Efficient market hypothesis is dead – for now

I have to report the sad passing of the efficient market hypothesis. The theory was officially declared dead yesterday at the World Economic Forum in Davos. There were no mourners.

The announcement was made at a brainstorming session that involved many of the world’s top economists, politicians and business leaders … together with a few bankers wearing dark glasses and false beards.

Asked which policy assumption had most contributed to the global financial crisis, the most popular answer by far was the belief that markets are self-correcting. (Nassim Nicholas Taleb, author of The Black Swan, said it was that markets “robustify” themselves, which amounts to the same thing … I think.)

In recent years, the belief in efficient markets has dominated economic policy and financial regulation in the Anglo-Saxon world and increasingly across the globe. Its death, if confirmed, is a momentous event. At the very least, it will cause anguish among countless MBA graduates who have paid good money, worked long hours and consumed large quantities of cold pizza to learn about something nobody now believes in.

The efficient market theory (or more precisely, the closely related efficient banks theory) has already been given a bit of a kicking by one of its greatest supporters, Alan Greenspan. The former Federal Reserve chairman has said that the big mistake he made was assuming that banks’ self-interest would prevent them doing anything that would threaten their own survival.

It was a good thing Mr Greenspan wasn’t at Davos yesterday. He would have been set upon. When it comes to the sins of bankers and regulators, the mood among Davos types is just as ugly as it is among the general population.

John Neill, chief executive of Unipart, was given one of the day’s biggest rounds of applause when he declared that bankers who were involved in developing toxic products that caused massive damage to the global economy should be punished. If you knowingly make other kinds of toxic products, you go to jail. Why should bankers be different, he asked.

Regulators also came in for a battering. But the Davos consensus on what needs to be done was concerning. Asked what the top priority should be in terms of financial regulation for the forthcoming G20 meeting, half the delegates at the session said it was addressing the lack of an international regulatory framework.

This echoes the oft-repeated call by politicians, including Gordon Brown, for better international regulatory co-ordination.

Yet, as Lord Turner, chairman of the Financial Services Authority, told me yesterday, international standards and better co-ordination would have made little difference to the course of the credit crisis. It would not have improved the Federal Reserve’s regulation of Citigroup or the FSA’s regulation of Northern Rock.

Moreover, coming up with an international regulatory framework will be extremely difficult. Unlike in trade, for example, there is no treaty-based international organisation in which such a framework can be hammered out.

It will take a very long time. So long, in fact, that it is unlikely to be finished before the efficient market hypothesis rises again from the dead. As it surely will.

 

David Wighton: Business Editor’s Davos commentary.

 

From The Times - January 29, 2009

http://business.timesonline.co.uk/tol/business/columnists/article5607960.ece

Filed under: Business , davos, efficient, market

How bad is the crisis going to get?

36 hours in September changed the world. When investment bank Lehman Brothers collapsed, the credit crunch became a global financial crisis.

But how bad is that crisis? Was it wrong to let Lehman fail? Or was Lehman just a symptom not the cause of the chaos in the global economy?

Tough questions, and the World Economic Forum had lined up five top experts (including two Nobel prize winners) to find answers.

The economists among them were Crunch Cassandras; two or three years ago they had predicted that our financial system was headed for a huge liquidity crisis – Nouriel Roubini, Nassim Taleb and economic historian Niall Ferguson.

A pity then, a participant said, that two years ago nobody had thought of inviting them to speak at the forum.

Little wonder that this session was hugely oversubscribed, with 150 people on the waiting list and probably more than that crowding into one of the cavernous dining rooms that are the hallmark of Davos hotels.

Under Davos rules this was a closed session, to encourage frank debate. So with a few exceptions I am not allowed to attribute quotes to individual speakers.

But I can report what was said, and this session was an intellectually stimulating eye opener – and utterly depressing (at least economically).

Depression 2.0?

The biggest question, of course, is how bad is it going to get, and nobody – neither on the panel nor in the audience – dared to provide any cheer.

There was talk of “Depression Lite” and “Depression 2.0″, although the experts also pointed out that it was unlikely to get as bad as the 1930s.

Back then, the US economy shrank on average 14% a year, prices fell at 8% a year and unemployment peaked at 25%.

The sharp rate cuts and fiscal stimulus packages around the world would prevent a repeat, everybody agreed.

Still, warned one of the experts, the world would have to brace itself for “a best case scenario” of at least a year of recession and a “lost decade” of low growth – and most people were still in denial about this prospect.

Nouriel Roubini warned of a credit crunch two years ago.

Root causes

But what caused the crisis? A popular theory is that Washington is to blame for the “global cardiac arrest”, because it allowed Lehman to fail.

The panellists rejected this suggestion as “tosh” and “a myth”.

 

This crisis, several economists said, started two years earlier and was “bound” to lead to a financial meltdown – whether it was a bank like Washington Mutual or the likes of Lehman and other parts of the lightly regulated shadow banking system of investment banks, hedge funds and broker dealers.

 

“How could banks be so stupid?,” several panellists asked, and allow things go so wrong so quickly?

The root causes for the economic crisis were too much debt, a culture of short-term rewards for long-term risk-taking and fatally flawed mathematical risk models. And plain old greed.

“Derivatives trading is all about how to make a bonus and how to screw your client,” said Nassim Taleb, a former derivatives trader and author of “The Black Swan,” a book about expecting the unexpected.

The result was a mountain range of “troubled assets” (one of the great euphemisms of the crisis, one expert said) that resulted in billion dollar losses and the need to bail out financial institutions like Fannie Mae, Freddie Mac and AIG even before Lehman collapsed.

Into the hurricane

Morgan Stanley, one expert ventured, was saved only because its share price bounced back when rumours emerged of Washington’s $700bn bail-out package.

Two thirds of the world’s hedge funds would collapse, suggested another. Financial institutions took on debt worth 40 times their assets – and failed to understand how risky this was. Bank’s risk models, a prominent participant revealed, were based on one year’s worth of data.

It was, another expert said, as if a pilot was assuming that he would never fly into a hurricane, because he hadn’t come across one during the past year.

Bankers had no memory, another panellist said, they had forgotten about the Asian crisis in the late 1990s, the collapse of the LTCM hedge fund, and much more.

But it is too easy to single out the bankers – a banker said.

Where were the regulators, rating agencies, corporate boards and central bankers?

What about the borrowers, who did not read contracts and had to know they could not afford these mortgages?

And what about the shareholders and investors, who did not question the business models of the companies they owned? 

 

 

By Tim Weber 
Business editor, BBC News website, in Davos.

http://news.bbc.co.uk/2/hi/business/davos/7859179.stm

Filed under: Business , Bad, Crisis, economic