Do Central Banks Have an Exit Strategy?

Do Central Banks Have an Exit Strategy?

By :Kennet Rogof

A year into the global financial crisis, several key central banks remain extraordinarily exposed to their countries’ shaky private financial sectors. So far, the strategy of maintaining banking systems on feeding tubes of taxpayer-guaranteed short-term credit has made sense. But eventually central banks must pull the plug. Otherwise they will end up in intensive care themselves as credit losses overwhelm their balance sheets.
The idea that the world’s largest economies are merely facing a short-term panic looks increasingly strained. Instead, it is becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning. Weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigor.
If this is the right diagnosis of the “financial crisis,” then efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Not allowing the necessary consolidation is weakening credit markets, not strengthening them.
The United States Federal Reserve, the European Central Bank, and the Bank of England are particularly exposed. Collectively, they have extended hundreds of billions of dollars in short-term loans to both traditional banks and complex, unregulated “investment banks.” Many other central banks are nervously watching the situation, well aware that they may soon find themselves in the same position as the global economy continues to soften and default rates on all manner of debt continue to rise.
If central banks are faced with a massive hit to their balance sheets, it will not necessarily be the end of the world. It has happened before – for example, during the 1990’s financial crises. But history suggests that fixing a central bank’s balance sheet is never pleasant. Faced with credit losses, a central bank can either dig its way out through inflation or await recapitalization by taxpayers. Both solutions are extremely traumatic.
Raging inflation causes all kinds of distortions and inefficiencies. (And don’t think central banks have ruled out the inflation tax. In fact, inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses.) Taxpayer bailouts, on the other hand, are seldom smooth and inevitably compromise central bank independence.
There is also a fairness issue. The financial sector has produced extraordinary profits, particularly in the Anglophone countries. And, while calculating the size of the financial sector is extremely difficult due to its opaqueness and complexity, official US statistics indicate that financial firms accounted for roughly one-third of American corporate profits in 2006. Multi-million dollar bonuses on Wall Street and in the City of London have become routine, and financial firms have dominated donor lists for all the major political candidates in the 2008 US presidential election.
Why, then, should ordinary taxpayers foot the bill to bail out the financial industry? Why not the auto and steel industries, or any of the other industries that have suffered downturns in recent years? This argument is all the more forceful if central banks turn to the “inflation tax,” which falls disproportionately on the poor, who have less means to protect themselves from price increases that undermine the value of their savings.
British economist Willem Buiter has bluntly accused central banks and treasury officials of “regulatory capture” by the financial sector, particularly in the US. This is a strong charge, especially given the huge uncertainties that central banks and treasury officials have been facing. But if officials fail to adjust as the crisis unfolds, then Buiter’s charge may seem less extreme.
So how do central banks dig their way out of this deep hole? The key is to sharpen the distinction between financial firms whose distress is truly panic driven (and therefore temporary), and problems that are more fundamental.
After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions’ key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit.
In principle, the financial industry can become smaller by having each institution contract proportionately, say, by 15%. But this is not the typical pattern in any industry. If sovereign wealth funds want to enter and keep capital-starved firms afloat in hopes of a big rebound, they should be allowed to do so. But they should realize that large foreign shareholders in financial firms may be far less effective than locals in coaxing central banks to extend massive, no-strings-attached credit lines.
It is time to take stock of the crisis and recognize that the financial industry is undergoing fundamental shifts, and is not simply the victim of speculative panic against housing loans. Certainly better regulation is part of the answer over the longer run, but it is no panacea. Today’s financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future.

