market efficiency and rationality: why financial markets
TRANSCRIPT
Market Efficiency and Rationality: Why Financial Markets are Different
Lionel Robbins Memorial Lectures
Lord TurnerChairman of the Financial Services Authority, the Climate Change Committee and the Overseas Development Institute
Christopher JohnsonChair, LSE
1
Lecture II
Financial Markets: Efficiency, Stability and Income
Distribution
London School of Economics12 October 2010
Adair Turner
Lionel Robbins Memorial Lectures
Economics after the crisis: Objectives and means
2
Capital inflows to emerging markets 1980 – 98
-200
-100
0
100
200
300
40019
80
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
$bn
Equity flows Debt flowsEquity includes direct investment and portfolio equity investment. Debt includes portfolio debt investment and other investment.
Emerging markets includes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Hungary, Hong Kong, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Singapore, South Africa, Thailand, Turkey and Venezuela.
3
Capital flows to emerging markets 1998 – 2008
-300
0
300
600
900
1,200
1,500
1,800
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
$bn
Equity flows Debt flows
Equity includes direct investment and portfolio equity investment. Debt includes portfolio debt investment and other investment.
Emerging markets includes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Hungary, Hong Kong, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Singapore, South Africa, Thailand, Turkey and Venezuela.
4
Total global cross-border inflows as % of global GD P
0
2
4
6
8
10
12
14
16
18
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Foreign Direct Investment Portfolio Equity Flows Debt Flows Other FlowsBanking and Other Flows
Source: IMF Global Financial Stability Report, 2007
5
FX trading values and world GDP: 1977 – 2007
Source: BIS Triennial Central Bank Survey, IMF International Financial Statistics
0
100
200
300
400
500
600
700
800
900
1,000
1,10019
77
1982
1987
1992
1997
2002
2007
$bn
Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn
$tn
$tn$tn $tn
6
USA debt as a % of GDP by borrower type
Source: Oliver Wyman
Household
Corporate
Financial
1929
1935
1941
1947
1953
1959
1971
1977
1983
1990
1996
2002
2007
10%
50%
100%
150%
200%
250%
300%19
29
1935
1941
1947
1953
1959
1965
1971
1977
1983
1990
1996
2002
2007
10%
50%
100%
150%
200%
250%
300%
7
Growth of interest rate derivatives values 1987 – 2009
0
50
100
150
200
250
300
350
400
45019
87
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
$Tr
OTC interest rate contracts, notional amount outstanding
Source: ISDA Market Survey (1987-1997), BIS Quarterly Review (1998-2009). Includes interest rate swaps and interest rate options.
8
Historical 'excess' wage in the US financial sector
0.1
0.0
0.1
0.2
0.3
0.4
0.5
1011121315161718202122232526272830313233353637384041424345464748505152535556575860616263656667687071727375767778808182838586878890919293959697980001020305
-
+
1910 2000
1910 2000
'Excess' wage
Source: Philippon, T and Reshef A (2009). Wages and Humal Capital in the US Financial Industry: 1909-2006, NBER Working Paper No 14644.A. Resh (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)
9
Income and Human Contentment: Possible stylised pattern over time
Inco
me
/ Con
tent
men
t
Pre-industrial societies The Great Transformation
Economic and technological progress
Income
Human wellbeingcontentment / happiness
China
Africa
Developed economies
10
Markets and economic growth
� Failure of pure planned economies
� Trade access key to rapid catch-up
� Entrepreneurship delivers– Better restaurants
– Better innovation, e.g. information technology
� US Pre-First World War
� Japan 1950s - 1970s and Korea 1960s - 1990s
� China But
11
� Efficient and rational financial markets: reasons f or disbelief
� The crash of 1997
� The crash of 2008
� Financialisation and income distribution
� Conclusions for policy and the discipline of economics
12
General equilibrium, complete markets and allocativ e efficiency
Arrow-Debreu:
A competitive equilibrium is efficient …
… IF all markets are complete
� Liquid stock markets
� Commodity futures markets
� Structured credit markets
� Credit derivatives markets
� Etc.
Innovation and liquidity bring us
closer to the Arrow-Debreu
nirvana where all possible markets
exist and are complete
13
Market imperfections within the neoclassical paradi gm
� Lack of transparency
� Manipulation
� Lack of liquidity
� Subsidies, taxes and other interventions
� Increase transparency
� Punish manipulation
� Remove government interventions
� Make all markets efficient
� Increase liquidity
Market imperfections arising from:
Lancaster and Lipsky:
- If a specific market is imperfect, liberalisation of other markets can be sub-optimal
And
� Ban products
� Dampen market volatility
� “Throw sand in the wheels of speculation” (Tobin Taxes)
But not
14
Rational valuation or self-referential cycle
“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole […] It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reachedthe third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”
The General Theory of Employment, Interest and Money, chapter 12John Maynard Keynes, 1936
15
Manias, Panics and Crashes: The Madness of Crowds
� 1635 – 1637: Dutch tulips
� 1711 – 1720: South Sea bubble
� 1719 – 1720: Mississippi scheme
� 1929: US equities, bonds and real estate
� 1987: Global equity markets
� 1997: Asian emerging markets: FX, equities and debt
� 2000: Internet equities
� 2007 – 2008: Credit, structured credit and credit derivatives
“This
time it’s
different “
16
Why are markets irrational?
