Economics get a dose of reality
taipeitimes.com
By Jeffrey D. Sachs
Almost every day, we learn of yet another greedy US corporate chief
executive who conspired with accountants, lawyers, and investment
bankers to defraud the investing public. But beyond the scandals, the
public should be more aware of the erratic nature of today's financial
markets. Exchange rates and stock market prices deviate enormously
from long-run fundamental values, which can cause major dislocations in
the real economy of jobs, production, and investment. And yet the
financial analysts that discuss these trends in the media have failed to
assess them realistically.
Take the case of the US dollar, whose value against the Euro is now
plummeting. From the mid-1990s until very recently, the dollar
strengthened sharply against European currencies. When the Euro was
introduced in January 1999, it traded at US$1.17. It then steadily lost
value, bottoming out at around US$0.83, before climbing back in recent
days to near-parity with the dollar.
For academic economists, the Euro's recent rise is no surprise. Currency
exchange rates have a tendency to return to long-run average values
following large deviations. Thus, the enormous strength of the dollar in
recent years implied an eventual reversal. That reversal is now underway.
Of course, if two economies have persistently different rates of inflation,
then the exchange rate between their currencies will not tend to return
to its historic level. But US and European inflation rates have been
roughly the same. It is also possible that the exchange rate will not return
to the long-run average if one economy is hit by a huge structural
change. But such changes occur less frequently than is often supposed or
alleged. The past, if interpreted with care, therefore remains a good guide
to the future.
Listening to the financial pundits, however, it often seems that history no
longer matters. When the dollar strengthened against the Euro after
1999, the investment analysts came up with one explanation after
another for why the trend would continue. They hailed the strength of
the US economy, bemoaned the alleged weaknesses of the European
economy, and claimed that the Euro was mismanaged. In short, they
over-interpreted short-term market movements, simplistically portraying
them as long-term trends.
Unfortunately, financial analysts are usually poorly trained in economics.
Their job is to say something clever for the television cameras. They do
not trade on fundamental information, but on the latest gossip and fads.
Of course, if such fads are common, and if they do not last forever, a
smart investor can profit handsomely from them, say, by selling the dollar
short in recent months.
Some investors do succeed at this, but it is tougher than it sounds. As the
great British economist John Maynard Keynes warned seventy-five years
ago, "markets can remain irrational longer than you can remain solvent."
In other words, even if you know that the dollar will eventually fall, you
could go bankrupt before you can prove your case if everyone else
continues betting that it will rise.
So it is often safer to run with the crowd, even if you think the crowd is
running in the wrong direction. For the same reason, Keynes famously
described the stock market as a beauty contest in which each judge
chooses not the most beautiful contestant according to his own views, but
rather the contestant that he believes will be chosen by the other judges!
Indeed, when US equity prices reached astronomical levels in the late
1990s, the pundits and investment bankers trotted out their silly
explanations and theories. We now know that some of those explanations
were deliberately fraudulent. Many brokerages sought to boost
investment banking fees from companies whose shares they pushed on
an unwitting public. But more generally, the pundits simply ran with the
crowd. As equity prices soared, they invented theories to justify the rise.
Deeper analysis would have told them instead that the rise would be
short-lived.
A few analysts got it right. Economist Robert Schiller of Yale explained
very clearly and at book length why US equity prices would fall. Leading
economic columnist Martin Wolf of the Financial Times distinguished
himself again by warning, stubbornly and correctly, that the US stock
market would eventually reverse to more normal historical levels.
But the real economic costs imposed by the crowd mentality have been
high. The excessive boom of the US stock market led to over-investment in
the US and a subsequent US recession when the bubble finally burst.
The strength of the dollar has similarly distorted investment decisions,
and the same kinds of exaggerated swings in exchange rates in emerging
markets have contributed to the boom-bust cycles in Asia and Latin
America in the past five years.
So what should be done? Clearly, the leading investment banks should
become much more serious about training and licensing their analysts to
provide knowledge rather than nonsense in their public pronouncements.
The responsible media should scrutinize economic trends critically,
rather than pandering to mass opinion. And academic economists should
be more steadfast in explaining how financial market prices reflect
fundamental economic values, even if this is not necessarily true in the
short term. Finally, tightened financial market regulation could perhaps
slow some of the hot-money flows that exaggerate the booms and busts.
Alas, Keynes stressed these same deficiencies long ago, so we should not
expect any miraculous changes in behavior now. Investor, beware!
Jeffrey D. Sachs is Galen L. Stone Professor of Economics and Director of
the Center for International Development at Harvard University.
taipeitimes.com Copyright: Project Syndicate |
