Lionel Robbins Memorial Lectures Market Efficiency and Rationality: Why Financial Markets are Different Lord Turner Chairman of the Financial Services Authority, the Climate Change Committee and the Overseas Development Institute Christopher Johnson Chair, LSE
Lionel Robbins Memorial Lectures Economics after the crisis: Objectives and means Lecture II Financial Markets: Efficiency, Stability and Income Distribution Adair Turner London School of Economics 12 October 2010 1
Capital inflows to emerging markets 1980 – 98 400 300 200 $bn 100 0 -100 -200 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 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. 2
Capital flows to emerging markets 1998 – 2008 1,800 1,500 1,200 900 $bn 600 300 0 -300 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 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. 3
Total global cross-border inflows as % of global GDP Foreign Direct Investment Portfolio Equity Flows Debt Flows Banking and Other Flows Other Flows 18 16 14 12 10 8 6 4 2 0 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 Source: IMF Global Financial Stability Report, 2007 4
FX trading values and world GDP: 1977 – 2007 1,100 1,000 900 800 700 600 ��� $bn 500 400 300 200 100 0 1977 1982 1987 1992 1997 2002 2007 ��� ��� ��� Global nominal GDP, $bn Global FX turnover, annual, $bn Global exports, $bn Source: BIS Triennial Central Bank Survey, IMF International Financial Statistics 5
USA debt as a % of GDP by borrower type ���� ���� ���� ���� Corporate ���� ���� Household ���� ���� ���� ���� Financial ��� ��� ��� ��� 1929 1929 1935 1935 1941 1941 1947 1947 1953 1953 1959 1959 1965 1971 1971 1977 1977 1983 1983 1990 1990 1996 1996 2002 2002 2007 2007 Source: Oliver Wyman 6
Growth of interest rate derivatives values 1987 – 2009 450 400 350 300 250 $Tr 200 150 100 50 0 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 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. 7
Historical 'excess' wage in the US financial sector 'Excess' wage 0.5 0.4 0.3 0.2 0.1 + 0.0 - 1910 2000 0.1 1910 2000 10 11 12 13 15 16 17 18 20 21 22 23 25 26 27 28 30 31 32 33 35 36 37 38 40 41 42 43 45 46 47 48 50 51 52 53 55 56 57 58 60 61 62 63 65 66 67 68 70 71 72 73 75 76 77 78 80 81 82 83 85 86 87 88 90 91 92 93 95 96 97 98 00 01 02 03 05 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) 8
Income and Human Contentment: Possible stylised pattern over time Pre-industrial societies The Great Transformation Income / Contentment Income Developed economies Human wellbeing contentment / happiness China Africa Economic and technological progress 9
Markets and economic growth � Failure of pure planned � US Pre-First World War economies � Japan 1950s - 1970s and � Trade access key to rapid Korea 1960s - 1990s catch-up But � China � Entrepreneurship delivers – Better restaurants – Better innovation, e.g. information technology 10
� Efficient and rational financial markets: reasons for disbelief � The crash of 1997 � The crash of 2008 � Financialisation and income distribution � Conclusions for policy and the discipline of economics 11
General equilibrium, complete markets and allocative efficiency � Liquid stock Innovation and Arrow-Debreu: markets liquidity bring us A competitive � Commodity futures closer to the equilibrium is markets Arrow-Debreu efficient … � Structured credit nirvana where all … IF all markets markets possible markets are complete � Credit derivatives exist and are markets complete � Etc. 12
Market imperfections within the neoclassical paradigm Market imperfections arising from: � Lack of transparency � Manipulation But not � Increase � Lack of liquidity transparency � Ban products � Subsidies, taxes � Punish manipulation and other � Dampen market � Remove government interventions volatility interventions And � “Throw sand in the � Make all markets Lancaster and Lipsky: wheels of efficient speculation” (Tobin - If a specific market is � Increase liquidity Taxes) imperfect, liberalisation of other markets can be sub- optimal 13
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 reached the 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 12 John Maynard Keynes, 1936 14
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 “This � 1987: Global equity markets time it’s � 1997: Asian emerging markets: FX, equities different “ and debt � 2000: Internet equities � 2007 – 2008: Credit, structured credit and credit derivatives 15
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 16
Value-at-risk assessment: Operational and inherent deficiencies Frequency distribution of observed daily trading Basic concept profit/loss Deficiencies � Observe over a past period � Non-normal distributions (e.g. last year) the distribution � Recursive systemic effects of profits / loss resulting over – non-independence: a defined time period (e.g. procyclicality day, 10 days) from a given � gross position Inherent irreducible uncertainty not � Hold capital sufficient to 99% 99% mathematically modelable cover some multiple of this confidence confidence risk ‘Value at Risk’ level level Profit Profit Loss Loss Daily VAR Daily VAR at 99% at 99% 17
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 18
� Efficient and rational financial markets: reasons for disbelief The crash of 1997 � The crash of 2008 � Financialisation and income distribution � Conclusions for policy and the discipline of economics 19
Does capital account liberalisation deliver economic 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 20
Bonanzas and sudden stops in international capital flows � Self-reinforcing optimism Bonanzas � New paradigm stories � “This time it’s different” And � Ride the wave and get out in time Sudden � Rush for the exit stops � Contagion to “similar” countries 21
Thai Baht, Korean Won and Indonesian Rupee: Exchange rates versus US$ 1990 – 1998 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0 1990 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) 22
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