April 7th, 2014 | By Nick SargenRemarks delivered at the Palm Beach Strategic Forum, April 7, 2014.
Mr. Chairman, thank you for the opportunity to address this session on evolving global risks and asset bubbles. My perspective is that of a Chief Investment Officer for a U.S. financial institution. This topic has become of paramount importance in the wake of the 2008-09 Global Financial Crisis and ensuing test of the euro-zone. However, it should be recognized at the outset, this was not an isolated event; there have been a series of global crises over the past 25 years that have affected policymakers and investors alike.
In my remarks, I will first examine the factors that have given rise to asset bubbles and why financial crises have become more prevalent in the past three decades. I will then consider what policies are being created to lessen the risks of financial crises and what investors can do to be protected.
There are two basic approaches to this question in the literature. One approach is non-economic, and views asset bubbles as being caused by irrational exuberance, while the alternative approach links bubbles to economic factors such as excessive credit creation and unstable international capital flows:
Irrational Exuberance. This view is commonly associated with Robert Shiller of Yale University. Shiller recently won a Nobel Prize for his work on asset bubbles, in which he forecast the bubble in technology stocks in the late 1990s and in home prices in the mid-2000s. The methodology he deployed involved looking at deviations from long-term price trends for technology stocks and for homes, both of which were unusually large. His explanation for bubbles is rooted in human behavior and psychology: "A bubble is a social epidemic where there's feedback from price increase to further price increases. The price increases attract investor attention, and then that's spread by word of mouth and draws more people in." (Asset Management, February 27, 2014.) The behavioral view challenges a key tenet of mainstream economics, which assumes people behave rationally at all times.
Excessive Credit. An alternative view links asset bubbles with rapid buildup in debt and easy conditions in credit markets. This view has been associated with the Austrian school of thought, and a leading proponent is William White, former Chief Economist for the Bank of International Settlements. In the early part of the last decade White argued that central banks had done well at reining in inflation, but he urged central bankers to devote more attention to insure financial stability. At the Kansas City Fed's annual meeting in Jackson Hole in 2003, for example, he recommended central banks "raise interest rates when credit expands too fast and force banks to build up cash cushions in fat times to use in lean years." Needless to say, his advice was not heeded by then Fed Chairman Alan Greenspan. Subsequently, as the debt buildup became more extreme, White warned that the global financial system was in peril.
Volatile Capital Flows. This approach focuses on the international dimension of asset bubbles. A leading advocate of this view is Robert Z. Aliber, formerly with the University of Chicago Booth School of Business and a co-author of Charles Kindleberger's classic book Manias, Panics, and Crashes. In a forthcoming book, Aliber contends that the main source of financial crises globally is that cross border capital flows are highly variable (and unstable): "the flows increase and then they accelerate, and the indebtedness of the borrowers is increasing at rates too high to be sustained. At some stage, the lenders realize that borrowers are excessively indebted or their indebtedness is increasing too rapidly; the slowdown in the borrower's ability to source new loans is the trigger for the crisis." While financial crises have occurred when currencies have been pegged or floating, Aliber observed they are more frequent when currencies float, because capital inflows typically drive up security prices as the currency appreciates.
While these approaches provide insights into the formation of asset bubbles, the behavioral view does not seek to explain their increased frequency, whereas the alternative views offer economic explanations. This is important because asset bubbles and financial crises have become increasingly common in the past three decades: Think of the bursting of Japan's bubble in the early 1990s, the so-called "tequila" crisis of the mid-1990s in Mexico and South America, the Asian financial crisis of the late 1990s, and the technology bubble as precursors to the grand daddy of them all.
What is interesting about these experiences is they occurred during a period of economic strength and low inflation – what Fed Chairman Ben Bernanke called "The Great Moderation." As William White argues, central bankers viewed their overriding mission as restoring the low inflation environment that prevailed during the Bretton Woods era. However, the context for setting monetary policies changed radically beginning in the second half of the 1970s, as financial deregulation and liberalization was accompanied by increasing capital market integration around the world. These changes included the repeal of Reg Q interest rate ceilings on bank deposits and the dismantling of the Glass-Steagall Act in the United States; the liberalization of foreign exchange controls in Japan, Europe and the emerging economies, as well as the creation of the euro-zone.
One result of the liberalization process was an increase in competitive pressures in the financial services industry and greater access to offshore funding. In addition, liberalization was accompanied by a transformation in information technology that gave rise to securitization and a broad spectrum of tradable instruments including futures, options, and OTC derivatives including credit derivatives.
