Old habits die hard—especially bad ones, and especially when they’re backed by well-heeled lobbyists and a powerful congressional committee chairman.
It was hard not to draw that conclusion over the past week, as Wall Street and Washington alike prepared for President Barack Obama’s much-anticipated June 17 speech outlining the Administration’s proposals to overhaul financial regulations. Despite the promise of tough reforms from the President and his top economic officials, the Administration—in its decision to put off tough political battles over regulatory turf and reining in executive pay—appeared to be backing away from the stiffest moves that were on the table.
With the worst of the crisis appearing to recede, the political will to take on those tough constituencies appeared to be fading as well. With it may go a once-in-a-generation opportunity to aggressively tackle some badly needed changes in the U.S. financial system.
“Is the drive for reform losing steam? Yes, absolutely,” says Daniel Clifton, a Washington-based policy analyst at institutional broker Strategas Research Partners. With Congress signaling that it is unlikely to act on the President’s financial-system reforms until the fall, Clifton and other observers warn that this week’s regulatory plan could be highly vulnerable to attack for five months. Short of an unexpectedly sharp return of crisis in the financial sector, which would force the Administration and Congress to conclude that the costs of retaining much of the status quo intact are too high, Clifton believes the push for reform “will lose a lot more momentum by October.”
The aim of the Administration’s regulatory plan, largely developed by Treasury Secretary Timothy Geithner, is to create a more effective and powerful regulatory structure that would have a better chance of preventing the sort of unseen and out-of-control financial excesses that brought about the current global crisis. In an op ed article in the June 15 Washington Post, Geithner and Lawrence Summers, director of the National Economic Council, said their goal is “to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess.” The plan will try to rein in systemic risk by “raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms.” It will give the Federal Reserve the power to unwind financial holding companies whose failure could threaten the world’s economy. And it will try to strengthen consumer and investor protections on products ranging from “credit cards to annuities.”
Is Obama Flubbing the Financial Fix? – Jane Sasseen, BusinessWeek
June 18th, 2009
Last week was a milestone for US treasury secretary Tim Geithner. He finally got to play the hero. The morning of June 9, Treasury notified 10 financial institutions, including JPMorgan Chase, Goldman Sachs, Morgan Stanley, US Bancorp, and Capital One Financial, that they were “eligible to complete the repayment process” for the capital they received under the Troubled Assets Relief Program (TARP). In other words, they would be allowed to pay back $68.3 billion. Even though they really owe $229.7 billion. That we know of. But Geithner didn’t mention that last bit. Instead, he professed that “these repayments are an encouraging sign of financial repair,” with the caveat that “we still have work to do.”
The “we” he refers to is himself and Wall Street, both of whom are getting a good deal out of this fractional payback scheme. The agreement frees the banks from restrictions on executive pay or, worse, their general practices, but it still allows them to keep the cash they’ve received through non-TARP venues like the FDIC Temporary Liquidity Guarantee Program— or the massive sums the banks recovered from AIG (thanks to its own federal bailout) to cover their losses on credit derivatives. Not to mention any cash provided by the mother of all cheap loan programs—the Federal Reserve.
Geithner, for his part, gets to convey the message that things are looking up. “These repayments follow a period in which many banks have successfully raised equity capital from private investors,” stated the press release. “Also, for the first time in many months, these banks have issued long-term debt that is not guaranteed by the government.”
Well, of course certain banks have raised some money on their own: Firms have a tendency to look a whole lot better when they’re backed by government capital and have cheap federal loans sitting on their books. Private investors notice that sort of thing. But more troubling than the misplaced praise is the fine print that accompanied the announcement: “These repayments,” the department noted, “help to reduce Treasury’s borrowing and national debt. The repayments also increase Treasury’s cushion to respond to any future financial instability that might otherwise jeopardize economic recovery.”
This statement belies some accounting sleight of hand.
The Big Bank Bailout Payback Bamboozle – Nomi Pins, Mother Jones
June 18th, 2009
Valuation Update: We estimate that the S&P 500 is currently priced to deliver total returns over the next decade in the range of 6.5-9.0%, centered at an expected total return of about 7.8% annually. Stocks are modestly overvalued here, except on metrics that assume a permanent recovery to 2007’s record profit margins (which were about 50% above the historical norm).
