Brian Romanchuk — The Financial Instruments Associated With Crises

This article is a continuation of previous comments on financial crises, with two lines of discussion. The first is a bit of a primer, explaining why I and other commentators associate financial crises with a buildup of private debt. The second part discusses the main problem with associating crises with private debt buildups: growth in debt stocks is by itself not enough to trigger a crisis. The catch is a variant of the efficient markets hypothesis: if we could easily forecast crises, it would be easy to outperform markets. However, other market participants are trying to do the same thing.…

Private sector financial crises are associated with private debt buildup. Unfortunately, we cannot expect simple rules based on debt growth to be able to accurately predict such crises.

Bond Economics
The Financial Instruments Associated With Crises
Brian Romanchuk

Chris Dillow — Progress in economics

Financial economics. e.g., EMH and CAPM.

Stumbling and Mumbling
Progress in economics
Chris Dillow | Investors Chronicle

James S. White — Abundance And The Inevitability Of Deflation, Bubbles And Panics

My last post was designed to offer historical precedent for the rise of China. It might have achieved that. But it raises more important questions. The most important is: how do financial systems cope with a world of deflation (created by both China and technology)?

The solution has resulted in a bi-polar personality for financial markets: capital destruction and capital accumulation all in the context of low interest rates. Indeed, deflation and its consequences is the key lesson global financial markets must adapt to. This offers substantial challenges.

An Abundant World
Abundance And The Inevitability Of Deflation, Bubbles And Panics
James S. White
(h/t Andy Blatchford via FB)

Michael Pettis — The unacceptable behavior of the market

To start off, in mid-June, just a couple of days before the Spanish treasury raised €2.2 billion in an auction – one in which the cost of borrowing surged, with 10-year bonds breaking 7% – France’s new president complained about the unfairness of the financial markets. According to an article two weeks ago the Financial Times,

“It’s not acceptable that Spain, which just got a promise for support, has interest rates around 7 per cent,” Mr Hollande said. “It’s not acceptable that countries that are making efforts, like Italy, to improve their public finances,” were paying high interest rates on their bonds.

It would be useful if policymakers (and not just in France) had an understanding of how markets actually work. Hollande is effectively complaining that markets are reacting not to what policymakers propose they will do but rather to something else, and he believes that this is unfair, even unacceptable.
But clearly it isn’t. Since that “something else” to which the market is responding is the underlying process of balance sheet unraveling, and this is happening no matter what policymakers might say in the G20 meetings or elsewhere, it actually makes a lot of sense that markets overall continue to deteriorate.

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I am not sure what O’Neill means by Europe’s behaving like a “true union”, but if he means Europe’s immediately becoming the United States of Europe overnight, which is certainly not a mind-bogglingly simple policy to implement, then the euro part of the euro crisis will certainly end. What won’t end, however, is the need to write down a staggeringly large amount of bad loans and to cover the banking losses with transfers from the housing sector, nor the rapid slowdown in growth even in countries like Germany....

At this point the only thing that can save the euro is a combination of moves in which the European banks are guaranteed by a credible institution and in which Germany takes steps to stimulate its economy quickly and dramatically. Until Germany is willing to boost domestic spending enough to run a deficit that allows Spain to run a surplus, it is impossible for Spain to repay its debt. This is just basic balance-of-payments arithmetic.

Read it at China Financial Markets
The unacceptable behavior of the market
by Michael Pettis

The post goes on to discuss China and Minsky on balance sheets.

Jeremy Grantham explains how asset management really works through herding

The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend as shown in Exhibit 1. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines! This incredible demonstration of the behavioral dominating the rational and the “efficient” was first noticed by Robert Shiller over 20 years ago and was countered by some of the most tortured logic that the rational expectations crowd could offer, which is a very high hurdle indeed.

Read the rest at GMO Quarterly New Letter
My Sister’s Pension Assets and Agency Problems 
(The Tension between Protecting Your Job or Your Clients’ Money)
by Jeremy Grantham

Grantham explains why managers and traders are much more interested in price momentum and relative strength than underlying fundamentals.

Roger Altman on how financial markets are now "the most powerful force on earth"

The succession of political dramas in Europe, most recently the end of Socialist dominance in Spain, again shows the financial markets acting like a global supra-government. They oust entrenched regimes where normal political processes could not do so. They force austerity, banking bail-outs and other major policy changes. Their influence dwarfs multilateral institutions such as the International Monetary Fund. Indeed, leaving aside unusable nuclear weapons, they have become the most powerful force on earth.

The power of financial markets, however, is a double-edged sword. When that power is flexed, the immediate impact on society can be painful – wider unemployment, for example, frequently results and governments fall. Yet history suggests the longer-term effects can be often transformative and positive. For all the recent hand-wringing over the role of the markets, this could yet be the case in Europe, too.

Read the rest at The Financial Times

We need not fret over omnipotent markets

By Roger Altman

Meet your new (faceless) masters.

BTW, someone please remind Mr. Altman that nothing is permanent.

Also, no clue that the monetary authority of a currency sovereign has control of the yield curve if it chooses to use it, and the fiscal authority as the power to maintain sectoral fiscal balance at full employment through functional finance. See Bill Mitchell, Who is in charge?