Friday, 6 April 2012

The Financial Market as a Vengeful God

                Reading this Jonathan Portes post, I recalled a point in my undergraduate lectures where I have a little fun at the expense of economic pundits from the City. After explaining Uncovered Interest Parity (if you do not know what UIP is, it does not matter), I tell them that they can now immediately comment on how the foreign exchange market reacts to an increase in interest rates, whatever happens to the exchange rate. If the exchange rate appreciates, that is because domestic assets are more attractive. If the exchange rate does not change, that is because the interest rate increase was already discounted. If the exchange rate depreciates, well the markets were expecting a larger increase.
                This is meant to make a serious point about the difficulties in testing UIP, but if I’m feeling mischievous I then point out that city pundits always seem to know with certainty why the markets have moved this way or that. Now in goods markets, firms pay market researchers serious money to find out why consumers are or are not buying their products, but in the financial markets this appears unnecessary. Despite market moves being made by thousands of trades and by thousands of people, the motivation for these trades appears clear. It is as if each trade is accompanied by the trader completing the following sentence: ‘I bought/sold this currency today because ....’. The truth, I reveal to my stunned audience, is that these pundits are just guessing based on no evidence whatsoever.
                Of course city pundits have no reason to be honest. When asked ‘why has the dollar appreciated’, I would like them to reply ‘well no one really knows, but one possible factor might be...’. They never do. If I wanted to be unkind, I might suggest that these pundits want to appear like high priests, with a unique ability to understand the mysterious mind of the market. As high priests have discovered over and over again, if you can convince people that you have a direct line to an otherwise mysterious but powerful deity, you can do rather well for yourself. And sometimes financial markets can appear a bit like vengeful gods, capable of sudden acts of destructive anger that appear to come from nowhere.
                If I wanted to ratchet up the unkindness I could go on as follows. It is in the priest’s interest to tell the faithful that the god is indeed quite fickle in its mood, and while placid at the moment, it could turn nasty at the slightest provocation. Keep those offerings coming, to make sure that the god stays happy (and don’t think about where those offerings go). If you are particularly generous, the priest will promise to give you the heads up if any changes in mood are imminent. If you cannot be a priest yourself, you can always set up as an advisor (HT DeLong), who will tell people which priests have a better line to the financial market god. 
                OK, this is a bit silly, but sometimes listening to policymakers you wonder whether they think this way. (Perhaps because they talk to the wrong people – see Jonathan again here.) For ‘confidence’, read the mood of the financial market god, or even the many gods of the economy as a whole. For offerings and sacrifices, read austerity. Muti and Padoan tell us “the Eurozone is still in a situation in which multiple equilibria can materialise”. They go on “In a situation of multiple equilibria, where confidence plays a crucial role, the distinction between short-term and long-term measures (suggesting the possibility of postponing action) is misleading and could be possibly dangerous. Short-term measures that weaken confidence would push the medium-term dynamics towards a bad equilibrium.”
                I assume this is about austerity. Here the game for many Eurozone countries is to demonstrate that they are not like Greece. I think that in this game there may be an advantage in front-loading austerity to demonstrate the ability and intension to avoid default, although I think Brad DeLong disagrees. However, as my very first post said, this need not be about appeasing a market god but instead the very human ECB. If deficit reduction programmes are reasonable and are implemented (in cyclically adjusted terms, without moving the potential output goalposts every time output falls), the ECB should ensure interest rates on debt are low enough to make those programmes sustainable.
                Having just gone through a recession largely caused by excessive over confidence in the financial markets about the ability to manage risks, it is natural to think everything is down to confidence. (The word appears eight times in Muti and Padoan’s article.) However in most situations I think markets and economies react in straightforward and understandable ways. The importance of confidence can be overdone, as it is often a symptom rather than a prime cause. To treat financial markets or the economy as a whole as always behaving like a vengeful god whose mood and confidence can ebb and flow at the slightest provocation is not the way to make good policy.
                Jonathan’s post also quotes Shakespeare, so how about this from Julius Caesar

Men at some time are masters of their fates;
The fault, dear Brutus, is not in our stars,
But in ourselves, that we are underlings.

4 comments:

  1. Bravo, Professor!

    Also, the appeal to 'confidence' always makes me (unkind as I am) think of the famous Kalecki paper on politics and full employment that you discussed a while ago in your hidden motives post.

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  2. " I would like them to reply ‘well no one really knows, but one possible factor might be...’. They never do. If I wanted to be unkind, I might suggest that these pundits want to appear like high priests, with a unique ability to understand the mysterious mind of the market."

    If I wanted to be kind about the same phenomenon I would suggest that journalists won't continue to ring up people who say "I dunno".

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  3. the idler of march18 April 2012 20:04

    I know this article may be intended light-heartedly, but I'm not sure if I agree with it. To compare a physical goods market to the financial market is not appropriate - people buy physical goods to make use of them, whilst 90% of most financial market players are investing in order to gain a financial return, not because they in any way want a lien on the underlying asset. Since other participants' buying/selling affects the value of their holding, no matter what the fundamentals of the situation, these actors do have to be aware of other participants' views. Without a direct way to exchange information, certain pieces of news or economic releases end up becoming widely-acknowledged arbiters for short-term market direction, and triggers for buying/selling. Thus, although you could very easily argue that a single Non-farm payroll number is completely irrelevant to the value of your holding in (say) Boeing, if you are worried about short-term mark-to-market losses then you may still need to react to that number's release. Hence the market generally is encouraged to follow certain acknowledged signals, which are easy enough for financial journalists to also track.

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  4. This is very true. Never believe someone who always has an explanation for everything. Often the market moves simply because there are more buyers than sellers or vice versa.

    Having said that, the market's reaction to a surprise for example in interest rates (the magnitude, since the direction is usually clear) can indicate the overall positioning of the market and thus which is the direction of highest vulnerability.

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