“But if I were you, wherever you are, I’d prepare for more pain”
Listen to these financial Wizards of Oz and prepare for another disaster
Our mighty bond markets, feared but also fearful, are in danger of triggering the very crisis they wish to avert
Timothy Garton Ash
Wednesday 23 June 2010
I thought it was time I got to know the almighty. I mean, of course, the bond markets: for, at their call, the governments of this world tremble. Before them, every knee shall bow. To fend off their wrath, George Osborne has just presented the most draconian budget in living memory – a burnt offering on the altar of this god we call simply “the markets”.
So over the past few weeks I have been talking to traders, strategists and analysts in London’s bond markets. Let me say at once that I am a complete novice and amateur in this field. If you want expertise, read no further; turn instead to the Financial Times or to Larry Elliott in these pages. If, however, you will accept me as your ordinary citizen’s emissary to Mount Olympus, read on.
The first thing that struck me was a Wizard of Oz effect. Pull back the curtain and you find, behind that giant figure with his booming, mysterious voice, a little man pushing buttons and pulling levers. Or rather, thousands of men (and a few women). Most of them, far from manifesting god-like, Olympian arrogance, seem even more terrified than the rest of us. Partly, no doubt, this is because they are paid to be nervous, but it is also because they understand better the very dangerous place we are in. And one reason they understand it better is that they know that the danger comes also from themselves, for the financial markets are a classic example of what social scientists call a collective action problem. Thousands of individual traders make decisions that are individually rational, at least in the short term, but collectively irrational.
An essential feature of financial markets is that those involved are simultaneously spectators and actors. George Soros, who has spent half a lifetime trying to explain this phenomenon to a wider world, said last week in London: “Markets don’t reflect the facts very well, partly because they create the facts themselves.” In what Soros calls “reflexivity”, trends in the real world reinforce a bias in market participants’ minds, which in turn reinforces those trends in “a double feedback, reflexive connection”. Realities create expectations, but expectations also create realities, and so on.
One analyst I spoke to had developed a compelling metaphor of the bond markets now standing like skiers before the threat of a “sovereign avalanche” – whereby a single government defaulting could initiate a chain reaction of further defaults, accelerated by the collapse of banks holding too much of that government’s debt. The difference is this: on the slopes of Chamonix, even if a thousand skiers peer nervously up the slopes, their fear will have no impact on the probability of an avalanche. In the financial markets, it is the skiers’ fear that triggers the avalanche.
Obviously, for such a danger of avalanche to exist, there had first to be teetering piles of snow up the mountain. While overheated, overleveraged financial markets did contribute to piling up the snow, they were not primarily responsible for it. Governments, companies and, not least, you and I – in our double role as consumers and voters – were the main pilers of the snow. What the bond market analysts show you with shocking clarity is, in most (though not all) of the developed world, and especially in many European countries, a ghastly tale of two Ds: debt and demography.
Over the past half-century we have built up a staggering burden of corporate, household and public debt. Following the financial crisis, the emphasis has shifted from unsustainable private sector borrowing to unsustainable public sector borrowing. While the good-time bankers are laughing all the way to their yachts, a private sector debt crisis has become a sovereign debt crisis. And, by the way, the virtuous, high-saving exporting nations, such as China and Germany (or “Chermany”, as Martin Wolf of the Financial Times wittily dubs it), have depended on the credit-fuelled profligacy of others who buy their exports.
Meanwhile, the baby-boomers are moving into retirement and the proportion of the population over 65 is soaring. Unless we have massive, successfully integrated youthful immigration, we will all have to work longer – and our welfare states will have to get shockingly leaner and meaner. Osborne’s axe is but a small taste of things to come.
Financial markets are not mainly to blame for this double whammy of debt and demography, but nor are they merely “the messenger”. The wizards to whom I spoke all identified some big problems with the way these markets work. Until recently it was taken as axiomatic that government bonds were virtually risk-free. Government bond yields were described as “the risk-free rate”. Within the eurozone, the markets grossly mispriced the risk on countries such as Greece. Yes, the Greek government had to pay a little more than Germany to borrow in the markets, but nothing like as much as it should have done.
Then there is the problem of chronic and growing short-termism. Asset managers now measure performance on a quarterly or, at most, a six-monthly time frame, with valuations being done at current market prices. So, if there is a bubble, you as a fund manager must jump into it – even if you know the bubble is going to burst. If you don’t jump in, your sober pessimism may be justified in the slightly longer term, but in the meantime you’ll be out of a job since investors will have taken their money elsewhere.
This in turn magnifies that inherent feature of markets, the Soros reflexivity effect. Whether you look at government debt, risk management or economic growth itself (which partly depends on how rich people feel, reflecting the current valuation of their assets), you see the same pattern of self-reinforcing upward or downward spirals. In layman’s terms, the ship is inherently unstable.
If this analysis is not completely wide of the mark (and I welcome all learned explanations of why it is), several questions follow. Can markets to some extent correct the way they themselves work – to address the problem of chronic short-termism, for example? If so, how? Can governments, international organisations and the co-ordinated actions of individual states regulate them more effectively? This will be a major subject of this weekend’s G20 meeting in Canada.
Yet if bond markets have a collective action problem, so do states. One clear impression I gained from my conversations is that one thing that really impresses the markets is determined, large-scale, “shock and awe”, coûte-que-coûte action by a single, serious sovereign – ie, a kind of power that the bond markets themselves can never be. Examples include the US in the financial crisis, China, and perhaps even (we shall see) little Britain today. One reason they are not yet convinced by the eurozone’s response to its crisis is that it does not have that single, serious, utterly determined sovereign. But if even the relatively tightly knit eurozone does not convince, how can a loose, disparate constellation of 20 states?
I hope for the best at the G20 summit this weekend; I hope against hope. But if I were you, wherever you are, I’d prepare for more pain – and watch out for another avalanche.