On normalized profit margins, sustainable S&P 500 earnings are slightly above $60 on the index. That’s certainly higher than the 7 bucks of net earnings that companies in the index have reported over the past 52 weeks, but unfortunately, even at current prices, the S&P 500 is near 16 times normalized earnings.
The Outlook Is Not Up, But Very Widely Sideways – Hussman Funds
June 18th, 2009
Irving Fisher lives on in American economic history mainly as a laughingstock. He was, after all, the ninny who declared on Oct. 15, 1929, that stock prices had reached “what looks like a permanently high plateau.” Two weeks later, stocks plunged off that plateau–not to return to their 1929 level for a quarter-century.
There was more to Fisher than those infamous words. The longtime Yale professor was a successful entrepreneur (he devised and marketed a precursor to the Rolodex), the author of a best-selling textbook on personal hygiene, one of the most prominent backers of Prohibition and a leading eugenicist (that is, he believed the human race could be improved through the weeding out of “degenerates”).
More to the point, Fisher was the country’s first great economist, a pioneer of the mathematical approach that came to dominate the discipline after his death. Fisher saw the behavior of the market in rational, mathematical terms. He wasn’t completely doctrinaire about this–earlier in his career, he had allowed that investors sometimes behaved like sheep. But in the 1920s, convinced that skilled monetary management at the Federal Reserve and the rise of new, professionally run investment trusts had reduced the riskiness of markets, he lulled himself into believing that the prices prevailing on Wall Street were a reflection of economic reality and not of investor mania or a credit bubble.
Does this sound familiar? The financial history of the past decade is replete with echoes of Fisher’s colossal 1929 miscalculation. A brilliant Fed chairman was credited with banishing panics and ushering in what economists called the Great Moderation. An explosion of financial innovation was deemed to have provided investors, corporations and banks with new ways of managing risk. Prices of stocks, houses and other assets rose to levels that were high by historical standards–but who was to say the market was wrong in fixing those high values?
In the 1990s and 2000s, in fact, this myth of the rational market was embraced with a fervor that even Irving Fisher never mustered. Financial markets knew best, the thinking went. They spread risk. They gathered and dispersed information. They regulated global economic affairs with a swiftness and decisiveness that governments couldn’t match. And then, as debt markets began to freeze up in 2007, suddenly markets didn’t do any of these things. “The whole intellectual edifice collapsed in the summer of last year,” former Fed chairman Alan Greenspan said at a congressional hearing in October.
Well, maybe not the whole edifice. For all its flaws, Fisher’s economic approach delivered genuinely important insights. He proposed in 1911 that the government issue inflation-linked bonds; in 1997, the Treasury Department finally got around to doing so. If anybody in power in Washington had been willing to follow his advice in 1930 or ‘31 (which essentially amounted to “Print more money”), the Great Depression might not have been so great. For the past two years, the Federal Reserve has been working right out of the Fisher playbook, and while the results haven’t been perfect, they’ve been a lot better than those of the early 1930s. The economics that Fisher espoused–reborn after his death in 1947–should not be discarded. But clearly, there are some issues with it.
Fisher fell on hard times after the 1929 crash–getting by thanks only to the generosity of a wealthy sister-in-law and his employer, Yale–and so did the myth of the rational market. For a few decades, financial markets were seen as unruly beasts that had to be tamed with tight regulation to help protect the hard-earned savings of regular Americans. But memories of the 1930s eventually faded, and in the 1950s, the idea that markets knew best began its comeback. This was part ideological reaction to the antimarket conventions of the day, part scientific progress. It was the combination of the two, in fact, that made the idea so powerful.
A key figure in the revival was the University of Chicago’s Milton Friedman–and his libertarian ideological bent was certainly a factor. Friedman never believed markets were perfectly rational, but he thought they were more rational than governments. Friedman saw the Depression as the product of a Fed screwup–not a market disaster–and convinced himself and other economists (without much evidence) that speculators tended to stabilize markets rather than unbalance them.
But Friedman was a scientist too. During World War II, he used his mathematical and statistical skills to help determine the optimal degree of fragmentation of artillery shells. Officers flew back to the U.S. in the middle of the Battle of the Bulge to get his advice on the trade-off between the likelihood of hitting the target (the more fragments, the better) and the likelihood of doing serious damage (the fewer and bigger the fragments, the better).
