Nothing to fear but...

Yesterday's big stock market falls pose the question: do we really have anything to worry about?

It's tempting to answer: no. The claim that stock markets have predicted nine of the last five recessions is a cliche because it is true - although why (pdf) this is is a matter of doubt. And we know from the very mild repercussions of the tech crash of the early 00s that exogenous falls in share prices don't have catastrophically negative wealth effects.

Nevertheless, I suspect there are four concerns here.

First, the fact that the Chinese economy is slowing down (pdf) is a symptom that world trade generally is stagnating; although today's figures from the CPB showed a good increase in this in June, the volume of world imports is still lower than it was last autumn. This means that a major force for the world's enrichment - an increased global division of labour - is now absent. Unsurprisingly, there's a close correlation between annual growth in world trade and annual returns on UK shares.

Secondly, we don't know how much further the world economy might weaken. Granted, the stock market is a lousy predictor of recessions. But so too is pretty much everything else (except perhaps the yield curve). Back in 2000, the IMF's Prakash Loungani wrote (pdf) that mainstream forecasters' "record of failure to predict recessions is virtually unblemished": the recession of 2008-09 merely corroborated this. Maybe recessions are inherently unpredictable because they arise from unknowable network effects.

Thirdly, a highly indebted (pdf) world increases the danger of a financial crisis. Someone, somewhere has leveraged exposure to commodities and commodity producers. If that someone is highly interconnected with other funds, there's a danger that their collapse will trigger others, via heightened counterparty or fire sale risk. The question is: will the collapse be like that of LTCM, which had big spillovers or like that of Amaranth, which didn't? (I stress that what matters is not so much the level of total debt as the distribution thereof .)     

Fourthly, there's less chance than before that macroeconomic policy could stabilize economies in the event of recession or financial crisis. Conventional QE is less effective when bond yields are low. And governments' commitment to austerity makes it less likely that we'd get timely countercyclical fiscal policy.

Now, I don't say all this to offer reasons to expect shares to fall further. It's also a cliche because it's true that bull markets climb a wall of worry. If you want comfort, the fact that yield curves are upward-sloping points to us avoiding recession. Personally, I think most efforts to time the market beyond obeying the "sell in May, buy on Halloween" rule are mistaken.

Instead, my point is a simple one that's been made before. It's that stock markets' falls remind us that high leverage, financial interconnectedness and the zero bound all combine to make us vulnerable to recession or crisis.

Comments

[Luis Enrique]

mainstream forecasters. pah!

http://www.taxresearch.org.uk/Blog/2015/08/24/sometimes-things-happen-sooner-than-you-expect/

[Luis Enrique]

also: in 2007 banks at least had the excuse that 20 years of apparent stability had bred complacency. If the financial system has already managed to get itself into a position where it will be knocked over by the bursting a rather obvious bubble in Chinese equities, and some sharp falls in Western markets, then they really are idiots.

[Keith]

Unfortunately for Luis and the rest of us banks and capitalists in general have no incentive to be wise and prudent as the state dances to their tune and keeps bailing them out when they screw up.

The politicians are busy attacking the disabled and migrants while padding their expenses and flipping their houses.

[An Alien Visitor]

"in 2007 banks at least had the excuse that 20 years of apparent stability had bred complacency."

We really should ask the question how such 'high achievers' and 'captains of the economy' couldn't spot that bubbles they were creating. And how they believed the graph always points upwards. This shows a staggering level of idiocy from 'the best among us'. It isn't like this was the first such crash now is it!

I suspect the reality was more like this - those bastards were greedy and were concerned with short term gain and to hell with the medium to long term affects. As long as they had made their dosh they were prepared to risk the wealth of the rest of us.

The main reason they have carried on regardless has less to do with their idiocy and more to do with the fact that they got away with it (as Keith says above). Instead the people who paid the price of their reckless behaviour and ultimately took the biggest risk were the sick and disabled.

[Luis Enrique]

AAV - what's come over you, no personal abuse?

I pretty much agree - so long as the profits kept rolling in, bankers were happy not to think too hard about what they were doing. And I think what they missed was not so much a bubble, but how the system had managed to tie itself up in knots so that the bubble bursting would destroy the lot. Remember in many cases they probably thought the risks they were running were hedged / insured against (with AIG).