The Failure of Inflation Targeting

The Failure of Inflation Targeting

By : Joseph E. Stiglitz

The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra.
The answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation , the best response is to increase interest rates. One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among the list of those who have officially adopted inflation targeting in one form or another are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway.)
Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is even higher and is expected to approach 18.2% this year, and in India it is 5.8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?
Inflation in these countries is, for the most part, imported . Raising interest rates won’t have much impact on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, not those in developing countries, should be raised.
So long as developing countries remain integrated into the global economy – and do not take measures to restrain the impact of international prices on domestic prices – domestic prices of rice and other grains are bound to rise markedly when international prices do. For many developing countries, high oil and food prices represent a triple threat: not only do importing countries have to pay more for grain, they have to pay more to bring it to their countries and still more to deliver it to consumers who may live a long distance from ports.
Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially non-traded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now – for example, 20% per year – and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.
So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign. Former US Federal Reserve Chairman Alan Greenspan, it is now recognized, deserves much blame for America’s current economic mess. He is also sometimes given credit for America’s low inflation during his tenure. But the truth is that America in the Greenspan years benefited from a period of declining commodity prices, and from deflation in China, which helped keep prices of manufactured goods in check.
Second, we must recognize that high prices can cause enormous stress, especially for lower-income individuals. Riots and protests in some developing countries are just the worst manifestation of this.
Advocates of trade liberalization touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance. Over a quarter-century ago, I showed that, under plausible conditions, trade liberalization could make everyone worse off. I was not arguing for protectionism, but rather sounding a cautionary note that we must be aware of the downside risks and be prepared to deal with them.
When it comes to agriculture, developed countries, such as the US and European Union members, insulate both consumers and farmers from these risks. But most developing countries do not have the institutional structures, or the resources, to do likewise. Many are imposing emergency measures like export taxes or bans, which help their own citizens, but at the expense of those elsewhere.
If we are to avoid an even stronger backlash against globalization, the West must respond quickly and strongly. Bio-fuel subsidies, which have encouraged the shift of land from producing food into energy, must be repealed. In addition, some of the billions spent to subsidize Western farmers should now be spent to help poorer developing countries meet their basic food and energy needs.
Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much impact on inflation; it will only make the task of surviving in these conditions more difficult.

The Dark Matter of Financial Globalization

The Dark Matter of Financial Globalization

By: Nouriel Roubini
Re-Publish : Zulfikar

The recent turmoil in global financial markets – and the liquidity and credit crunch that followed – raises two questions: how did defaulting sub-prime mortgages in the American states of California, Nevada, Arizona, and Florida lead to a worldwide crisis? And why did systemic risk increase rather than decrease in recent years?

Blame should go to the phenomenon of “securitization.” In the past, banks kept loans and mortgages on their books, retaining the credit risk. For example, during the housing bust in the United States in the late 1980’s, many banks that were mortgage lenders (the Savings & Loans Associations) went belly up, leading to a banking crisis, a credit crunch, and a recession in 1990-1991.

This systemic risk – a financial shock leading to severe economic contagion – was supposed to be reduced by securitization. Financial globalization meant that banks no longer held assets like mortgages on their books, but packaged them in asset-backed securities that were sold to investors in capital markets worldwide, thereby distributing risk more widely.
What went wrong?

The problem was not just sub-prime mortgages. The same reckless lending practices – no down-payments, no verification of borrowers’ incomes and assets, interest-rate-only mortgages, negative amortization, teaser rates – occurred in more than 50% of all US mortgages in 2005-2007. Because securitization meant that banks were not carrying the risk and earned fees for transactions, they no longer cared about the quality of their lending.

Indeed, a chain of financial intermediaries now earn fees without bearing the credit risk. As a result, mortgage brokers maximize their income by generating larger volumes of mortgages, as do the banks that package these loans into mortgage-backed securities (MBS’s). Investment banks then earn fees for re-packaging these securities in tranches of collateralized debt obligations, or CDO’s (and sometimes into CDO’s of CDO’s).

Moreover, credit rating agencies had serious conflicts of interest, because they received fees from the managers of these instruments. Regulators sat on their hands, as the US regulatory philosophy was free-market fundamentalism. Finally, the investors who bought MBS’s and CDO’s were greedy and believed the misleading ratings. Nor could they do otherwise, as it was nearly impossible to price these complex, exotic, and illiquid instruments.

Similar reckless lending practices prevailed in the leveraged buyout market, where private equity firms take over public companies and finance the deals with high debt ratios; the leveraged loan market, where banks provide financing to private equity firms; and the asset-backed commercial paper market, where banks use off-balance sheet schemes to borrow very short term.

