Market Efficiency and Rationality: Why Financial Markets are - - PowerPoint PPT Presentation

Market Efficiency and Rationality: Why Financial Markets are Different

Lionel Robbins Memorial Lectures

Lord Turner

Chairman of the Financial Services Authority, the Climate Change Committee and the Overseas Development Institute

Christopher Johnson

Chair, LSE

1

Lecture II Financial Markets: Efficiency, Stability and Income Distribution

London School of Economics 12 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

100 200 300 400 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 $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.

3

Capital flows to emerging markets 1998 – 2008

• 300

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 GDP

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 Flows Banking 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

100 200 300 400 500 600 700 800 900 1,000 1,100 1977 1982 1987 1992 1997 2002 2007 $bn Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn

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

• 1929

1935 1941 1947 1953 1959 1965 1971 1977 1983 1990 1996 2002 2007

7

Growth of interest rate derivatives values 1987 – 2009

50 100 150 200 250 300 350 400 450 1987 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 10 11 12 13 15 16 17 18 20 21 22 23 25 26 27 28 30 31 32 33 35 36 37 38 40 41 42 43 45 46 47 48 50 51 52 53 55 56 57 58 60 61 62 63 65 66 67 68 70 71 72 73 75 76 77 78 80 81 82 83 85 86 87 88 90 91 92 93 95 96 97 98 00 01 02 03 05

• +

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

Income / Contentment Pre-industrial societies The Great Transformation Economic and technological progress Income Human wellbeing contentment / 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 for

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 allocative 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 paradigm

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-

• ptimal

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

• ne’s judgement, are really the prettiest, nor even those which

average opinion genuinely thinks the prettiest. We have reached the 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 12 John 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

• f 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

• bserved 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 for

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 economic 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 80.0 100.0 120.0 140.0 1990 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

• f 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 for

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

50 100 150 200 250 300 350 400 450 1987 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: ISDA Market Survey

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

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 production

Global oil consumption vs. traded oil futures 1983-2009 200 400 600 800 1,000 1,200 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Year Oil barrels equivalent (millions) Exchange futures volumes (million barrels 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

• verall 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

• !"
• #$%
• 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 for

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

50 100 150 200 250 300 350 400 1855 1875 1895 1915 1935 1955 1975 1995

Financial Intermediation Aggregate

1975=100

Source: Andrew Haldane, The Future of Finance, LSE Report, 2010)

36

Average annual growth rate of financial intermediation

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)

%

1 2 3 4 5 6 7 8 9 50 70 90 10 30 50 70 90 1850 1910

38

Historical 'excess' wage in the US financial sector

0.1 0.0 0.1 0.2 0.3 0.4 0.5 10 11 12 13 15 16 17 18 20 21 22 23 25 26 27 28 30 31 32 33 35 36 37 38 40 41 42 43 45 46 47 48 50 51 52 53 55 56 57 58 60 61 62 63 65 66 67 68 70 71 72 73 75 76 77 78 80 81 82 83 85 86 87 88 90 91 92 93 95 96 97 98 00 01 02 03 05

• +

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

5 10 15 20 25 30 35 1921 1941 1961 1981 2001 = 7.0 σ = 2.0 = 20.4 σ = 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

• ptions

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 for

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

• f 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

Income / Contentment Pre-industrial societies The Great Transformation Economic and technological progress Income Human wellbeing contentment / happiness

China Africa Developed economies

45

Conclusions

All imperfect markets are different The benefits of financial market liberalisation differ by stage

• f development

Stability matters a lot – minor increments of allocative efficiency, little Economics for the real world

46

Conclusions

All imperfect markets are different The benefits of financial market liberalisation differ by stage

• f 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