Emboldened by this work, economists began to apply their number-crunching skills to the postwar market. Chicago graduate student Harry Markowitz devised a model for picking stocks that was, in Friedman’s estimation, “identical” to his artillery-shell-fragmentation trade-off. And in the late 1950s, scholars at Chicago and the Massachusetts Institute of Technology became enamored of the idea that stock-market movements were, like many physical phenomena, random.
The two strands of statistics and pro-market ideology came together in the mid-1960s. It was the great MIT economist Paul Samuelson who made the case mathematically that a rational market would be a random one. But Samuelson didn’t share Friedman’s political views, and he never claimed that actual markets met this ideal. It was at Chicago that a group of students and young faculty members influenced by Friedman’s ideas began to make the case that the U.S. stock market, at least, was what they called “efficient.”
Their evidence? Mutual-fund managers failed as a group to outsmart the market, and studies showed that new information was quickly incorporated into prices. Eugene Fama, a young professor at Chicago’s business school, tied all this together in 1969 into what he dubbed the efficient-market hypothesis. “A market in which prices always ‘fully reflect’ available information is called ‘efficient,’” he wrote–and the evidence that such conditions prevailed in the U.S. stock market was “extensive, and (somewhat uniquely in economics) contradictory evidence is sparse.”
Upon that basis, economists and finance scholars cleared the way in the 1970s for a new approach to investing and risk management that included index funds, risk-weighted portfolio allocation and mathematical models to price options and other derivatives. A lot of this was, as with Fisher’s economics, useful. But a basic assumption underlying much of it–that prices were reliable reflections of economic reality–was problematic.
It didn’t take long for a new generation of scholars, many with roots at Samuelson’s MIT, to start pointing out the problems. Samuelson protégé Joseph Stiglitz showed that a perfectly efficient market was impossible, because in such a market, nobody would have any incentive to gather the information needed to make markets efficient. Another Samuelson student, Robert Shiller, documented that stock prices jumped around a lot more than corporate fundamentals did. Samuelson’s nephew Lawrence Summers demonstrated that it was impossible (without a thousand years of data) to tell a rationally random market from an irrational one.
Shiller and Summers in particular came to revel in tweaking the rational-market establishment. Shiller declared in 1984 that the logical leap from observing that markets were unpredictable to concluding that prices were right was “one of the most remarkable errors in the history of economic thought.” Summers described how financial markets were often dominated by “idiots” (he later dubbed them “noise traders” and co-authored a series of academic papers showing how their errors could move prices) and lamented at the 1984 meeting of the American Finance Association that “virtually no mainstream research in the field of finance in the past decade has attempted to account for the stock-market boom of the 1960s or the spectacular decline in real stock prices during the mid-1970s.”
The 1987 stock-market crash gave Shiller and Summers all the ammunition they needed. “If anyone did seriously believe that price movements are determined by changes in information about economic fundamentals,” Summers said just after the crash, “they’ve got to be disabused of that notion by Monday’s 500-point movement.” The crash also demonstrated that prices didn’t follow the statistical model of a random walk–if they did, a 20% one-day market drop like that of 1987 should happen only once in billions upon billions of years.
Subsequent years saw more challenges to the core assumptions of the rational market. Even Fama retested his 1969 efficient-market hypothesis and found it wanting. But the strong performance of the U.S. stock market and economy tended to silence doubts about the wisdom of the market both on campus and where it really mattered–in Washington and on Wall Street. Shiller warned repeatedly of irrational exuberance in stocks in the late 1990s and in housing in the early 2000s. He was largely ignored both times–until he turned out to be right. Unwillingness to countenance the possibility that market prices might be wildly wrong defined the behavior of regulators, corporate executives and most Wall Streeters during both the tech-stock and real estate bubbles.
The issue isn’t whether financial markets are useful–they are–or whether the prices of stocks or bonds or collateralized debt obligations convey information–they do. There’s also much to be said for the insight at the heart of efficient-market theory: markets are hard to outsmart. But when we give up second-guessing the market, we suspend our judgment. And without participants’ exercising judgment–applying research, heeding a broker’s opinion–markets stand no chance of ever getting prices right.
Based on Fox’s book The Myth of the Rational Market, published this month by HarperBusin
Exploring The Myth of the Rational Market – Justin Fox, TIME
June 18th, 2009