Keith is wrong, another bust would cost bankers jobs and bonuses (like the last one did) not to mention ignominy, fines, bank levy etc. and whilst the promise of bailouts mitigate some of that, they still have reason enough to want to avoid another crisis. It doesn't make sense to say profit motivated people do not care about losses.

Hopefully, this time around they are in a position to tolerate losses without knocking each other over like dominoes.

[An Alien Visitor]

I refuse to allow your sycophancy to wind me up.

What annoys me is that you are clearly clued up but then for example say you knew nothing of the financial deregulation debates. Which I can't believe anyone with your level of knowledge would be unaware of. So I have to put it down to apologism.

But maybe you are very young and they just don't teach that stuff!

I disagree with your view that bankers want to avoid another crisis because they fear for their jobs and bonuses, just look at their bonuses since 2008! It is as if they enjoy winding up the plebs! I used to work among these sociopaths, they have no concept of right and wrong believe me.

[Bob]

Luis, cut the right wing crap and read some of Bill Black's work.

[Bob]

"Keith is wrong, another bust would cost bankers jobs and bonuses (like the last one did) not to mention ignominy, fines, bank levy etc. and whilst the promise of bailouts mitigate some of that, they still have reason enough to want to avoid another crisis. It doesn't make sense to say profit motivated people do not care about losses."
Haha. You have got to be kidding. Here it is - the recipe. Read it several times. From an expert.
The “Recipe’s” Four “Ingredients” for a Lender (or Loan Purchaser)

1.Grow like crazy
2. By making (buying) vast amounts of toxic loans at a premium nominal yield
3. While employing extreme leverage, and
4. Providing only grotesquely inadequate loss reserves (Allowance for Loan and Lease Losses – ALLL)
The Recipe Produces Three “Sure Things”

1.The firm will promptly report record profits
2.The firm’s executives will promptly be made wealthy by executive compensation
3.The firm will suffer catastrophic losses
Malady #2: The Evisceration of Effective Underwriting

In order to make massive amounts of bad loans the worst bankers have to gut the bank underwriting rules and suborn the supposed “controls.” We have known for centuries that this will produce “adverse selection” and cause the loans to have a “negative expected value” at the time they are made. (In plain English, this means that the bank will lose money. The banker maximizes his income by causing the bank to make terrible loans.

Malady #3: The “Gresham’s” Dynamic

George Akerlof used the metaphor to Gresham’s law in his 1970 article on markets for “lemons,” a variety of “control fraud” in which the seller uses his asymmetrical information advantage as to the quality of the goods or services being sold to deceive the buyer. Akerlof was made a Nobel Laureate in Economics in 2001, with the award citing particularly his article on “lemons” (a U.S. term for a car with severe defects).

[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence (Akerlof 1970).

Akerlof’s key observation was that market forces became perverse when dishonest officers use the firm’s seemingly legitimacy to defraud the firm’s customers and gain a competitive advantage over honest rival firms.

[Matt M]

Interesting thought Bob. Goes back to the agent-principal problem of bankers using banks as giant pinatas and whacking them until money falls out. Perhaps the board should share blame for not aligning incentives appropriately (laugh along with me).

As regards the stockmarket, interesting that nobody is predicting to many adverse effects on AD through lower wealth effects but people were banging on about how a higher stock market would mean more jobs for Lola the maid and Jeeves the butler. The stockmarket is a rubbish predictive variable because it proxies demand from the upper class, not the bulk of consumers. For sure, yacht sales will be hit, but low fat digestives in Sainsbury arent going to see a massive tumble. The stock market is almost an irrelavent indicator of the health of the general economy.

Looking at sales of digestives is probably more of a leading indicator.

