Yellow Fever

In the financial markets, we see crashes and corrections happen again and again, but we are taught that this is part and parcel of investing. We are also made to believe that keeping our capital in the stock market is the best way to preserve and grow it. We know of no absolute causes except that historically, markets will trend upwards, and therefore, our expectations should be that by the time we retire, that sum that we put in when we were young should have grown by a positive percentage. Without firm understanding of why this should be so, such blind faith and heuristic thinking is dangerous.

For a long time, the cause of the yellow fever in the New Orleans was unknown too, it was thought that the fever was caused by something that was airborne. Some believed that the burning of tar or dung would clear up the air. This of course, only provided the most awful stench in the air and did not help stem the epidemic at all.

The real reason however, was the mosquitoes that bred in the water wells in the courtyards of the buildings. The water wells were built as part of the regulation imposed on the buildings to provide water after the many fires that swept through the French Quarters and many other parts in the New Orleans. The unidentified cause and that no one ever thought of searching for the cause cost many lives for a long time.

What if it is the same with the financial markets? What if we could identify the causes of the corrections? Could there be symptoms that manifest themselves in the market before a correction occurs? And what if there is one symptom that was bred from multiple causes, or vice versa, multiple symptoms that point to a particular cause? What if we had seen these symptoms over and over again, but fail to recognise them?

It is very important not to dismiss corrections as merely a fact of life of investing, or even as a result of bubbles, but rather to isolate each and every case as per a medical practitioner would wont to do for a disease. That would be the first step towards designing a more stable mechanism for the preservation of wealth, and as wealth goes hand in hand with growth, this would also have an implication on the growth of the financial environment.

Looking at a bigger picture, it may be prudent to realise that quantitative easing may affect more than just the current price level or market, but also the flora, fauna and the ecosystem of investing. It may change the whole way that valuation is calculated, the construction of investment themes and goals, and ultimately, the all-important corporate behaviour.

And it is not only quantitative easing that we should be aware of. Every single artificial (or even natural) interference in the market can change the investing environment. Just like how Katrina changed the landscape of New Orleans, or the tsunami in Japan, we have to identify the ‘lowlands’ of our financial landscape. Identifying which parties such as banks and large financial corporations, or even hedge funds as having special status and requiring certain safeguards may be the first step, but it is obvious that a financial structure that has been built on historical themes may yet evolve into something more unstable.  This will depend on what we build into the structure today and how we operate in it.

From Martin Sandbu in the FT,

Central banks have been given a larger range of responsibilities than before, including the unexcitingly named task of “macro-prudential” policy. This is to regulate financial markets to guard against risks to the financial system as a whole (and as a result, to the economy). This challenge is distinct from the traditional one of fine-tuning the economic cycle. A much-debated question is whether the tools for managing the challenge should also be distinct, or whether interest-rate setting should be carried with a view to financial stability as well. One of the chief arguments for raising rates now is that their historically low level risks creating new bubbles. Ben Bernanke is among those arguing that the interest rate should not be used as a bubble-pricking tool.

Brad DeLong has engaged his colleague Barry Eichengreen in a highly readable online joust on this topic. DeLong makes the excellent argument that raising rates to prick a bubble presupposes that investors respond rationally — which the existence of a bubble rather puts in doubt. “It has always seemed to me that raising interest rates knocks down asset prices by knocking down their fundamental values. It thus affects a bubbly asset price only to the extent that the marginal investor has a good sense of fundamentals on top of which he or she layers a bubble premium. I suspect that model of the marginal investor in a bubble is rarely right.”

It is my fear that whilst we are still trying to grasp the historical and current effects of interest rates on bubbles, we should not ignore that every policy action now creates a new learning point for market participants that may exacerbate future bubbles (e.g. Greenspan put). Alternatively, we must be careful not to reduce our financial environment into one that, via maximising our gains and exploiting the system, we cause collective damage to the system that we all rely on. Policy makers too, with simple solutions and lack of foresight might inadvertently cause this as well.

From Barry Eichengreen,

Policymakers should respond to these challenges by working hard not only to develop effective macroprudential tools, but also to demonstrate that they can be deployed evenhandedly… the process will take time. In the meantime, situations may arise in which the interest rate is the only instrument available…

In addition, financial engineering currently relates to pricing and is centred on Markowitz and the random walk, but the future of financial engineering and the roles of financial engineers should be to come up with tools that help stabilise the markets. Financial tools constructed for beyond arbitraging purposes that provide anchors for valuations, perhaps preventing bubbles, or at least reducing the possible deleterious effects of one. Medicinal tools in the form of contracts, if you will.

More understanding is needed as to the feedbacks present in the system. Just like a system of rivers, or multi-connecting highways, what flows that can be traced should be meticulously chartered for within these flows, possible information and insights may be gleaned as to how we can avoid disasters.

This is not dissimilar to what earthquake scientists or weather analysts do to predict the next earthquakes or hurricanes. It will not be precise, far from it, but it can give us a better picture of how one factor relates to the other, what happens when one cycle acts in concert with another, the effects of agents responding individually and as a herd, and where the fragile points and bottlenecks may be situated. Had the ground engineers inspected and maintained the levees in New Orleans, perhaps the disastrous consequence of Katrina would have been mitigated, and indeed this is the consensus of many people there.

More studies on the coordination problems between financial agents within the system, inclusive of policy makers would not go amiss either.

Most important of all is the realisation that assuaging the financial gods with more capital and asking the central banking shamans to dance can no longer cut it. It is time we are more scientific about this.

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