There were also noteworthy changes in the financial system that contributed to increased risk taking. In the United States, for example, the transition of investment banks from partnerships to publicly owned entities was accompanied by increased financial leverage and compensation packages that rewarded executives for higher stock prices. Also, the securitization process was extended to cover sub-prime mortgages, and originators of mortgages were able to off load what they had underwritten.
The end result was that the U.S. and European financial systems became highly leveraged and inter-connected. The institutions that were at the epicenter of the financial crisis had several common characteristics including: (i) a high percentage of "toxic assets;" (ii) leverage of 30-40 times equity capital for investment banks and significant off-balance sheet exposures for some of the biggest commercial banks; and (iii) significant mismatches in the duration of their assets and liabilities that left them vulnerable.
This issue is the most contentious. Prior to the 2008 Financial Crisis, the prevailing view in the economics profession was that asset bubbles were difficult, if not impossible to predict, and advocates of Efficient Markets challenged the very concept of a bubble. For his part, Fed Chairman Alan Greenspan maintained that policymakers should not attempt to burst an asset bubble, but should be prepared to mop them up by providing ample liquidity to the financial system. This approach became known as the "Greenspan put."
In the wake of the fallout from the Financial Crisis, there have been some important changes on the regulatory front. Fed and Treasury officials now pay greater attention to regulatory oversight of individual institutions and to macro-prudential issues that affect the stability of the financial system as a whole. These efforts are certainly welcome developments and are long past due.
On the legislative front, the passage of the Dodd-Frank Act is the most comprehensive overhaul of the U.S. regulatory structure since Glass-Steagall. Many of the goals seem laudatory:
The main problem with Dodd-Frank, however, is its complexity: The Act contains 849 pages of legislation and several thousand pages in subsequent rule making documentation. While the primary objective is to lessen the chances of another financial crisis, many question whether it will succeed. The banking industry, for example, has become even more concentrated, with the top five U.S. banks today accounting for nearly one half of all deposits compared to 30% ten years ago. At the same time, Dodd-Frank imposes significant new restrictions on the activities of many banks, insurance companies, and other financial institutions that had little to do with the Financial Crisis. Consequently, some fear it could result in regulatory overload.
From my perspective, a more targeted approach, such as the Basel III proposal to increase minimum requirements for bank capital and liquidity is preferable. The reason is that excess leverage in the financial system was a key factor contributing to the severity of the Crisis. Addressing this issue, therefore, is central to restoring the safety and soundness of the international financial system.
Turning to monetary policy, it is difficult to identify any policy changes that are directed at financial stability. Indeed, the Federal Reserve and other central banks have pursued unorthodox monetary policies to keep interest rates near zero, much to the chagrin of William White and proponents of the Austrian school. While the Fed's strategy is designed to encourage greater risk taking, it at the same time has distorted prices in capital markets and could have the consequence of creating yet another market bubble.
Weighing these considerations, I find it difficult to be confident that policymakers can eliminate bubbles or financial crises. If so, what then can investors do to be protected?
My response is there are no easy answers, as it is inherently challenging to identify bubbles in advance and assess their impact on the economy and financial system. But one thing is equally clear – namely, investors can no longer ignore the possibility of future bubbles.
My belief is that investors who are disciplined and have a value orientation have the best chance of outperforming over the long-term. Not only are they less inclined to get caught up in a bubble mind-set, but they are also more inclined to look for opportunities after a bubble has burst, when others are selling securities indiscriminately. That said, the challenges value investors face when momentum investing is in vogue should not be underestimated. During the tech bubble, for example, value investors underperformed the broad market from 1995 to 1999. The challenge then was to maintain their discipline even as they were losing assets.
From my perspective, one of the most difficult challenges today is to peer inside the black box of the financial system and identify the leverage and inter-connectedness in it. Research by the BIS on bank exposures is particularly useful in this regard. And work now being undertaken by the U.S. Treasury and the Federal Reserve to identify macro-prudential risks should prove valuable.
Still, in the end, investment professionals must make judgments when they do not have complete information. For this reason, my colleagues and I now look at a broad array of market indicators that will provide clues about possible stresses and strains in the system. We also have developed a set of indicators to monitor conditions in the credit markets, as they provided early warning signals leading up to the Financial Crisis.
Finally, investors were not alone in missing the Financial Crisis - most economists did so, as well. While the economics profession is only beginning to do its soul searching, some prominent economists are pointing at the failure of models to grasp the importance of the credit creation process. Hopefully, the economics profession will take up the challenge, as it holds the key to assessing potential booms and busts in asset markets.