Small wonder that when the sub-prime market blew up, these markets also froze. Because the size of the losses was unknown – sub-prime losses alone are estimated at between $50 billion and $200 billion, depending on the magnitude of the fall in home prices, which is also unknown – and no one knew who was holding what, no one trusted counterparties, leading to a severe liquidity crunch.

But the liquidity crunch was not the only problem; there was also a solvency problem. Indeed, in the US today, hundreds of thousands – possibly two million – households are bankrupt and thus will default on their mortgages. Around sixty sub-prime lenders have already gone bankrupt.
Many homebuilders are near bankrupt, as are some hedge funds and other highly leveraged institutions. Even in the US corporate sector, defaults will rise, owing to sharply higher corporate bond spreads. Easier monetary policy may boost liquidity, but it will not resolve the solvency crisis.

There are two reasons for this:
1. massive uncertainty about the size of the losses. In part, the size will depend on how much home prices fall -- 10%? 20%? Moreover, it is hard to price losses on exotic instruments that are illiquid (i.e. do not have a market price).

2. thanks to securitization, private equity, hedge funds, and over-the-counter trading, financial markets have become less transparent. This opacity means that no one knows who is holding what, which saps confidence. When the repricing of risk finally occurred in September, investors panicked causing a liquidity run and a credit strike.

So what is to be done? It will be hard to reverse financial liberalization, but its negative side effects – including greater systemic risk – require a series of reforms.
First, more information and transparency about complex assets and who is holding them are needed. Second, complex instruments should be traded on exchanges rather than on over-the-counter markets, and they should be standardized so that liquid secondary markets for them can arise.

Third, we need better supervision and regulation of the financial system, including regulation of opaque or highly leveraged financial institutions such as hedge funds and even sovereign wealth funds. Fourth, the role of rating agencies needs to be rethought, with more regulation and competition introduced. Finally, liquidity risk should be properly assessed in risk management models, and both banks and other financial institutions should better price and manage such risk; most financial crises are triggered by maturity mismatches.
These crucial issues should be put on the agenda of the G7 finance ministers to prevent a serious backlash against financial globalization and reduce the risk that financial turmoil will lead to severe economic damage.

The Fed vs. the Financiers

The Fed vs. the Financiers

By : Kenneth Rogoff

Republish : Zulfikar

In his August 31 address to the world’s most influential annual monetary policy conference in Jackson Hole, Wyoming, United States Federal Reserve Chairman Ben Bernanke coolly explained why the Fed is determined to resist pressure to stabilize swooning equity and housing prices. Bernanke’s principled position – echoed by European Central Bank head Jean Claude Trichet and Bank of England head Mervyn King – has set off a storm in markets, accustomed to the attentive pampering lavished on them by Bernanke’s predecessor, Alan Greenspan.
This is certainly high-stakes poker, with huge sums hanging in the balance in the $170 trillion global financial market. Investors, who viewed Greenspan as a warm security blanket, now lavish him with fat six-figure speaking fees. But who is right, Bernanke or Greenspan? Central bankers or markets?
A bit of intellectual history is helpful in putting today’s debate in context. Bernanke, who took over at the Fed in 2006, launched his policy career in 1999 with a brilliant paper presented to the same Jackson Hole conference. As an academic, Bernanke argued that central banks should be wary of second-guessing massive global securities markets. They should ignore fluctuations in equity and housing prices, unless there is clear and compelling evidence of dangerous feedback into output and inflation.
Greenspan listened patiently and quietly to Bernanke’s logic. But Greenspan’s memoirs, to be published later this month, will no doubt strongly defend his famous decisions to bail out financial markets with sharp interest rate cuts in 1987, 1998, and 2001, arguing that the world might have fallen apart otherwise.
On the surface, Bernanke’s view seems intellectually unassailable. Central bankers cannot explain equity or housing prices and their movements any better than investors can. And Bernanke knows as well as anyone that none of the vast academic literature suggests a large role for asset prices in setting monetary policy, except in the face of extraordinary shocks that influence output and inflation, such as the Great Depression of the 1930’s.
In short, no central banker can be the Oracle of Delphi. Indeed, many academic economists believe that central bankers could perfectly well be replaced with a computer programmed to implement a simple rule that adjusts interest rates mechanically in response to output and inflation.
But, while Bernanke’s view is theoretically rigorous, reality is not. One problem is that academic models assume that central banks actually know what output and inflation are in real time. In fact, central banks typically only have very fuzzy measures. Just a month ago, for example, the US statistical authorities significantly downgraded their estimate of national output for 2004!
The problem is worse in most other countries. Brazil, for example, uses visits to doctors to measure health-sector output, regardless of what happens to the patient. China’s statistical agency is still mired in communist input-output accounting.
Even inflation can be very hard to measure precisely. What can price stability possibly mean in an era when new goods and services are constantly being introduced, and at a faster rate than ever before? US statisticians have tried to “fix” the consumer price index to account for new products, but many experts believe that measured US inflation is still at least one percentage point too high, and the margin of error can be more volatile than conventional CPI inflation itself.
So, while monetary policy can in theory be automated, as computer programmers say, “garbage in, garbage out.” Stock and housing prices may be volatile, but the data are much cleaner and timelier than anything available for output and inflation. This is why central bankers must think about the information embedded in asset prices.
In fact, this summer’s asset price correction reinforced a view many of us already had that the US economy was slowing, led by sagging productivity and a deteriorating housing market. I foresee a series of interest rate cuts by the Fed, which should not be viewed as a concession to asset markets, but rather as recognition that the real economy needs help.
In a sense, a central bank’s relationship with asset markets is like that of a man who claims he is going to the ballet to make himself happy, not to make his wife happy. But then he sheepishly adds that if his wife is not happy, he cannot be happy. Perhaps Bernanke will soon come to feel the same way, now that his honeymoon as Fed chairman is over.

