Summary: As one market after another drifts off into bubble valuations, a few institutions warn of the consequences. As usual (we’ve done this so many times), we ignore them — our passivity and ignorance earning our role as the deep pockets paying for the resulting damage. This post looks at a few of the warnings from the venerable Bank of International Settlements — the “world’s oldest international financial organization”, the central banks’ central bank.
For more about this see How we’ve become accustomed to bubbles bursting the economy, instead of fighting them.
This is post #3,000, with over 5.5 million page views since opening in Nov 2007.
The BIS gives us yet another warning about the increasing prevalence of asset price bubbles in our financial system: “Asset Bubbles: Re-thinking Policy for the Age of Asset Management“. A excerpt appears at the end of this post, but the message should be obvious to all by now. Earlier analysis by the BIS pointed to the dangers of rising leverage (traditional buying on margin plus and endless array of derivatives) coupled with expansive monetary policy — and (although they can hardly mention this) little regulation of banks). This report (carefully labeled as not representing BIS views) warns of structural factors encouraging speculative buying (e.g., herding and trend-following by investment managers). After all, it’s not their money.
It’s an enlightening report, typical of the BIS. It carefully avoids more than gentle questions about central banks’ role in this, especially the “put” (price guarantee) they’ve created on prices of financial assets. On the other hand, let’s be grateful for any warnings we get. Although we’ll ignore them, as we did during the housing and tech bubbles. FAILure to learn is an expensive vice.
Previous warnings from the BIS
These are unusually blunt warnings from an institution such as the BIS. Of course they know better than most that nobody is listening because the game must continue while there is money to be made by the financial industry. It’s the public’s role afterwards to politely write checks for the damage.
William R. White (former CIS chief economist)
“I see speculative bubbles like in 2007.” (Interview, 11 April 2014)
BIS Annual Report, 29 June 2014
Financial markets have been exuberant over the past year, at least in AEs {advanced economies}, dancing mainly to the tune of central bank decisions (Chapter II). Volatility in equity, fixed income and foreign exchange markets has sagged to historical lows. Obviously, market participants are pricing in hardly any risks. … Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.
… Despite the euphoria in financial markets, investment remains weak. Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions. And despite lacklustre long-term growth prospects, debt continues to rise. There is even talk of secular stagnation.
… As history reminds us, there is little appetite for taking the long-term view. Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms. Or to address balance sheet problems head-on during a bust when seemingly easier policies are on offer. The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end. The road ahead may be a long one. All the more reason, then, to start the journey sooner rather than later.
BIS Quarterly Review, 14 September 2014
By fostering risk-taking and the search for yield, accommodative monetary policies thus continued to support elevated asset price valuations and exceptionally subdued volatility.
… There are also signs that investor confidence in the continuation of low volatility and ample funding at low rates has encouraged market participants to take increasingly speculative positions on volatility in derivatives markets.
Excerpts from the latest warning
“Asset Bubbles: Re-thinking Policy for the Age of Asset Management“, Bradley Jones, BIS, 11 February 2015.
Summary
… In distilling a vast literature spanning the rational — irrational divide, this paper offers reflections on why asset bubbles continue to threaten economic stability despite financial markets becoming more informationally-efficient, more complete, and more heavily influenced by sophisticated (i.e. presumably rational) institutional investors. Candidate explanations for bubble persistence — such as limits to learning, frictional limits to arbitrage, and behavioral errors — seem unsatisfactory as they are inconsistent with the aforementioned trends impacting global capital markets.
In lieu of the short-term nature of the asset owner-manager relationship, and the momentum bias inherent in financial benchmarks, I argue that the business risk of asset managers acts as strong motivation for institutional herding and ‘rational bubble-riding.’ Two key policy implications follow. First, procyclicality could intensify as institutional assets under management continue to grow. Second, remedial policies should extend beyond the standard suite of macroprudential and monetary measures to include time-invariant policies targeted at the cause (not just symptom) of the problem. …
Introduction
… The transmission mechanism between asset markets and the economy is generally well understood. Asset booms that compress risk premiums to abnormally low levels can lead to a misallocation of resources; induce excessive consumption, investment and debt accumulation; distort derivative markets commonly used to manage risk; and give an impression of false health for private and public sector balance sheets.
As boom gives way to bust, the ensuing chain reaction can include: a negative wealth effect (stemming from a hit to the balance sheet and confidence of households and firms) which results in sharply reduced aggregate demand; a second round credit crunch, as banks respond to the decline in the value of collateral held on their balance sheet by tightening lending standards; and possibly sovereign-banking sector contagion, where the health of the sovereign balance sheet is impaired due to a collapse in tax revenues and bank recapitalization costs, with feedback effects for banks which are exposed to sovereigns in their asset holdings and as their funding costs derive from the sovereign borrowing rate.
In extreme cases, severe asset price busts can also give rise to longer-term issues of intertemporal equity as future taxpayers become liable for ‘crimes they did not commit.’ More generally, the global financial crisis demonstrated that the adverse effects of financial disruptions on economic activity can be far worse than previously anticipated; with 93 countries (and most advanced economies) recording outright declines in real GDP in 2009, globally synchronous busts are especially virulent.
… One of my central arguments is that the business risk of rapidly growing asset managers lends itself toward herding and ‘rational bubble-riding,’ and that even in the absence of leverage, this industry will tend to contribute to procyclicality and financial instability. It should perhaps serve as a shot across the bow that the rise of the institutional investment management industry — populated with what are presumably the most sophisticated, well resourced and rational speculators in the world — has coincided with three of history’s largest bubbles in the last 25 years: the Japanese Heisei bubble of the late 1980s, the global equity bubble of the late 1990s, and the structured credit bubble of the mid 2000s. Because asset bubbles have continued to pose a threat to financial stability despite the increasing sophistication and institutionalization of financial markets, conventional explanations for bubbles — such as information shortages (‘limits to learning’) and incomplete markets (‘frictional limits to arbitrage’) — no longer seem a complete or useful guide. …
Conclusion
By process of deduction, this paper seeks to offer an explanation for why asset bubbles have posed — and will likely continue to do so — a threat to economic stability despite financial markets being characterized by more complete information, a greater array of securities through which to express views, and a more pronounced impact of sophisticated institutional investors, than ever before. The arguments advanced here suggest other candidate explanations for the persistence of bubbles, such as limits to learning, frictional limits to arbitrage, and behavioral errors, are unsatisfactory (by themselves at least) as they are inconsistent with the aforementioned trends sweeping across global capital markets.
By contrast, investment manager incentives, the nature of the principal-agent relationship, and the growing presence of institutional investors, are all entirely consistent with the persistence of financial bubbles. Importantly, this explanation does not require a baseline assumption of widespread irrationality in the conventional sense. Simply put, it can be entirely rational — from the perspective of business and compensation risk — for asset managers to knowingly ride bubbles because of benchmarking and the short-term performance appraisal periods often imposed on asset managers by asset owners.
For More Information
- Larry Summers gives us the bad news. Worse, the only solution is more of the same.
- The new tech bubble takes us to a new world. A mad world.
- A guide into the weird numbers that run our world, describing both financial bubbles & climate change.
- Lessons from WWI about “markets” ability to see the future. (spoiler: often they don’t).
- Let’s ignore another warning from the BIS. Do we enjoy paying for burst bubbles?
- How we’ve become accustomed to bubbles bursting the economy, instead of fighting them.
