market efficiency and rationality: why financial … · market efficiency and rationality: why...

Market Efficiency and Rationality: Why Financial Markets are Different

Lionel Robbins Memorial Lectures

Lord TurnerChairman of the Financial Services Authority, the Climate Change Committee and the Overseas Development Institute

Christopher JohnsonChair, LSE

1

Lecture II

Financial Markets: Efficiency, Stability and Income

Distribution

London School of Economics12 October 2010

Adair Turner

Lionel Robbins Memorial Lectures

Economics after the crisis: Objectives and means

2

Capital inflows to emerging markets 1980 – 98

-200

-100

0

100

200

300

40019

80

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

$bn

Equity flows Debt flowsEquity includes direct investment and portfolio equity investment. Debt includes portfolio debt investment and other investment.

Emerging markets includes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Hungary, Hong Kong, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Singapore, South Africa, Thailand, Turkey and Venezuela.

3

Capital flows to emerging markets 1998 – 2008

-300

0

300

600

900

1,200

1,500

1,800

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

$bn

Equity flows Debt flows

Equity includes direct investment and portfolio equity investment. Debt includes portfolio debt investment and other investment.

Emerging markets includes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Hungary, Hong Kong, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Singapore, South Africa, Thailand, Turkey and Venezuela.

4

Total global cross-border inflows as % of global GD P

0

2

4

6

8

10

12

14

16

18

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Foreign Direct Investment Portfolio Equity Flows Debt Flows Other FlowsBanking and Other Flows

Source: IMF Global Financial Stability Report, 2007

5

FX trading values and world GDP: 1977 – 2007

Source: BIS Triennial Central Bank Survey, IMF International Financial Statistics

0

100

200

300

400

500

600

700

800

900

1,000

1,10019

77

1982

1987

1992

1997

2002

2007

$bn

Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn

$tn

$tn$tn $tn

6

USA debt as a % of GDP by borrower type

Source: Oliver Wyman

Household

Corporate

Financial

1929

1935

1941

1947

1953

1959

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300%19

29

1935

1941

1947

1953

1959

1965

1971

1977

1983

1990

1996

2002

2007

10%

50%

100%

150%

200%

250%

300%

7

Growth of interest rate derivatives values 1987 – 2009

0

50

100

150

200

250

300

350

400

45019

87

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

$Tr

OTC interest rate contracts, notional amount outstanding

Source: ISDA Market Survey (1987-1997), BIS Quarterly Review (1998-2009). Includes interest rate swaps and interest rate options.

8

Historical 'excess' wage in the US financial sector

0.1

0.0

0.1

0.2

0.3

0.4

0.5

1011121315161718202122232526272830313233353637384041424345464748505152535556575860616263656667687071727375767778808182838586878890919293959697980001020305

-

+

1910 2000

1910 2000

'Excess' wage

Source: Philippon, T and Reshef A (2009). Wages and Humal Capital in the US Financial Industry: 1909-2006, NBER Working Paper No 14644.A. Resh (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)

9

Income and Human Contentment: Possible stylised pattern over time

Inco

me

/ Con

tent

men

t

Pre-industrial societies The Great Transformation

Economic and technological progress

Income

Human wellbeingcontentment / happiness

China

Africa

Developed economies

10

Markets and economic growth

� Failure of pure planned economies

� Trade access key to rapid catch-up

� Entrepreneurship delivers– Better restaurants

– Better innovation, e.g. information technology

� US Pre-First World War

� Japan 1950s - 1970s and Korea 1960s - 1990s

� China But

11

� Efficient and rational financial markets: reasons f or disbelief

� The crash of 1997


� Financialisation and income distribution

� Conclusions for policy and the discipline of economics

12

General equilibrium, complete markets and allocativ e efficiency

Arrow-Debreu:

A competitive equilibrium is efficient …

… IF all markets are complete

� Liquid stock markets

� Commodity futures markets

� Structured credit markets

� Credit derivatives markets

� Etc.

Innovation and liquidity bring us

closer to the Arrow-Debreu

nirvana where all possible markets

exist and are complete

13

Market imperfections within the neoclassical paradi gm

� Lack of transparency

� Manipulation

� Lack of liquidity

� Subsidies, taxes and other interventions

� Increase transparency

� Punish manipulation

� Remove government interventions

� Make all markets efficient

� Increase liquidity

Market imperfections arising from:

Lancaster and Lipsky:

- If a specific market is imperfect, liberalisation of other markets can be sub-optimal

And

� Ban products

� Dampen market volatility

� “Throw sand in the wheels of speculation” (Tobin Taxes)

But not

14

Rational valuation or self-referential cycle

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole […] It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reachedthe third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

The General Theory of Employment, Interest and Money, chapter 12John Maynard Keynes, 1936

15

Manias, Panics and Crashes: The Madness of Crowds

� 1635 – 1637: Dutch tulips

� 1711 – 1720: South Sea bubble

� 1719 – 1720: Mississippi scheme

� 1929: US equities, bonds and real estate

� 1987: Global equity markets

� 1997: Asian emerging markets: FX, equities and debt

� 2000: Internet equities

� 2007 – 2008: Credit, structured credit and credit derivatives

“This

time it’s

different “

16

Why are markets irrational?