The Federal Reserve makes a bold cut in interest rates

The Federal Reserve makes a bold cut in interest rates

By : economist.com

Republish : Zulfikar, ST

IS THE Federal Reserve running scared of the financial markets—or the housing market? On Tuesday September 18th America’s central bank cut its target for the federal funds rate by half a point, to 4.75%, the first reduction for more than four years. Financial markets had thought a quarter-point cut a shade more likely, but prayed fervently for a half. Rejoicing, the S&P 500 jumped by nearly 3% after the Fed’s announcement and the Dow Jones index closed more than 300 points up.
Once the cheering stops, it may be worth reflecting on what the Fed’s action—and words—say about the state of the economy, especially the housing market. The “tightening of credit conditions”, said the Fed, “has the potential to intensify the housing correction and to restrain economic growth.” The Fed seems to be trying to act before things get worse: the cut, it said, “is intended to help forestall some of the adverse effects on the broader economy”.

This argument is close to that laid out by Frederic Mishkin, a Fed governor, at the Jackson Hole central bankers’ symposium a fortnight ago. If a central bank cuts rates swiftly, Mr Mishkin argued there, it can soften the effects of even a sharp drop in house prices—not least because falling house prices translate only slowly into lower spending. The arguments of Janet Yellen, head of the San Francisco Fed, also seem to have been persuasive, says Adam Posen of the Peterson Institute of International Economics in Washington, DC: “the San Francisco Fed is one of the only regional Feds to have independent full-scale forecasts”. She gave warning this week that “financial market turmoil seems likely to intensify the downturn in housing”.

The Fed will have been helped towards its half-point cut by benign data on both consumer and producer prices: the latter, released on the day of the Fed’s decision, showed a 1.4% fall in August. More bad news from the housing market, published the same day, will have added weight to the argument for a bigger cut. An index of homebuilders’ confidence fell to match the lowest level reached since its inception in 1991. And the rate of foreclosures has more than doubled in the past year.
To some, it will seem as if the Fed has caved in to Wall Street. The emphasis on the housing market may help to dispel that impression. So might the Fed’s insistence that “some inflation risks remain” and that it will “continue to monitor inflation developments carefully.” So too, notes Mr Posen, will recent data on inflation, housing and jobs. Even so, the Fed will have to keep choosing its words carefully in the months ahead.

