Government and central bank panic?
Are we now witnessing government and central bank panic? Just google the news over last few years and read how the same politicians and central banks have kept telling us “the financial system is sound”, “the economy is sound”, relax!
Are they now reaching out in “panic” forbidding short selling?
Lets go back to my home country in the late 1980’s. The Vikings were barbarians and did not develop modern financial markets before recently. Short selling of shares was not allowed yet in the 1980’s (there were few OTC forwards); there were no stock futures trading and no equity derivatives. Did this stop the Norwegian stock market from crashing massively in 1987? No it crashed Massively!.
Did this stop what used to be AAA Norwegian banks from going bankrupt and be bailed out from the government? No almost every big bank in Norway had to be saved by the government. The Norwegian banks did not go under because speculators and hedgers shorted their shares, but because the banks had lent out too much money and used similar non-robust risk-management models as most of them still use do today (but now under new fancy names). Yes there is more to the story: the unstable monetary system.
What the politicians and government now are doing by forbidding short sales is possibly adding more chaos to the system. Short selling is actively used for hedging as well as speculation. (Pure naked short selling were you not have been lending the shares I am not familiar with so excluding this from my analysis here).
Why will investors buy convertible bonds anymore and in this way help companies with their financing. Tomorrow or already today hedging some of the risk in convertible bonds by for example by shorting shares against them could or already is suddenly forbidden? (country dependent etc.).
There is also a lot of blaming on free market forces these days. And yes banks and financial institutions were creating all to much credit (leveraging) relying on housing prices as collateral. Housing prices they themselves helped spiraling-up in the expanding credit boom. But the problem is more complicated than this. The main reason for the bubble was probably not from free market forces, but to a large degree from lack of free market forces in the most central part of the so called market based economy. What is the largest of all markets in the world?
Oil? No,
Shares? No
Currency derivatives? No.
Credit derivatives? No.
The largest of all markets in the world is MONEY.
The supply and demand for money was (and still is) only partly controlled by market forces. A handful of central banks (which again is controlled by a handful of people, selected by the government or otherwise...) did years back set the price of money artificially low, to a large degree by relaying on lagging inflation measures. One has to expect banks and homeowners to be greedy or at least naïve? As we have seen time over again reading the history; homeowners borrow as much as they can, and surprisingly(?) banks also tend to lend out as much as they can. There could never have been so much credit created if it not was for the fractional FIAT money system where the central banks were setting the price of money artificial low, even in periods with relatively good economic conditions. Very low rates should at least be saved for extreme credit crunches. Well if the price for money (in a non fractional monetary system) had been set by the market in the first place we would not have got this gigantic credit bubble. Yes there would have been bubbles, but nothing like the one that now has started to burst.
On one hand modern economic theory talks about how it is almost impossible to beat the market, because the market always collectively have more information than a single investor or a handful of investors. At the same time the supply and demand for the largest of all markets — money — to a large degree is controlled by central banks, that is a handful of people.
It would be much better to have the politicians and central banks and government regulatory bodies spent more time on regulating the top of what supposedly should be market based economy. That is they should long time ago have stopped certain toxic loans to be pushed to often naive homeowners. Homeowners that often have entrusted the bank sales man or women to also be their financial advisor. The current monetary system is built to artificially regulate the fundament of the so called market economy: Money. The market does only partially control the price of money and thereby the supply and demand for money. Would anyone that had worked hard and saved up some cash 5 years ago actually have lent out his or her money to home owners at 4% or 5% if market forces had controlled the price of money? Probably very few. However if the central banks to a large degree were setting the price of money artificial low you had little or no choice, but to accept the few percent the bank offered you in a deposit account. The larger the demand was for borrowing the more credit the banks created (only possible in a fractional FIAT money system). Instead of the price of money quickly going up and dampen the demand for loans, the rates went down and the demand just kept increasing. The markets were flooded with cheap credit. Credit created based on increasing house prices, that themselves where driven by expanding credit. It was all crazy, there was plenty of warnings. And now the crazy credit expansion has turned into the madness of what can be described as an almost uncontrollable credit contraction.
Of course the central bank ministers are often themselves operating under restricted mandates given by the politicians, so it is hard to say exactly who is doing a good job and who is doing a bad job. Politicians (and bankers) founded our modern unstable monetary system long time ago, probably in good belief. Now again we see the result of a monetary system where the fundament of a so called market economy not is controlled by market forces. Yes now that the monetary system is out of control the best is possibly that the central banks steps in and helps clean up the mess that they also were a big part of creating. The question is if they will be able to do so when the system seems to be flawed in the first place.
