Like alchemists on an eternal quest for a method for turning base metals into gold, the financial markets have proved susceptible to one dogma after another—with disastrous consequences.
One of the primary causes of the massive growth in the subprime market was the idea that if you took a well-diversified portfolio of sub-investment grade loans you could convert them into AAA securities. Some market professionals were even of the opinion that the level of risk reduction that could be achieved through diversification could effectively, with the aid of a few credit derivatives, immunize banks from any significant losses whatsoever.
While acknowledging that was the prevailing view, Alan Greenspan the former Fed Chairman had another perspective. In a column in the Financial Times of March 26, 2009 Greenspan stated:
“All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions”.
Clearly, Mr. Greenspan had been hiding under a rock as this was certainly not the first time that dogma had so spectacularly upended the financial markets. As a matter of fact, the prevalence of one dogma or another has been a feature of the financial markets over the past 40 years.
In the 1970s and 1980s, the LDCs (Lesser Developed Countries) took on huge amounts of debt after Walter Wriston, then CEO of Citibank, uttered the immortal words “countries don’t go bust”. That particular dogma exploded in 1982 when Mexico defaulted on its debt. Most of the rest of the developing world took note and followed Mexico into default.
The LDC debt crisis resulted in huge losses for banks and ruination for many LDC economies.
Later in the 1980s, market assumptions turned to Modigliani and Miller or MM Theory—the idea that the level of debt which a firm uses to finance itself is irrelevant. Michael Milken of Drexel played the Pied Piper on this one as corporations outdid each other to load up on high-yielding debt securities or junk bonds, in order to “unleash the value” within their organizations.
The market, and with it much of the economy, came to a shuddering halt when the high levels of expensive debt crippled the corporate world. It also cost banks and investors billions of dollars.
During the Japanese Asset Price Bubble of the late 1980s and early 1990s the Nikkei reached the dizzying heights of 40,000 and the value of real estate in Tokyo was worth more than the all the real estate in the United States. Property prices were so high that Japanese homebuyers had to start taking out 100 year mortgages.
The prevailing dogma of the period was that the markets were always right as they reflected the fact that Japan was on its way to taking over the world. Eventually of course, the Nikkei crashed, Japanese banks had to be bailed out or forced into mergers and property prices slumped.
Today, the Nikkei still lags below 10,000 and the Japanese economy has experienced two decades of virtual stagnation.
As things moved onto the turn of the 21st century a new dogma arose—and they all said that this time it would be different because the Internet was going to change everything. As long as you had a dotcom and with it your precious piece of cyberspace then you were on your way to untold riches. Banks made a lot of money on overpriced IPOs and the NASDAQ, which mainly consisted of technology stocks, exploded up to the 5,000 mark as everyone invested into this “new economy”.
Unfortunately, the new economy had the same bad habits as the old—meaning there was an inevitable downfall as the bubble burst and the markets crashed. Reality set in, investors and bankers lost billions on the overpriced technology stocks, and the NASDAQ dived. These days it still lingers around the 3,000 mark.
Another dogma was consigned to the dustbin of history.
Even after the disasters of the subprime crisis we still find ourselves beholden to destructive dogmas. To say that we have not learned how dogmas destroy values would be an understatement. Post the subprime crisis it appears that the Eurozone has been caught up in its own version of the now discredited dictum that countries don’t go bust. Apparently the countries in the Eurozone believed that defaults only happened to LDC countries.
However, the world is now witnessing an even bigger and perhaps potentially even more destructive dogma than that which has prevailed in Europe. That dogma has arisen in the form of an unshakeable belief that the rise of China is inexorable, unstoppable and undeniable.
There are two aspects of this, which in view of the history of financial and market dogmas, that should give everyone cause for contemplation and concern. The first is that observers / commentators are now saying that the value of real estate in Beijing is worth more than the value of real estate in all the US—the same thing they used to say about Tokyo at the time of Japan’s bubble economy.
The second is that China remains to a very large extent a centrally planned economy where the government plays by far the greatest role in terms of allocating resources and choosing industry winners. Yet, in the latter part of the 20th century this was ultimately considered a very bad thing even in Western Europe.
Many might not remember this but one of the very good things the EU did was greatly reduce the level of subsidies given to loss-making nationalized industries. This was part of the reason why countries such as France and Italy were forced into the privatization of more of their economies than their left-leaning politicians were initially willing to contemplate.
The EU took that course of action because subsidies by national governments on industries of choice were believed to distort competition, and were considered singularly unhelpful to the development of free and competitive markets.
In the long run, why would this prove any different for China?
Jonathan Ledwidge is the author of the book Clearing The Bull: The Financial Crisis and Why Banks Need a Human Transformation. Use this link to give your opinion on the performance of banks post the financial crisis.