FEAR OF FINANCE

FEAR Of Finance

By :J.Bradford D.Long

Re-publish : Zulfikar

Fear of finance is on the march. Distrust of highly paid people who work behind computer screens doing something that doesn’t look like productive work is everywhere. Paper shufflers are doing better than producers; speculators are doing better than managers; traders are doing better than entrepreneurs; arbitrageurs are doing better than accumulators; the clever are doing better than the solid; and behind all of it, the financial market is more powerful than the state.
Common opinion suggests that this state of affairs is unjust. As Franklin D. Roosevelt put it, we must cast down the “money changers” from their “high seats in the temple of our civilization.” We must “restore the ancient truths” that growing, making, managing, and inventing things should have higher status, more honor, and greater rewards than whatever it is that financiers do.
Of course, there is a lot to fear in modern global finance. Its scale is staggering: more than $4 trillion of mergers and acquisitions this year, with tradable and (theoretically) liquid financial assets reaching perhaps $160 trillion by the end of this year, all in a world where annual global GDP is perhaps $50 trillion.
The McKinsey Global Institute recently estimated that world financial assets today are more than three times world GDP – triple the ratio in 1980 (and up from only two-thirds of world GDP after World War II). And then there are the numbers that sound very large and are hard to interpret: $300 trillion in “derivative” securities; $3 trillion managed by 12,000 global “hedge funds”; $1.2 trillion a year in “private equity.”
But important things are created in our modern global financial system, both positive and negative. Consider the $4 trillion of mergers and acquisitions this year, as companies acquire and spin off branches and divisions in the hope of gaining synergies or market power or better management.
Owners who sell these assets will gain roughly $800 billion relative to the pre-merger value of their assets. The shareholders of the companies that buy will lose roughly $300 billion in market value, as markets interpret the acquisition as a signal that managers are exuberant and uncontrolled empire-builders rather than flinty-eyed trustees maximizing payouts to investors. This $300 billion is a tax that shareholders of growing companies think is worth paying (or perhaps cannot find a way to avoid paying) for energetic corporate executives.
Where does the net gain of roughly $500 billion in global market value come from? We don’t know. Some of it is a destructive transfer from consumers to shareholders as corporations gain more monopoly power, some of it is an improvement in efficiency from better management and more appropriately scaled operations, and some of it is overpayment by those who become irrationally exuberant when companies get their names in the news.
If each of these factors accounts for one-third of the net gain, several conclusions follow. First, once we look outside transfers within the financial sector, the total global effects of this chunk of finance is a gain of perhaps $340 billion in increased real shareholder value from higher expected future profits. A loss of $170 billion can be attributed to future real wages, for households will find themselves paying higher margins to companies with more market power. The net gain is thus $170 billion of added social value in 2007, which is 0.3% of world GDP, equal to the average product of seven million workers.
In one sense, we should be grateful for our hard-working M&A technicians, well-paid as they are: it is important that businesses with lousy managements or that operate inefficiently be under pressure from those who may do better, and can raise the money to attempt to do so. We cannot rely on shareholder democracy as our only system of corporate control.
The second conclusion is that the gross gains – fees, trading profits, and capital gains to the winners (perhaps $800 billion from this year’s M&A’s) – greatly exceed the perhaps $170 billion in net gains. Governments have a very important educational, admonitory, and regulatory role to play: people should know the risks and probabilities, for they may wind up among losers of the other $630 billion. So far there is little sign that they do.
Finally, finance has long had an interest in stable monopolies and oligopolies with high profit margins, while the public has an interest in competitive markets with low margins. The more skeptical you are of the ability of government-run antitrust policy to offset the monopoly power-increasing effects of M&A’s, the more you should seek other sources of countervailing power – which means progressive income taxation – to offset any upward leap in income inequality.
Eighteenth-century physiocrats believed that only the farmer was productive, and that everyone else was somehow cheating the farmers out of their fair share. Twentieth-century Marxists thought the same thing about factory workers.
Both were wrong. Let us regulate our financial markets so that outsiders who invest are not sheared. But let us not make the mistake of fearing finance too much.