� Human beings are part rational, part instinctive

� Inherent information and principal/agent imperfections: collective irrationality even if individual humans were fully rational

� Inherent irreducible uncertainty

17

Value-at-risk assessment: Operational and inherent deficiencies

� Non-normal distributions

� Recursive systemic effects – non-independence: procyclicality

� Inherent irreducible uncertainty not mathematically modelable risk

Deficiencies

� Observe over a past period (e.g. last year) the distribution of profits / loss resulting over a defined time period (e.g. day, 10 days) from a given gross position

� Hold capital sufficient to cover some multiple of this ‘Value at Risk’

Basic concept

Frequency distribution of observed daily trading

profit/loss

Loss Profit

99% confidence

level

Daily VAR at 99%

Loss Profit

99% confidence

level

Daily VAR at 99%

18

Mervyn King (et al), Uncertainty in macro-economic policy making: art or science

“There are probably few genuinely ‘deep’ (and therefore stable) parameters or relationships in economics as distinct from in the physical sciences, where the laws of gravity are as good an approximation to reality one day as the next”

Royal Society, March 2010

19


The crash of 1997




20

Does capital account liberalisation deliver economi c benefits?

“Despite the numerous cross-country attempts to analyse the effects of capital account liberalisation, there appears to be only limited evidence that supports the notion that liberalisation enhances growth”

Capital flows and emerging market economies, CGFS Papers No. 33 January 2009

21

Bonanzas and sudden stops in international capital flows

Bonanzas � Self-reinforcing optimism � New paradigm stories� “This time it’s different”

� Ride the wave and get out in time

� Rush for the exit� Contagion to “similar” countries

Sudden stops

And

22

Thai Baht, Korean Won and Indonesian Rupee: Exchange rates versus US$ 1990 – 1998

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.019

90

1990

1991

1991

1992

1992

1993

1993

1994

1994

1995

1995

1996

1996

1997

1997

1998

1998

US$ to Thai Baht US$ to South Korean Won US$ to Indonesian Rupiah

Source: GTIS and Datastream)

23

The Washington Consensus response: conditions and sequencing

Fx markets overshoot and are volatile because

of poor fiscal and monetary policies and

lack of appropriate domestic financial

conditions

Problem lies not within financial liberalisation, but in badly executed and

incomplete liberalisation

Conditions and

sequencing are vital

24

Short-term capital flows and optimal policy

� Theories of irrational markets and observation of bonanzas and sudden stops

� Neoclassical axioms and impossibility of proving that movements were irrational

� No perfect policies

� But take policy options out of the index of forbidden thoughts

– Capital inflow taxes or controls

– Financial transaction taxes

Are they rational? And if not, what follows?

VS

25



The crash of 2008



26

Growth of interest rate derivatives values 1987 – 2009

0

50

100

150

200

250

300

350

400

45019

87

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

$Tr

OTC interest rate contracts, notional amount outstanding

Source: ISDA Market Survey (1987-1997), BIS Quarterly Review (1998-2009). Includes interest rate swaps and interest rate options.

27

Global issuance of asset-backed securities

Notes: Public issuance only. Full-year issuance except for 2008 which is up to and including September 2008. ‘Other ABS’ includes Auto, Credit Card and Student Loan ABS.

Source: Bank of England

28

Global credit derivatives outstanding

Source:

ISD

A M

arket Survey

0 10 20 30 40 50 60 70

Jun 2001

Dec 2001

Jun 2002

Dec 2002

Jun 2003

Dec 2003

Jun 2004

Dec 2004

Jun 2005

Dec 2005

Jun 2006

Dec 2006

Jun 2007

Dec 2007

Jun 2008

Dec 2008

Jun 2009

Notional amounts outstanding, $Tr

29

Global issuance of Collateralised Debt Obligations:Cash and synthetic

Source: IMF Global Financial Stability Report, 2006

0

50

100

150

200

250

300

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Synthetic

Cash

$bn

30

Global daily oil futures trading and daily oil prod uction

Global oil consumption vs. traded oil futures 1983-2009

0

200

400

600

800

1,000

1,20019

83

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Year

Oil

barr

els

equi

vale

nt (

mill

ions

)

Exchange futuresvolumes (millionbarrels equivalent)

)

Source: NYMEX

31

Complete markets as a route to…

Credit derivatives “enhance the

transparency of the markets’

collective view of credit risks..

[and thus]… provide valuable

information about broad credit

conditions and increasingly set

the marginal rice of credit.

