Martin Wolf: Neurotic ‘Mr Market’ has plenty to be anxious about
Martin Wolf: Neurotic ‘Mr Market’ has plenty to be anxious about
By Martin Wolf
Published: May 23 2006 18:59 | Last updated: May 23 2006 18:59. Copyright by The Financial Times
Benjamin Graham, Warren Buffett’s teacher, used to warn that the person he called “Mr Market” is a neurotic: his moods fluctuate between incredible optimism and overwhelming depression. At present, he is moving from insouciance to anxiety and so from riskier assets towards cash or even that classic hedge – gold.
Mr Market has reason to be anxious. The contemporary combination of high to very high valuations of real assets (such as housing and equities), low spreads of risky assets over risk-free ones (such as emerging market and corporate bonds over US Treasuries), rising real prices of commodities (notably oil) and huge shifts in patterns of saving, investment and finance around the world (shown in the global “imbalances” and rising indebtedness of household sectors, notably in the US) is good reason for nervousness.
Why have markets reached their exposed position? The answer is that success breeds excess. This is the argument of a fascinating new paper from William White, economic adviser to the Bank for International Settlements.*
Mr White argues that a monetary policy aimed at stabilising inflation in the medium term may well be destabilising in the long term. Beneficial changes in the world economy – the fall in oil prices after 1985, collapsing prices of computing and communication, declining prices of exports of manufactures from China and liberalisation of economies – lowered inflationary pressures.
Mr White explains booms and subsequent busts as follows: “Buoyed by justified optimism about some particular development, credit is extended which drives up related asset prices. This both encourages fixed investment . . . and increases collateral values, which supports still more credit expansion. With time, and underpinned by an associated increase in output growth, this process leads to increasing willingness to take risks (‘irrational exuberance’), which gives further impetus to the credit cycle . . . Subsequently, as exaggerated expectations concerning both risk and return are eventually disappointed, the whole process goes into reverse.”
The longer the period of macroeconomic stability, the greater the underlying excesses in investment and borrowing are likely to become. What happened to Japan in the 1980s is an example of this danger.
This analysis raises three questions: first, is it correct? Second, if it is, what does it tell us about where the world economy is now? And, third, what are the policy lessons?
The answer to the first question is that the story is plausible. The past two and a half decades have seen a host of financial crises preceded by easy credit and excessive investment. Still easier monetary policy has been one response. An equally interesting one, notably in east Asia, has been a return to reliance on competitive exchange rates and export-led growth. In that case, however, the increase in debt on which these countries’ growth relies occurs elsewhere: overwhelmingly, in the US.
The answer to the second question is that this process can continue for a long time, provided inflation remains low. The limit is reached only when inflation becomes a serious concern. That may now be the danger. Alternatively, it may only be a threat for a country with a vulnerable currency, such as the US. The increase in the prices of gold and other commodities suggests inflationary fears may be rising.
The answer to the third question is less clear. Mr White suggests reconsideration of narrow inflation targeting. One justification is that the present regime provides limited resistance to inordinate increases in confidence. Another is that monetary loosening in downturns tends to be asymmetrically aggressive. This not only permits the survival of “zombie capital”, but distorts the healthy functioning of financial markets, even the entire world’s markets in the case of the “carry trade” in cheap yen.
Another reason for reconsideration, suggests Mr White, is that the inflation-targeting response to supply shocks increases output instability, by letting demand expand aggressively in response to a positive price shock and be cut back in response to a negative one. Above all, the cumulative impact of inflation targeting in a benign environment is to encourage excessive debt accumulation.
Yet the lengthy period of stability in inflation and output that large parts of the world have enjoyed argues against radical change in the policy regime. Disturbances in the financial system can be managed, defenders of the present orthodoxy would argue, as long as inflation is kept under control.
I am inclined to think that policymakers should take some account of emerging financial imbalances – including growing indebtedness – in monetary policy. In any case, the wise investor cannot ignore such developments. In the expansionary phase a euphoric Mr Market will always ignore the accumulation of risks. But sooner or later he will wake up to them – and promptly start panicking. It is what he is doing now. He is, after all, only human.