� Human beings are part rational, part instinctive
� Inherent information and principal/agent imperfections: collective irrationality even if individual humans were fully rational
� Inherent irreducible uncertainty
17
Value-at-risk assessment: Operational and inherent deficiencies
� Non-normal distributions
� Recursive systemic effects – non-independence: procyclicality
� Inherent irreducible uncertainty not mathematically modelable risk
Deficiencies
� Observe over a past period (e.g. last year) the distribution of profits / loss resulting over a defined time period (e.g. day, 10 days) from a given gross position
� Hold capital sufficient to cover some multiple of this ‘Value at Risk’
Basic concept
Frequency distribution of observed daily trading
profit/loss
Loss Profit
99% confidence
level
Daily VAR at 99%
Loss Profit
99% confidence
level
Daily VAR at 99%
18
Mervyn King (et al), Uncertainty in macro-economic policy making: art or science
“There are probably few genuinely ‘deep’ (and therefore stable) parameters or relationships in economics as distinct from in the physical sciences, where the laws of gravity are as good an approximation to reality one day as the next”
Royal Society, March 2010
19
� Efficient and rational financial markets: reasons f or disbelief
The crash of 1997
� The crash of 2008
� Financialisation and income distribution
� Conclusions for policy and the discipline of economics
20
Does capital account liberalisation deliver economi c benefits?
“Despite the numerous cross-country attempts to analyse the effects of capital account liberalisation, there appears to be only limited evidence that supports the notion that liberalisation enhances growth”
Capital flows and emerging market economies, CGFS Papers No. 33 January 2009
21
Bonanzas and sudden stops in international capital flows
Bonanzas � Self-reinforcing optimism � New paradigm stories� “This time it’s different”
� Ride the wave and get out in time
� Rush for the exit� Contagion to “similar” countries
Sudden stops
And
22
Thai Baht, Korean Won and Indonesian Rupee: Exchange rates versus US$ 1990 – 1998
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.019
90
1990
1991
1991
1992
1992
1993
1993
1994
1994
1995
1995
1996
1996
1997
1997
1998
1998
US$ to Thai Baht US$ to South Korean Won US$ to Indonesian Rupiah
Source: GTIS and Datastream)
23
The Washington Consensus response: conditions and sequencing
Fx markets overshoot and are volatile because
of poor fiscal and monetary policies and
lack of appropriate domestic financial
conditions
Problem lies not within financial liberalisation, but in badly executed and
incomplete liberalisation
Conditions and
sequencing are vital
24
Short-term capital flows and optimal policy
� Theories of irrational markets and observation of bonanzas and sudden stops
� Neoclassical axioms and impossibility of proving that movements were irrational
� No perfect policies
� But take policy options out of the index of forbidden thoughts
– Capital inflow taxes or controls
– Financial transaction taxes
Are they rational? And if not, what follows?
VS
25
� Efficient and rational financial markets: reasons f or disbelief
� The crash of 1997
The crash of 2008
� Financialisation and income distribution
� Conclusions for policy and the discipline of economics
26
Growth of interest rate derivatives values 1987 – 2009
0
50
100
150
200
250
300
350
400
45019
87
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
$Tr
OTC interest rate contracts, notional amount outstanding
Source: ISDA Market Survey (1987-1997), BIS Quarterly Review (1998-2009). Includes interest rate swaps and interest rate options.
27
Global issuance of asset-backed securities
Notes: Public issuance only. Full-year issuance except for 2008 which is up to and including September 2008. ‘Other ABS’ includes Auto, Credit Card and Student Loan ABS.
Source: Bank of England
28
Global credit derivatives outstanding
Source:
ISD
A M
arket Survey
0 10 20 30 40 50 60 70
Jun 2001
Dec 2001
Jun 2002
Dec 2002
Jun 2003
Dec 2003
Jun 2004
Dec 2004
Jun 2005
Dec 2005
Jun 2006
Dec 2006
Jun 2007
Dec 2007
Jun 2008
Dec 2008
Jun 2009
Notional amounts outstanding, $Tr
29
Global issuance of Collateralised Debt Obligations:Cash and synthetic
Source: IMF Global Financial Stability Report, 2006
0
50
100
150
200
250
300
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Synthetic
Cash
$bn
30
Global daily oil futures trading and daily oil prod uction
Global oil consumption vs. traded oil futures 1983-2009
0
200
400
600
800
1,000
1,20019
83
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Year
Oil
barr
els
equi
vale
nt (
mill
ions
)
Exchange futuresvolumes (millionbarrels equivalent)
)
Source: NYMEX
31
Complete markets as a route to…
Credit derivatives “enhance the
transparency of the markets’
collective view of credit risks..
[and thus]… provide valuable
information about broad credit
conditions and increasingly set
the marginal rice of credit.
Therefore, such activity improves
market discipline”
“There is a growing recognition
that the dispersion of credit risk
by banks to a broader and more
diverse group of investors has
helped make the banking and
overall financial system more
resilient …
The improved resilience may be
seen in fewer bank failures and
more consistent credit provision”.