Therefore, such activity improves

market discipline”

“There is a growing recognition

that the dispersion of credit risk

by banks to a broader and more

diverse group of investors has

helped make the banking and

overall financial system more

resilient …

The improved resilience may be

seen in fewer bank failures and

more consistent credit provision”.

… efficiency … and stability

IMF, Global Financial Stability Review, April 2006

32

Financial firms’ CDS and share prices

Source: Moody’s KMV, FSA Calculations

Exhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

Dec 02

Apr 03

Aug 03

Dec 03

Apr 04

Aug 04

Dec 04

Apr 05

Aug 05

Dec 05

Apr 06

Aug 06

Dec 06

Apr 07

Aug 07

Dec 07

Apr 08

Aug 08

Dec 08

Average CDS Spread in Percent

-

0.50

1.00

1.50

2.00

2.50

MarketCap Index

CDS SHARE-PRICE-ADJUSTED

Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway, Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS.

CDS series peaks at 6.54% in September 2008.

33

Did financial intensification deliver…

Increased stability? Clearly not

Improved allocative efficiency?

� Argument by axiom

� Markets in general beat planned economies

+

+

Vs

� Instability itself generating misallocation

� Diminishing marginal benefits

34




Financialisation and income distribution


35

UK financial intermediation and aggregate real GVA

0

50

100

150

200

250

300

350

400

1855 1875 1895 1915 1935 1955 1975 1995

FinancialIntermediationAggregate

1975=100

Source: Andrew Haldane, The Future of Finance, LSE Report, 2010)

36

Average annual growth rate of financial intermediat ion

Sources : Office for National Statistics (ONS) and Bank of England calculations (as referenced by Andrew Haldane in The Future of Finance LSE Report, 2010)

Note: Real values

GVA: Aggregate

GVA: Financial Intermediation Difference (pp)

1856 – 1913 2.0 7.6 5.6

1914 – 1970 1.9 1.5 -0.4

1971 – 2008 2.4 3.8 1.4

37

Share of the financial industry in US GDP

Source: Philippon, T (2008), The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)

%

0

1

2

3

4

5

6

7

8

9

50 70 90 10 30 50 70 901850 1910

38

Historical 'excess' wage in the US financial sector

0.1

0.0

0.1

0.2

0.3

0.4

0.5

1011121315161718202122232526272830313233353637384041424345464748505152535556575860616263656667687071727375767778808182838586878890919293959697980001020305

-

+

1910 2000

1910 2000

'Excess' wage

Source: Philippon, T and Reshef A (2009). Wages and Humal Capital in the US Financial Industry: 1909-2006, NBER Working Paper No 14644.A. Resh (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)

39

Return on equity in finance

0

5

10

15

20

25

30

35

1921 1941 1961 1981 2001

µ = 7.0σ = 2.0

µ = 20.4σ = 6.9

%

Sources : Capie, F. and Billings, M. (2004), BBA and Bank of England calculations (as referenced by Andrew Haldane in The Future of Finance LSE Report, 2010)

40

Increased financial sector factor incomes

Increase in the real value added functions performed within more complex and more global economies

� Opacity of margin and asymmetries of knowledge and power

� Complex opaque put options

� Tax and regulatory arbitrage� Creation of volatility – which

non-financial sector needs to hedge

OR

41

Why are some bankers paid so much?

� Highly skilled labour produces high marginal product

…. but will never receive wage higher than the social value delivered

� Mix of indirectly “creative”and purely “distributive” / “rent extracting” activities –private marginal product can diverge from social

� Measurability of (apparent) marginal product is key driver of pay levels

Theory Practice

42





Conclusions for policy and the discipline of economics

43

Conclusions

� All imperfect markets are different

� The benefits of financial market liberalisation differ by stage of development

� Stability matters a lot – minor increments of allocative efficiency, little

� Economics for the real world

44

Income and Human Contentment: Possible stylised pattern over time

Inco

me

/ Con

tent

men

t

Pre-industrial societies The Great Transformation

Economic and technological progress

Income

Human wellbeingcontentment / happiness

China

Africa

Developed economies

45

Conclusions



� Stability matters a lot – minor increments of alloca tive efficiency, little


46

Conclusions



� Stability matters a lot – minor increments of allocative efficiency, little


47

Implications for economics

� Human beings as they are

� Markets as they actually operate

� Economic history as key input

� Complex and multiple understandings– No all-encompassing model

48

Robert Lucas, Professional Memoir

“I prefer to use the term ‘theory’ … [as] something that can be put on a computer and run… the construction of a mechanical artificial world populated by interacting robots which economics typically studies”

Professional Memoir, Page 21, 2001

49

Implications for economics

� Human beings as they are

� Markets as they actually operate

� Economic history as key input

� Complex and multiple understandings– No all-encompassing model

market efficiency and rationality: why financial … · market efficiency and rationality: why...

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