By Martin Wolf
Published: May 23 2006 18:59 | Last updated: May 23 2006 18:59. Copyright by The Financial Times
Benjamin Graham, Warren Buffett’s teacher, used to warn that the person he called “Mr Market” is a neurotic: his moods fluctuate between incredible optimism and overwhelming depression. At present, he is moving from insouciance to anxiety and so from riskier assets towards cash or even that classic hedge – gold.
Mr Market has reason to be anxious. The contemporary combination of high to very high valuations of real assets (such as housing and equities), low spreads of risky assets over risk-free ones (such as emerging market and corporate bonds over US Treasuries), rising real prices of commodities (notably oil) and huge shifts in patterns of saving, investment and finance around the world (shown in the global “imbalances” and rising indebtedness of household sectors, notably in the US) is good reason for nervousness.
Why have markets reached their exposed position? The answer is that success breeds excess. This is the argument of a fascinating new paper from William White, economic adviser to the Bank for International Settlements.*
Mr White argues that a monetary policy aimed at stabilising inflation in the medium term may well be destabilising in the long term. Beneficial changes in the world economy – the fall in oil prices after 1985, collapsing prices of computing and communication, declining prices of exports of manufactures from China and liberalisation of economies – lowered inflationary pressures.
Mr White explains booms and subsequent busts as follows: “Buoyed by justified optimism about some particular development, credit is extended which drives up related asset prices. This both encourages fixed investment . . . and increases collateral values, which supports still more credit expansion. With time, and underpinned by an associated increase in output growth, this process leads to increasing willingness to take risks (‘irrational exuberance’), which gives further impetus to the credit cycle . . . Subsequently, as exaggerated expectations concerning both risk and return are eventually disappointed, the whole process goes into reverse.”
The longer the period of macroeconomic stability, the greater the underlying excesses in investment and borrowing are likely to become. What happened to Japan in the 1980s is an example of this danger.
This analysis raises three questions: first, is it correct? Second, if it is, what does it tell us about where the world economy is now? And, third, what are the policy lessons?
The answer to the first question is that the story is plausible. The past two and a half decades have seen a host of financial crises preceded by easy credit and excessive investment. Still easier monetary policy has been one response. An equally interesting one, notably in east Asia, has been a return to reliance on competitive exchange rates and export-led growth. In that case, however, the increase in debt on which these countries’ growth relies occurs elsewhere: overwhelmingly, in the US.
The answer to the second question is that this process can continue for a long time, provided inflation remains low. The limit is reached only when inflation becomes a serious concern. That may now be the danger. Alternatively, it may only be a threat for a country with a vulnerable currency, such as the US. The increase in the prices of gold and other commodities suggests inflationary fears may be rising.
The answer to the third question is less clear. Mr White suggests reconsideration of narrow inflation targeting. One justification is that the present regime provides limited resistance to inordinate increases in confidence. Another is that monetary loosening in downturns tends to be asymmetrically aggressive. This not only permits the survival of “zombie capital”, but distorts the healthy functioning of financial markets, even the entire world’s markets in the case of the “carry trade” in cheap yen.
Another reason for reconsideration, suggests Mr White, is that the inflation-targeting response to supply shocks increases output instability, by letting demand expand aggressively in response to a positive price shock and be cut back in response to a negative one. Above all, the cumulative impact of inflation targeting in a benign environment is to encourage excessive debt accumulation.
Yet the lengthy period of stability in inflation and output that large parts of the world have enjoyed argues against radical change in the policy regime. Disturbances in the financial system can be managed, defenders of the present orthodoxy would argue, as long as inflation is kept under control.
I am inclined to think that policymakers should take some account of emerging financial imbalances – including growing indebtedness – in monetary policy. In any case, the wise investor cannot ignore such developments. In the expansionary phase a euphoric Mr Market will always ignore the accumulation of risks. But sooner or later he will wake up to them – and promptly start panicking. It is what he is doing now. He is, after all, only human.
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