree the comments on the city boys and girls and their narrow views, I do think there are reasons for real concerns on growth and inflation for us all ... and sometime that will feed into stock markets ... maybe it has already

Alan Bevan, Gerrards Cross, England

When US sub-prime borrowers pleaded for rate cuts in 2006 and the first half of 2007, the Fed ignored them. When Wall Street (aka Masters of the Universe) threatened a sell off in August \ September 2007, the Fed delivered interest rate cuts of 0.75%. It seems when the rich \ mega rich want interest rate cuts they get it. When house price start to fall to in the UK, expect middle class Britain to hollower for interest rate cuts and expect the Bank of Engalnd to deliver even if it stokes inflation which affects the poor, low wage earners, those receiving welfare benefits, old age pensioners, the unemployed etc. But then democracy is about helping the rich not the poor.

Gemma Jones, London, UK

The main task of a central bank is to keep inflation in controll, 'bail-out' for bad investments is not. I'm not sure,for which option the writer is favored for.The rest is no news!

petr , kouvla,

Rob, You may agree with Pete - but I agree with Victor!

Now, if only I could stop these pink butterflies from crawling all over me.

Nick Utcase, Cane, Hill

The analogy of the spoilt child is bang on. At some point the sweeties have to be withheld by the Fed. Is the proviso that shares can go down as well us up no longer the case?

Jay Sanders, London, UK

Good article - as usual.

Market commentators, who are themselves 'insiders' are almost invariably bluffers. Reeling of a series of economic indicators and using pychobabble about 'markets' being 'nervous' etc is a trick anyone can pick up (I did it myself for a while) and serves only to impress upon the rest of us that this is complicated stuff that we cannot possibly understand (it is, but most financial service professionals are in the same boat as the rest of us).

It is only a shame that there are not more Kalesty's around to expose the staggering incompetence and self-interest that characterises much of the financial services industry. That it is protected by govt. and hugely subsidized by the tax payer (to say nothing of the abnormal profits creamed from us account holders and investors) makes the current round of bleating hard to swallow.

Journalists are lions when it comes to challenging politicians. But Paxman challenging the money men? Forget it

Ross, Dakar, Senegal

"Markets are soaring"

Really? Where's that then?

Jim, Crewe,

Fantastically written article, well done Kaletsky.

I like the:
"for example, the dollar is falling sharply and this is boosting US exports. The acceleration of export growth is easily offsetting the slowdown in construction and consumer finance ?"

I guess you know more than the rest of us with attending the Bilderberg meeting this year. How will them setting there targets for $100 a barrel by 2008, (which they are set to achive) affect the financial markets?

Andy Towell, Hartlepool,

The image of the Fed as Wall Street's poodle is enduring but incomplete. To suggest that bailing out the fat cats is the only reason for the rate cuts would be to ignore the fact that the US housing market is in meltdown (new home sales at >10-year lows), which will have negative impacts as much on the real economy as for the financial sector. The Fed's aggressive cuts are entirely appropriate.

Pete Clarke, London,

All of these analysis are just verbal masturbation. The Federal Reserve is a Private Bank which gained control of the American Economy, the last time, by a sneak vote of the only three Senators present in the Senate that evening, on Christmas Eve in 1913. The Federal Reserve itself is under the complete control of the old European Banking Cartel, which now has its headquarters in Switzerland.......along with, as more than a few believe, the majority of gold which used to reside in Ft. Knox. Therefore, no surprise that the Federal Reserve is bailing out the Stock Market. The same people (their identities always secret under the Bank's charter!!!!) who original chartered the Bank, are also among the biggest investors in the Stock Market. Everyone who works for the Fed should have "conflict of interest' stamped on his forehead. see the film on the internet, "The Money Masters" at http://www.informationliberation.com/?id=8702, then
Close Down The Federal Reserve Bank

Victor Compton, Cherbourg, France

A pertinent, well written article which backs my view of the financial market - it helps explain but of course it doesn't help our decision making - that is still down to instinct and pure risk!

Paul Butler, Reading, UK

I agree with Pete.

Rob x

Rob McNamara, London,

It seems that when an economy expands it's usually driven by events from the 'real economy'. That is, technical innovation, a better skilled or growing workforce, expansion of capital or the discovery of new resources. These incremental advances allow people to produce more goods and services and make us all better off.
When an economy contracts and makes us poorer, however, it seems it's usually due to issues arising in the financial world (banking crises, stock market slumps, currency devaluations, subprime etc. etc.) So it seems that the banking sector is indeed really good at one thing - precipitating recessions! Why financiers are so self-important and imagine themselves as the 'Masters of the Universe' one has to wonder.

Ted, London, UK

The image of the Fed as Wall Street's poodle is enduring but incomplete. To suggest that compensating and bailing out the fat cats is the sole reason for the further Fed rate cuts would be to miss the fact that the US housing market is imploding (new home sales at >10-year lows), which will be a huge problem for the real economy as much as for the financial sector. It is entirely appropriate for the Fed to cut aggressively.

Pete Clarke, London,

it's always been this way since as far as i can remember, the central banks always bail out the bankers using taxpayer's money

Tom, Glasgow,

An outstanding and balanced article. The accompayment is of course the business news channels - which has become akin to listening to Peter O'Sullivan describing the last hurdles of the Grand National - when will they re-classify CNBC and Bllomberg as Sp[orts Channels? When a forecast storm in the North Sea is mentioned in TV despatches as a major influence on the oil price then I think we can safely say that it is all over-hyped. Gosh - I do hope Mr Bernanke doesn't have a cold this winter as I couldn't imagine the resulting market speculation

C Richards, Bristol,

Is Kaletsky about the best economic commentator around these days? I'm starting to think so.

Rob Szente, Budapest, Hungary

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Anatole Kaletsky

Anatole Kaletsky writes for The Times Comment pages on Thursdays. One of the country's leading commentators on economics, he was formerly Economics Editor and is now an Associate Editor of The Times. He has won many awards for his financial and political journalism. Before joining The Times, he worked for 12 years on the Financial Times

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The FA is no longer interested in policing, just politicking

Ignore Wall Street's tantrums

Is the financial world about to collapse? You'd think so if you listened to the financiers