[Luis Enrique]

well yes Bob, also see the picking up nickels from in front of a steamroller strategy. Except how long does it take for the wheels to fall off, and how often are shareholders going to stump up money for these crooks to lose once it is apparent that's what they are doing? This has been going on for centuries? more realistic to think that some banks, or some parts of some banks, look like that (in less dramatic form) and investors have difficulty ascertaining which, which explains why banks promise such large returns on equity - excellent column by Martin Wolf on that
http://blogs.ft.com/martin-wolf-exchange/2011/09/25/what-do-the-banks%E2%80%99-target-returns-on-equity-tell-us/#axzz1ZFK0bNXs

(although that does not say the high risks that banks take arise from this deliberate seeking of bad loans. you can take too much risk buying gilts)

[Bob]

That's what has happened. You can try and deny it just like you deny MMT but it is the truth. And it caused a financial crisis in 2008, which became a completely avoidable recession because the government refused to respond with large enough stinulus.
It's I be gone you be gone.
"also see the picking up nickels from in front of a steamroller strategy."
These people are made incredibly wealthy by modern executive compensation. They also have a lot of power. Paulson, CEO of Goldman Sachs was US treasury secretary 2006-2009. The Obama treasury secretaries have links to the banking industry.

[Bob]

Stimulus I mean.
Luis, look up "Bill Black bank regulator" and "New Economic Perspectives." Read the articles by Bill Black by clicking on his name.
Click. Read. Digest.

[Bob]

William K Black is a top bank regulator during the same savings and loans crisis in the US 80s and early 90s. He is a criminologist and expert on this matters.
Read:
http://neweconomicperspectives.org/category/william-k-black
Also use this as your search engine ;)
https://duckduckgo.com/

[Bob]

http://www.amazon.com/gp/aw/d/0292721390/ref=mp_s_a_1_1?qid=1440534948&sr=1-1&pi=AC_SX110_SY165_QL70
Here is his book on the savings and loan debacle.
The blog I posted above is his.

[Ralph Musgrave]

Re Chris’s claim in his last sentence that the zero bound is part responsible, there are actually good arguments for a permanent zero rate. Milton Friedman proposed that, as does Warren Mosler.

[Bob]

RM, agreed. It's not even clear higher interest rates are contractionary. Just set rates at zero and use fiscal policy. In Zimbabwe interest rates were at 300% IIRC but they owed debt in foreign currency.

[ThomasH]

The fundamental uncertainty is, have monetary authorities learned anything from 2008-15? If they have (not overwhelmingly apparent from actual policy 2008-15) then we have nothing to worry about. They simply do enough QE, lower interest rates on reserves, buy non-government financial assets, etc. to keep NGDP from falling farther below its pre-crisis trend. MY guess is that BoC has, the Fed (reluctant;y) has and the ECB has not.

[Bob]

"They simply do enough QE, lower interest rates on reserves,"
This will lower interest income going into the economy.
It won't boost lending as loans create deposits.
If it does there will be another credit bubble.
"buy non-government financial assets,"
This is fiscal policy by another name.
Great if you have financial assets (you are rich.) The rest of us would prefer something other than constant asset price bubbles ;)

Here is an idea - instead of calling for better unelected Solomons in the Court of the Bank of England set interest rates to zero and just use fiscal policy.

[greg]

"Maybe recessions are inherently unpredictable because they arise from unknowable network effects."

Ha Ha Ha! Maybe economists can't predict recessions because there is something deeply wrong with economic theory.

Rather than say "The world's economy 'cannot' be understood!" maybe economists should say: "The world's economy cannot be understood, based on our current defective theory!"

One place to start: http://www.nakedcapitalism.com/2015/06/the-standard-definition-of-money-is-in-error.html

[ChrisA]

Recessions are not due to "network effects" they are usually the result of excessive monetary tightening. Lets take the list in the UK since 1979 - the early 1980's was Howe's attempt to kill inflation in the UK, early 1990's the disastrous attempt to shadow the DM, 2008 was due to various monetary policy errors by Fed/BoE/ECB (the ECB actually raised rates for goodness sake). Predicting recessions like this is hard, because you would have to predict somehow the thinking process of a policy maker.

The Chinese stock market crash will be contained if policy makers don't screw up and proceed to keep NGDP growth on track. It won't be if they decide, for whatever reason, that they need to raise interest rates for "normalisation" reasons and slow NGDP growth. But can anyone reasonably predict how the combined ECB/FED/BOE will react? This is why we need a rule based system for controlling NGDP growth.

[Bob]

No. Just leave interest rates at zero and use fiscal policy! And have very strong automatic stabilisers.
We know how to deal with recessions - more govt spending. All this "we can't do anything" is BS. Maybe we can't predict the start of recessions but once in one turn on the spending taps fast.