What are the track records of central bank policy in modern time? Not long ago most central banks believed in a fixed currency exchange rate policy. Yes it created an illusion of exchange rate stability over a long period of time. Again market forces were not allowed to control the supply and demand for money at a fundamental level of the so called market economy (in this case the exchange rates). Slowly, but certainly supply demand imbalances were building up. At some point the system could not take it anymore. One country after another had to devalue in a burst of volatility. Then the central banks came up with a another new and what they thought better solution: controlling supply and demand for money based on adjusting the rates based on lagging inflation measures. You cannot stop a river by building a dam, only for a limited period of time, the bigger the dam, the bigger the burst. Neither can you stop market forces by building the illusion of low risk. The bigger the illusion the bigger the collapse.
I promises you there will always be such things as economic upturns and downturns (at least as long as there are civilizations). Chaos is the seed of order, Order is the seed of chaos. However a system where the market forces control at least the fundament of the market economy: the price of money, this will likely reduce the size of the booms and the bust "cycles". Today’s system is not a market economy, the fundament of the system is not controlled by market forces. I would not be surprised if this all will be blamed on market forces, but nothing could be further from the truth. The biggest of all markets are only partly controlled by market forces.
A full reformation of the monetary system is needed. My best guess would be the politicians some years down the road will consider to reform the monetary system, or possibly but not for sure (and hopefully not) be forced to do so by a "total" market melt down. The question is will they then simply reform one bad system into another bad system, just like they did by going from fixed exchange rate policy to a lagging inflation measure controlled policy. They do not understand or discuss that the fundament of the system: the price for Money itself must be controlled by market forces for a market economy to work well, and this is not the case. Each country could and possibly should have stronger regulation on the top of the system, but should not regulate the fundament of the market economy as they have tried doing now for generations. Protecting home owners from certain types of toxic loans, a more transparent derivatives market are probably all good stuff, but a market economy will never avoid massive boom bust cycles as long as the fundament of the system not is controlled by market forces. Yes we can create the illusion of stable system, but that is all an illusion that will burst.
If we go back in the history we will see short selling, options and several forms of financial instruments got forbidden in bust cycles, this is nothing new. Now everyone looks for a place to blame the credit crunch, I mentioned this on my blog back in 2006, looks like we could approach the left hand tail of the distribution where short selling, and options get blamed for the bust. The credit crunch is related to a series of problems:
- The fundament of the so-called market economy — Money — was (and still is) only partly controlled by market forces. This together with a fractional money system is the recipe for building massive bubbles. Such bubbles will burst, and we are now likely in the middle of the burst. (real estate in big parts of Europe probably in the beginning of the burst).
- Homeowners, banks, where all "greedy" and or "naive". But market forces should have controlled “greed” at least to some extent if market forces had controlled the price of money, but market forces only partly, and very weekly, controlled the price of money and thereby the supply and demand for money. Yes in the credit crunch market forces will in much larger degree control the price of money, this is when central banks loose control, well they also lost control in the credit expansion.
— Central banks and politicians according to what they have said over the last few years (the economy is sound bla bla bla) seems like they must have been relaying on Gaussian type models.
- Banks and financial institutions were relaying on Gaussian type risk management systems, or they had improved probability models where they though they took into account fat-tails with high precision. This without understanding the fat-tails not can be estimated with precise probability models (yes Nassim has written a lot on this). This even if fat-tails have been empirically discovered in finance already in the early 1900.
- The Bonus system has been built in such a way to encourage leaders and traders etc. to take massive risk (that they could move in front of them for a while). And it seems few people had high moral standards or knowledge to overrun the flawed system.
- Also investors where greedy and they should be “greedy“, but this combined with trusting flawed risk measures like Sharpe ratios and VaR to pour money into strategies that gave the illusion of low risk (short tail risk in credit or otherwise) helped fueling the credit bubble and is in general a recipe to go bust (often at around the same time).
- Researchers have produce a series of models based on flawed assumptions, the models are not robust for breaks in the assumptions. Many or most of them tend to think the same (following their 'leaders' or the so called 'accepted theories'). They have been able to strongly marketing such non-robust models as robust to financial firms etc. Investors and bank managers that often have limited quantitative skills themselves have bought into this non-robust models, and in some cases probably cynically abused them to get investors to pour money into illusionary low risk trades. Also many (most?) of the MBA and master of finance programs spend all to little time talking about the non-robustness of many of these models. They are pouring out Gaussian or extended Gaussian risk managers and quants with little or no market experience often set to develop credit derivatives models.
- Lack of transparency in the OTC derivatives market, more derivatives should probably be exchange traded. In particular the credit derivatives market seems to have been very non-transparent.
More on this later! I am afraid the credit crunch not is over, I have run to secure some assets; there is a lot of hidden risk out there. A “new-old risk” is now added to the system: sudden panic-changes from the governments. The same people short term ago claiming the Banking system was sound and stable. Tell that to someone that lost big parts of their savings when "their" bank went bust.
