Wall Street Revalued

Financial turmoil and recessions are closely linked. Crashes do not occur randomly, but generally follow the booms that are associated with asset bubbles. When these are extreme, the subsequent turmoil is most severe. The three most extreme examples of modern times are today, Japan after 1990 and the US in the 1930s.

Falling asset prices, among their many undesirable consequences, make it difficult and sometimes impossible for central banks to control their economies simply through changes in short-term interest rates. The current turmoil has its origin in the series of asset bubbles that began with the stock market in the latter part of the 20th century. If the agreed policy of central banks had been to restrain asset bubbles, and they had acted to do so, the current pain could and probably would have been avoided. But while the view that we were then putting forward seems to have been justified in retrospect, it will not command, and should not command, the necessary authority to influence future policy decisions unless it has the support of a coherent and testable economic theory.

The symptoms of the financial mania, which began in the 1990s, were many. Not only were asset prices driven to absurd levels, but bankers and others believed that these prices had some fundamental validity and, on the basis of this confidence, created complicated additional structures whose assumed values became, in turn, articles of faith and the basis for further leverage. Loans were extended on the assumption that the assets which backed them were reasonably valued and, in the resulting boom in business, it was the bankers who believed in these follies who were most likely to be rewarded with extravagant bonuses.

It has been well remarked that the most successful sellers of snake oil believe wholeheartedly in the virtues of their product, and in recent times bankers became the quintessential sellers of snake oil. When asset prices fell, the whole house of cards came tumbling down and there is a tendency to see the fundamental problem in terms of these symptoms of absurd asset prices, complicated financial structures, extravagant bonuses and undisciplined bank lending. But these symptoms were not the fundamental cause of the mania, although the asset prices alone should have given sufficient warning of the looming problems.

Human nature doesn’t change quickly, and people respond to opportunities and incentives. Bankers and other financiers will always hang themselves, and us with them, if provided with sufficient rope. The excessive rope provided by central bankers was not only a necessary condition of the current turmoil, it was a sufficient one. We have a world of fiat money that is, money which can be created at the whim of our central bankers, as distinct from one based on gold, for example, and if their whims are wayward, the results will be disastrous, without any other conditions for disaster being required except the normal human responses and frailties.

The cause of our present troubles was the actions of incompetent central bankers, who provided excessive liquidity on which the asset price bubbles and their associated absurdities were built. When too much liquidity is being created, the results will appear either in consumer or asset prices. Central bankers were alert to the former and, if the symptoms of excess liquidity had appeared in consumer prices, they would no doubt have responded to dampen them down, even at the cost of having a much earlier recession than the one which is deepening as I write. But an earlier recession would have been relatively mild with a limited loss of output and welfare. Unfortunately, it was in asset rather than consumer prices that the excesses were revealed and, equally unfortunately, the Federal Reserve, which in this instance deserves far more opprobrium than other central bankers, announced that this did not matter.

The single most important element in the Federal Reserve’s view was the claim that asset prices cannot be valued. This was modified at various times and different arguments were regularly trotted out as changing circumstances made each previous claim less credible. But the ability to value assets is the central issue and claims that it can be done run against the long-held view that, while the real economy operates in a less than fully efficient way, financial markets are different. This view is no longer widely held in its starkest form but, in practice, many of the arguments that are produced about financial markets involve the same underlying assumptions, even though those who are making them seldom recognise the implicit, rather than explicit, assumptions that they are making.

It is therefore necessary to show that assets can be valued and that financial markets are not perfectly efficient. But this is not enough. It is also necessary to expose arguments that rely implicitly on these assumptions. Otherwise the same follies will return by the back door.

The ability to value asset prices is obviously important for investors, fund managers, actuaries, pension consultants and those concerned with the regulation of financial institutions, as well as for central bankers. Shares are not the only assets with which central bankers need to be concerned. House, bond and loan prices are also extremely important. Even assuming that agreement can be reached on the importance of asset prices and how they should be valued, it is necessary to consider the actions that central banks, investors and consultants should take or recommend in the event that assets become markedly misevaluated.