The condition is easily diagnosed. Over the last half century, the rise of the investment industry has created overwhelming incentives for investors to follow one another into risks they often do not understand. As a result, world markets are hopelessly synchronized. This obstructs rational pricing and, in a capitalist world that relies on markets to set prices, endangers our prosperity. Finding a cure, however, is more difficult.
The financial disaster of 2007–2009 has not cured any of the underlying factors that led markets to become intertwined and overinflated. They may still not be addressed even if, as is possible, the world navigates the next few years without a second recession or a major new collapse in stocks, real estate, or other assets. If the twin planks of the recovery—China’s resurgence and the ability of big U.S. banks to “muddle through” with government help—stay in place, then the prospects for a recovery are good. But the stakes are higher now. Markets turned in 2009 because the United States put its credit rating on the line by borrowing furiously while extending guarantees to many private companies and securities that were in trouble. By setting the price of money, the U.S. Treasury market drives all others, and if bond investors decide that mountainous U.S. debt will lead to inflation or to default by Uncle Sam, yields will rise. The crisis of confidence in the debt of countries like Portugal and Greece shows what could happen. And in such circumstances, the U.S. Treasury will not be able to help because it will not be able to borrow more. Thus, the next asset price crash could be profoundly worse than the last one—and this makes the need to cure the underlying conditions that lead to crashes all the more urgent.
Some fixes are easy. The absurdly complicated instruments that created the subprime bubble, like synthetic collateralized debt obligations, should of course go. But the roots of the problem lie deeper. The institutionalization of investment cannot be reversed. Most of the financial innovations that created the synchronized bubble, like index funds, or even securitized mortgages, are in any case good ideas, so finding fixes will involve hard choices.
Making this harder, solutions must deal with human nature, our tendencies to suffer swings of emotion, to move in herds, and to expect that others will rescue us from the consequences of our actions. Over the last half century, the investing industry has unwittingly intensified those tendencies. Changing this requires a cultural shift; investors must have an incentive to treat others’ money as if it were their own.
Excerpted from The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How to Prevent them in the Future
by John Authers (FT Press).
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