Friday, May 11, 2012

A Challenge to Economists

Here is my challenge:

Give us tools that we can use to measure the correlation between prices for assets traded in the Capital Markets and the value creation activities associated with those assets in the commercial markets, so that we can build a consensus around when the bubbling in the Capital Markets is getting out of hand that will support mobilization of the political will required to intervene to back things down before people get hurt.

Bubbles are an essential feature of the Capital Markets. For the most part, they are benign.  To some extent, they are desirable.  As long as the bubbles "stay inside the glass", so to speak, it is not really a matter for much concern.  When, however, the bubbling gets too energetic, the overflow makes a mess that can be quite expensive to clean up.

Economics has already given us the tools we need to intervene if we must.  What is still lacking are the tools we need to mobilize the political will to take action when we should.

Since the last explosion of excessive effervescence, in 2008, many organizations have formed in opposition to ever letting this happen again. One such organization is the Institute for New Economic Thinking (INET). INET was founded with support from George Soros and others to stimulate thinking among Economists about the challenges facing us in the 21st Century.  Among other things, INET has provided a grant to Moritz Schularick, an Economist working at the Free University of Berlin, in Germany, to fund research into the cause of credit bubbles that Moritz contends drive the recurring cycle of booms-that-go-bust in our economy today.

One of the insights that I believe Moritz will be exploring is the relationship between where credit is extended within the economy and the formation of credit bubbles.

This feels like a good step in the right direction.  I consider myself, in the language of INET, a "non-credentialed economic thinker[] using the methods of other disciplines".  I approach this problem as a practitioner in the business of attracting investment into enterprise through alignment of interests along multiple points of value creation.  By focusing my efforts on value creation, as opposed to more industry-standard architectures for driving Investment through asset trading, I have come to see how the proper flow of money through our economy perpetuates our prosperity, but also to see that this flow must be regulated in order to remain proper.  Left to its own devices, the money flow gravitates to one of two extremes: not enough liquidity; or too much.

Consider the infographic, below.  It shows the money flow starting with earning and moving through spending to saving to investing, then back again, to keep the right flows flowing.  

  • When investing flows back in to support earning, that gives us sustainable prosperity.
  • When investing flows back to stimulate spending, that can also contribute to sustainability, but only to a point.  Stimulating spending that accurately anticipates future earning is a proven, successful way to stimulate trading in the commercial markets.  This can help get the cash flow flowing, if it should stall, for example, after a bubble has burst.  Care must be taken, however to keep the investment-based spending properly aligned with future earnings.  As experience teaches, and I expect Moritz's work will confirm, when investing is made to stimulate spending that is not balanced properly against earning, what we get is a credit bubble: an unsustainable rate of spending that creates a false prosperity and leads, eventually, to painful dislocations.
  • When investing flows back into saving, sustainability get short-sheeted.  This kind of investing turns Savings into Asset Prices.  Asset prices are, both in theory and in normal practice, an attempt to reduce an expected flow of future cash streams to a single price point, in the moment.  Every asset price starts out as essentially a discounted cash flow.  The price is always, at best, a guess, and this for at least two reasons.  One, nobody really knows what the cash flows will be.  The future, after all, has not yet happened, and things do change.  Two, reasonable minds can disagree on what the discount rate should be.  This is what creates volatility on the Exchange, as different people form different views on both future earnings and proper discounts.  So far, so good.  Volatility is not instability, and it has the decided advantage of providing liquidity that can help keep the cash flows flowing.  The problem arises when the game of "pump-and-dump" begins.  Earnings expectations are hyped (that is, inflated through hyperbole) to increase prices, so assets can be sold at a profit, and cash flows can be realized (essentially reversing the process that turned cash held as Savings into Assets priced for trading in the first place: do you see the circularity working here?).  Rising prices become a self-fulfilling prophecy.  All asset pricing is essentially speculative, but now the focus of speculation shifts from expectations for future earnings in the commercial markets to expectations for further price increases in the Capital Markets.  As price speculation drives further price increases, asset prices in the Capital Markets become increasingly de-coupled from value creation in the commercial markets.  Now we have not just volatility, but instability.  Sooner or later the earnings will come in at levels below what is required to support the prices being paid, and a "correction" will occur.  This level of instability is bad enough, but it gets worse when artifices are constructed to make prices look more stable than they really are, such that discount rates start getting lowered to justify a further round of unsustainable price increases.  Now, the stage is set for a real economic catastrophe, because the actuarial risk pooling strategies that are designed to provide a certain margin for error in pricing assets by Market participants are no longer properly matched to the possibility for error inherent in the prices being paid for the assets being traded.  When that bubble bursts, the losses overwhelm the portfolio.  When these are the personal portfolios of private persons participating in the Markets with their own money, that hurts.  When they are the quasi-public portfolios of financial institutions participating in the Markets with Other People's Money (i.e. our money), it can be a catastrophe.
In hindsight (and in the abstract), it is easy to see that this is what happens.  The hard thing, that still eludes us, is being able to see in the moment what is developing, as it develops, with sufficient certainty and clarity that we can mobilize the political will it takes to support the intervention that we need to deflate the effervescence. 

That is the most important challenge I see for Economics in the 21st Century: giving us a reliable system of early warning when the bubbling in the Markets is becoming too highly energized, sufficient to allow us to mobilize the political will to step in and re-balance, before something breaks.

Maybe Moritz will show us the way.

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