… efficiency … and stability
IMF, Global Financial Stability Review, April 2006
32
Financial firms’ CDS and share prices
Source: Moody’s KMV, FSA Calculations
Exhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
Dec 02
Apr 03
Aug 03
Dec 03
Apr 04
Aug 04
Dec 04
Apr 05
Aug 05
Dec 05
Apr 06
Aug 06
Dec 06
Apr 07
Aug 07
Dec 07
Apr 08
Aug 08
Dec 08
Average CDS Spread in Percent
-
0.50
1.00
1.50
2.00
2.50
MarketCap Index
CDS SHARE-PRICE-ADJUSTED
Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway, Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS.
CDS series peaks at 6.54% in September 2008.
33
Did financial intensification deliver…
Increased stability? Clearly not
Improved allocative efficiency?
� Argument by axiom
� Markets in general beat planned economies
+
+
Vs
� Instability itself generating misallocation
� Diminishing marginal benefits
34
� Efficient and rational financial markets: reasons f or disbelief
� The crash of 1997
� The crash of 2008
Financialisation and income distribution
� Conclusions for policy and the discipline of economics
35
UK financial intermediation and aggregate real GVA
0
50
100
150
200
250
300
350
400
1855 1875 1895 1915 1935 1955 1975 1995
FinancialIntermediationAggregate
1975=100
Source: Andrew Haldane, The Future of Finance, LSE Report, 2010)
36
Average annual growth rate of financial intermediat ion
Sources : Office for National Statistics (ONS) and Bank of England calculations (as referenced by Andrew Haldane in The Future of Finance LSE Report, 2010)
Note: Real values
GVA: Aggregate
GVA: Financial Intermediation Difference (pp)
1856 – 1913 2.0 7.6 5.6
1914 – 1970 1.9 1.5 -0.4
1971 – 2008 2.4 3.8 1.4
37
Share of the financial industry in US GDP
Source: Philippon, T (2008), The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)
%
0
1
2
3
4
5
6
7
8
9
50 70 90 10 30 50 70 901850 1910
38
Historical 'excess' wage in the US financial sector
0.1
0.0
0.1
0.2
0.3
0.4
0.5
1011121315161718202122232526272830313233353637384041424345464748505152535556575860616263656667687071727375767778808182838586878890919293959697980001020305
-
+
1910 2000
1910 2000
'Excess' wage
Source: Philippon, T and Reshef A (2009). Wages and Humal Capital in the US Financial Industry: 1909-2006, NBER Working Paper No 14644.A. Resh (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)
39
Return on equity in finance
0
5
10
15
20
25
30
35
1921 1941 1961 1981 2001
µ = 7.0σ = 2.0
µ = 20.4σ = 6.9
%
Sources : Capie, F. and Billings, M. (2004), BBA and Bank of England calculations (as referenced by Andrew Haldane in The Future of Finance LSE Report, 2010)
40
Increased financial sector factor incomes
Increase in the real value added functions performed within more complex and more global economies
� Opacity of margin and asymmetries of knowledge and power
� Complex opaque put options
� Tax and regulatory arbitrage� Creation of volatility – which
non-financial sector needs to hedge
OR
41
Why are some bankers paid so much?
� Highly skilled labour produces high marginal product
…. but will never receive wage higher than the social value delivered
� Mix of indirectly “creative”and purely “distributive” / “rent extracting” activities –private marginal product can diverge from social
� Measurability of (apparent) marginal product is key driver of pay levels
Theory Practice
42
� Efficient and rational financial markets: reasons f or disbelief
� The crash of 1997
� The crash of 2008
� Financialisation and income distribution
Conclusions for policy and the discipline of economics
43
Conclusions
� All imperfect markets are different
� The benefits of financial market liberalisation differ by stage of development
� Stability matters a lot – minor increments of allocative efficiency, little
� Economics for the real world
44
Income and Human Contentment: Possible stylised pattern over time
Inco
me
/ Con
tent
men
t
Pre-industrial societies The Great Transformation
Economic and technological progress
Income
Human wellbeingcontentment / happiness
China
Africa
Developed economies
45
Conclusions
� All imperfect markets are different
� The benefits of financial market liberalisation differ by stage of development
� Stability matters a lot – minor increments of alloca tive efficiency, little
� Economics for the real world
46
Conclusions
� All imperfect markets are different
� The benefits of financial market liberalisation differ by stage of development
� Stability matters a lot – minor increments of allocative efficiency, little
� Economics for the real world
47
Implications for economics
� Human beings as they are
� Markets as they actually operate
� Economic history as key input
� Complex and multiple understandings– No all-encompassing model
48
Robert Lucas, Professional Memoir
“I prefer to use the term ‘theory’ … [as] something that can be put on a computer and run… the construction of a mechanical artificial world populated by interacting robots which economics typically studies”
Professional Memoir, Page 21, 2001
49
Implications for economics
� Human beings as they are
� Markets as they actually operate
� Economic history as key input
� Complex and multiple understandings– No all-encompassing model