There will be an­other cri­sis. It’s a ques­tion of when

The Pak Banker - - OPINION - Ben Wright

FI­NAN­CIAL bub­bles are in­evitable and their patholo­gies vir­tu­ally iden­ti­cal. The only vari­able is tim­ing. This is why fi­nan­cial crises ap­pear so ob­vi­ous in hind­sight yet re­main frus­trat­ingly dif­fi­cult to pre­dict. A few years ago, the hedge fund Win­ton Cap­i­tal pro­duced a hand­some and richly-il­lus­trated book called The Pit and the Pen­du­lum, chron­i­cling many, but by no means all, of the fi­nan­cial crises through­out his­tory. Win­ton makes its money by us­ing so­phis­ti­cated math­e­mat­i­cal mod­els to de­tect when as­sets are mis­priced. It shouldn't work, ac­cord­ing to the ef­fi­cient mar­ket hy­poth­e­sis, which posits that cur­rent prices fully and ac­cu­rately re­flect all avail­able in­for­ma­tion.

But David Harding, the founder and chief ex­ec­u­tive of Win­ton Cap­i­tal, thinks the hy­poth­e­sis is bunkum. He re­cently told a con­fer­ence that if mar­kets are ef­fi­cient, he must be ei­ther "a lucky mon­key or a fraud­ster", adding that "nei­ther of those char­ac­ter­i­sa­tions ap­peals". Mar­kets are, Harding ar­gues, hu­man con­structs. As such, they are prey to ev­ery hu­man foible. His com­pre­hen­sive chron­i­cle of spec­u­la­tive ma­nia and pan­ics was meant to ham­mer home the point.

The book in­cludes well-known bub­bles, such as the tulip ma­nia that gripped 17th cen­tury Hol­land, and the boom in US sub­prime lend­ing which re­sulted in the 2008 fi­nan­cial cri­sis. Along the way, it ven­tures from the wilds of Qa­jar Per­sia to the bazaars of Con­stantino­ple, and high­lights lit­tle-known bub­bles such as the Ja­panese rab­bit ma­nia of 1873, dur­ing which fluffy bun­nies im­ported from Europe could fetch up to ¥600, at a time when the av­er­age monthly salary was about ¥0.6. (Ap­par­ently those with yel­low ears were par­tic­u­larly highly prized.)

The same thing hap­pened with div­ing pa­tents in the 17th cen­tury (which were sup­pos­edly go­ing to be used to sal­vage sunken Span­ish gold in the Caribbean); Brazil­ian rubber in the 18th cen­tury; and Span­ish merino sheep, mul­berry trees and Bri­tish rail­way se­cu­ri­ties in the 19th cen­tury. And so on and so on: his­tory stuck on re­peat.

Such fi­nan­cial crises tend to oc­cur ev­ery two to three years on av­er­age, ac­cord­ing to Danske Bank, which help­fully points out that the last one, the Euro­pean sov­er­eign debt cri­sis, ended more than three years ago. The pat­tern is al­ways the same. Cheap money floods the fi­nan­cial sys­tem. In 19th cen­tury Ja­pan it was com­pen­sa­tion pay­ments made to Samu­rai who were dis­banded in the wake of the Meiji Rev­o­lu­tion. Since 2008 it has the been the 637 in­di­vid­ual in­ter­est rate cuts per­pe­trated by global cen­tral banks and their com­bined pur­chase of more than $12 tril­lion in as­sets, ac­cord­ing to Bank of Amer­ica Mer­rill Lynch.

That money flows into the less risky as­sets and pushes their yield (which moves in­versely to price) down. In­vestors get greedy and start search­ing for higher yields among riskier as­sets. They also start bor­row­ing money to make th­ese in­vest­ments. This drags in the banks. Lev­er­age builds up. Bub­bles start to in­flate. So where might this cur­rently be hap­pen­ing? Where to be­gin? Emerg­ing mar­ket debt is a good can­di­date, as are US high-yield bonds. The Chi­nese con­struc­tion bub­ble has ar­guably al­ready burst and dragged global com­mod­ity prices down. But we have still got Lon­don house prices, govern­ment bonds, and en­ergy com­pa­nies (es­pe­cially US shale pro­duc­ers), to name but a few frothy as­sets. At some point, money will be­come less cheap and the process will go into re­verse. This is why the fi­nan­cial world is hang­ing on ev­ery word that the chair­man of the US Fed­eral Re­serve, Janet Yellen, ut­ters. It is also the rea­son be­hind the cur­rent ob­ses­sion with the ef­fi­cacy of neg­a­tive in­ter­est rates in cer­tain parts of the world.

In Den­mark and Switzer­land, banks have to pay to place money on de­posit with their cen­tral banks. Some are pass­ing this on to cus­tomers by, for ex­am­ple, in­creas­ing mort­gage rates. And why is that im­por­tant? It means that cen­tral bank mon­e­tary pol­icy de­ci­sions that have been de­signed to stim­u­late the econ­omy are ac­tu­ally re­sult­ing in a tight­en­ing of credit. This is, need­less to say, far from ideal. It could be among the first, faint signs that the world's cen­tral banks are run­ning out of room for ma­noeu­vre. Are we close to the cru­cial point in ev­ery cri­sis - some­times known as the Min­sky mo­ment - when over­con­fi­dence flips into fear? This is what causes mar­kets to crash, banks to start with­draw­ing credit and economies to plunge into re­ces­sion. (The Ja­panese au­thor­i­ties burst the bunny bub­ble by im­pos­ing a "rab­bit" tax: prices slumped and des­ti­tute Samu­rai ended up eat­ing their port­fo­lios.)

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