byBurhan Javaid
It has been well over two weeks since I gambled discussing this illustrious crisis, currently having its hands full of blood, sucked out of the two financial maestros, London and New York. The tale of these two financial power houses, is well known to the world. London, with its ideal strategic location has been a safe haven for global equity investors, for much of the last few decades, where as New York, has been a champion in alternative investments, fuelling fresh bubbles and battling its way out of stormy financial seasons.
This year has been a watershed, in what has been an otherwise, an exceptional saga of success. London as many global financial analysts hold, has lost its competitiveness as a major world city. Its equity losses are at an all time high. Its banks are bearing the pains of the crunch and have fully exposed the depths of their resilience. The investors confidence is at an all time low, and compounding with that is a huge nose dive in household confidence, as credit card spending has dropped many fold in the last year. Its Investment bankers are constantly eyeballing at their phone sets, linked with the human resource departments, fearing an exit. More than 11000 further job losses have been predicted by the city analysts, in the ensuing year, as Britain enters into its third quarter of sluggish growth, which is in tune, with the technical definition of a recession. All this and more has been the tragedy of London, or may I say the casualty of the credit crunch, especially in the wake of the famous Northern rock debacle, woes of which are still lurking in the docklands. Complementing all the financial seriousness, there have been strange market signals aswell.
Markets in London and New York, for much of the last few decades used the commodities index , mainly crude oil, as a major benchmark, to gauge the performance in the financials. There appeared to be a somewhat negative correlation between the commodity prices and the financials, or let’s just say, the upside in one was the downside in the other. Recent trends suggest that even though the fuel prices have rebounded, the financials have kept to their sluggishness, citing fears that a serious change in trends announce a financial weakening, never crossed the human eye, since the great depression. The markets are simply irresponsive. The US has been the mainstay of the crises, or the precipitator of it. The fact that it has the largest market for industrial imports, has enabled the crises to spread contagiously to rest of the world. US has ofcourse not been without its casualties, with Bear Stearns, a famous Wall street Investment bank, failing to put up a show, and got wiped out. UBS , the famous Swiss Investment bank, has laid off nearly 2,600 staff members, to hedge against a further risk of a downside on its balance sheet.
The stock market crash of 1929 followed by a disastrous economic and financial meltdown, in which seven hundred and fourty four banks went bust within a few weeks, must have produced shocking scenes. Nearly eighty years down the line, the world fears yet another financial meltdown, with a high probability of a serious knock on effect on the wider real economy, as both the EU and the US, have officially plunged into recession. The volatile capitalist world sinks once again, being in the grip of the recent credit crises, that has just wreaked havoc in the international financial system, by claiming the life of a giant Wall street superstar, “Lehman Brothers”. Adding to the woes has been the disappearance of another illustrious Investment bank. “Merill Lynch”. Two other Wall street superstars Morgan Stanley and Goldman Sachs are feeling the pinch aswell, as panic in the financials deepens by the day. This is history in the making, as Wall street banks badly need a reshape. Thousands of fresh job concerns are out on the street and the stock market scenes are reminiscent of the pre-1929 stock market crash, which is refreshing the memories of finance mongers around the world.What is going wrong? Will we see yet another great depression? With the world banking system collapsing like a pack of cards, and the adventourous Investment banking model being brought into question. I shall here make an attempt to see why the last century has been plagued with a series of financial crises and what lies at the root of the current mess. I am quite seriously struck with Soros’s theory of reflexivity, that contradicts the general belief that market fundamentals i.e financial markets tend towards equilibrium. Most of the crises in the markets, are quite possibly due to the self equilibrating notion of financial markets. This belief inturn, has its roots in what I call as the uncontrolled or unmonitored free market principle, of Laissez faire economics. The guideline principle of this belief are the dynamics of perfect competiton, that market participants have somewhat perfect knowledge about the market behaviour. Their buy and sell decisions are embedded in their perfect understanding of the demand and supply fundamentals, that drive the market valuations. It therefore appears that something must be wrong with the conceptions, investors or market players form in relation to market behaviour. These misconceptions yield uncertainty, that biggest hurdle of a successful equity investor. In Soros’ view the world has perhaps failed to understand the interplay between the cognitive function and the manipulative function, which inturn helps to explain the boom-bust cycle much better than the existing belief of a random walk expectations theory. The random walk theory, when applied to markets, talk about a mean reversion to normalcy or equilibrium with occasional random shifts in prices. This principle of free market capitalism is the root cause of the various periodic crises and the subprime credit crunch, as this inturn, weakens the hold of financial regulators on the system. The cognitive function attempts to view the world as it is, whereas the manipulative function attempts to view the world as it is and then influences it. The interplay between these two forces, yield uncertainty which completely contradicts the guiding principle of a self equilibrating free market capitalism. This in Soros’s view is known as the theory of reflexivity, which seems to be more efficient in explaining the mess we currently find ourselves into. This theory of reflexivity is also helpful in explaining the boom-bust cycle, that has not been explained fully by the prevailing intellectual order.We have certainly had periodic crises post great depression, like the international banking crises of the early 1980’s , the savings and the loan crises of the early 1990’s and the emerging market crises of 1997, but the current crises has gone several paces beyond in both its vastness and severity. It is certainly the second biggest financial meltdown post depression. Although, the banking system this time, I am hopeful, would not be allowed to collapse. Let us fit this theory of reflexivity in the present scheme of things. Soon after the abolition of the famous 1932 Glass Steagal act in 1999, the free market world returned to its true careless, carefree form. Boundaries between Commercial banks and Investment banks became somewhat blurred, as commercial banks started securitising loans, and founded structured investment vehicles to raise additional capital. This development was supplemented by the bursting of the internet bubble in 2000, and the September 2001 terrorist attacks, as the federal reserve had pushed the interest rates exceedingly low, to around one percent, which fueled a speculative bubble, as most bubbles are speculative, with real estate at the heart of their development. Credit expansion was rapid, and the rapidity of this expansion had stretched beyond the financial and mortgage sectors, and was affecting the real economy. One must also consider the role played by the rising emerging market players, like China, India and the Sovereign Wealth funds of the Gulf region, mainly Dubai and Abu dhabi, promoting huge capital inflows into the Western economies and heavily liquidating them. The role of the commodities boom, that backbone of the present Middle-eastern wealth fund industry, and the three most common trends in post depression crises are a must to mention.The three most common trends, or shall I say the hallmark of pseudo controlled free market system were a) The countercyclical policy response to the great depression, which are timely institutional interventions, which can and have supported the disease of moral hazard and asymmetric information in credit markets as a whole, b) The globalization of financial markets, which supports the privilege of free capital movement and c) Weak financial regulation and monitoring, in addition with the introduction of new synthetic financial instruments, as part of the financial innovation to have more sources of credit expansion.
Having said that, I have no doubts that after the recent dramatic turn of events at both the Docklands in London and the financial capital of the world across the Atlantic, London may not be the Rome of the present world, and the same goes for the its cousins on the Wall street. The notion of US sneezers ensnaring the rest of the world may not be credible any more.
(The writer is a Cambridge University Economist)