Stock Markets’ Fear of Falling

STOCK MARKET'S FEAR Of FALLING

By : Robert J.Shiller

Re-Publish : Zulfikar

NEW HAVEN -- The sharp drop in the world’s stock markets on August 9, after BNP Paribas announced that it would freeze three of its funds, is just one more example of the markets’ recent downward instability or asymmetry. That is, the markets have been more vulnerable to sudden large drops than they have been to sudden large increases. Daily stock price changes for the 100-business-day period ending August 3 were unusually negatively skewed in Argentina, Australia, Brazil, Canada, China, France, Germany, India, Japan, Korea, Mexico, the United States and the United Kingdom.
In the US, for example, the Standard and Poor’s 500 index in July recorded six days of declines and only three days of increases amounting to more than 1%. In June, the index dropped more than 1% on four days, and gained more than 1% on two days. Going back further, there was a gigantic one-day drop on February 27, 2007, of 3.5%, and no sharp rebound.
The February 27 decline began with an 8.8% one-day drop in the Shanghai Composite, following news that the Chinese government might tax capital gains more aggressively. This news should have been relevant only to China, but the drop there fueled declines worldwide. For example, the Bovespa in Brazil fell 6.6% on February 27, and the BSE 30 in India fell 4% the next day. The subsequent recovery was slow and incremental.
In the US, the skew has been so negative only three other times since 1960: at the time of the 6.7% drop on May 28, 1962, the record-shattering 20.5% plummet on October 19, 1987, and the 6.1% decline on October 13, 1989.
Stock markets’ unusually negative skew is not inconsistent with booming price growth in recent years. The markets have broken all-time records, come close to doing so, or at least done very well since 2003 ( the case in Japan) by making up for the big drops incrementally, in a succession of smaller increases.
Nor is the negative skew inconsistent with the fact that world stock markets have been relatively quiet for most of this year. With the conspicuous exception of China and the less conspicuous exception of Australia, all have had low standard deviations of daily returns for the 100-business-day period ending August 3 when compared with the norm for the country.
The February 27 drop in US stock prices was only the 31st biggest one-day drop since 1950. But all of the other 30 drops occurred at times when stock prices were much more volatile. Thus, the February 27th drop really stands out, as do other recent one-day drops.
Indeed, one of the big puzzles of the US stock market recently has been low price volatility since around 2004, amid the most volatile earnings growth ever seen. Five-year real earnings growth on the S&P 500 set an all-time record in the period ending in the first quarter of 2007, at 192%. Before that, between the third quarter of 2000 and the first quarter of 2002, real S&P 500 earnings fell 55% – the biggest-ever decline since the index was created in 1957.
One would think that market prices should be volatile as investors try to absorb what this earnings volatility means. But we have learned time and again that stock markets are driven more by psychology than by reasoning about fundamentals.
Is psychology somehow behind the pervasive negative skew in recent months? Maybe we should ask why the skew is so negative. Should we regard it as just chance, or, when combined with record-high prices, as a symptom of some instability?
The adage in the bull market of the 1920’s was “one step down, two steps up, again and again.” The updated adage for the recent bull market is “one big step down, then three little steps up, again and again,” so far at least. No one is looking for a sudden surge, and volatility is reduced by the absence of sharp up-movements.
But big negative returns have an unfortunate psychological impact on markets. People still talk about October 28, 1929, or October 19, 1987. Big drops get their attention, and this primes some people to be attentive for them in the future, and to be ready to sell if another one comes.
In fact, willingness to support the market after a sudden drop may be declining. The “buy-on-dips stock market confidence index” that we compile at the Yale School of Management has been falling gradually since 2001, and has fallen especially far lately. The index is the share of people who answered “increase” to the question, “If the Dow dropped 3% tomorrow, I would guess that the day after tomorrow the Dow would: Increase? Decrease? Stay the Same?” In 2001, 72% of institutional investors and 74% of individual investors chose “increase.” By May 2007, only 48% of institutional investors and 59% of individual investors chose “increase.”
Perhaps the buy-on-dips confidence index has slipped lately because of negative news concerning credit markets, notably the US sub-prime mortgage market, which has increased anxiety about the fundamental soundness of the economy.
But something more may be at work. Everyone knows that markets have been booming, and everyone knows that other people know that a correction is always a possibility. So there may be an underlying sensitivity to price drops, which could fuel a succession of downward price changes, amplifying public concerns about problems in the economy and heralding a profound change in investor sentiment