Since the middle of the 1990s the US stock exchange has played a pivotal role in the expansion of the world economy. With Europe stagnating until recently and Japan stagnating still, the American economy has been the OECD’s locomotive. The long US boom, dissected by Robert Pollin (NLR 3), has been underpinned by very rapid growth of household consumption. Rising share prices have allowed the well-off to increase their spending by realizing capital gains or borrowing against them. If the stock market continues rising, then capital gains will continue flowing, consumption will remain buoyant and the growth of the US economy will be limited only by the growth of its productive capacity. If the stock market stops rising (as it has in recent months) American economic growth will slow and a ‘soft landing’ to a more moderate growth path is possible. But if the stock market falls to much lower levels, it would precipitate a severe recession. Spending would drop as households rushed to repay borrowings and build up depleted savings, just as happened in many countries at the end of the 1980s, when consumption booms based on credit collapsed spectacularly. The upsurge in US corporate investment would falter. The government’s budget surplus would disappear as tax revenues declined. The dollar would plummet as investors sought safer havens elsewhere—vainly, as bourses abroad would fall in sympathy. The medium-term perspectives for the world economy literally rest on the Dow Jones index.
‘Irrational exuberance’ was how Alan Greenspan characterized the rising stock market at the end of 1996. Robert Shiller, the Yale economist who testified before the Federal Reserve Board just prior to Greenspan’s speech, and so has some claims on the notorious phrase, has written an accessible, interesting and worried book aimed at probing the exuberance and justifying its label as irrational. It is easy to demonstrate that stock prices are at unprecedented levels. Shiller shows that the US stock market is valued more highly than ever before, including 1929, in relation to the trend in corporate profits which it is supposed to reflect. But has the rise in the stock market been irrational? The orthodox view today is ‘Efficient Markets Theory’ (EMT). This disputes that the valuation of shares or indeed any financial asset (including currencies like sterling) could ever be ‘irrational’. Shiller has been in the forefront of those questioning this view, along the lines of the critique of speculative processes in financial markets sharply outlined by Keynes (who, amazingly, does not rate a mention in Shiller’s index).
The rationality of financial markets is the key premise of the worldwide drive towards financial deregulation. By pricing all investment opportunities according to their underlying worth, and parcelling out risks to those most willing and able to bear them, capital is allocated to wherever it can be most productive and profitable; any interference with this process reduces economic efficiency and therefore GDP. Such is the theory.
Shiller discusses the ideas behind Efficient Markets Theory rather briefly, being more concerned with showing how implausible it is empirically. The fundamental arguments behind EMT, on the other hand, are set out with great clarity in the first chapter of Inefficient Markets, written by Andrei Shleifer, a finance specialist at Harvard ill-famed for his role in Russian privatization schemes. According to Shleifer, the EMT rests on three arguments which require progressively weaker assumptions. In its simplest form, investors are assumed to be rational and hence to value securities rationally—in other words, they assess the likely future returns to the investment, making appropriate allowance for risk. ‘When investors learn something about fundamental values of securities, they quickly respond to the new information by bidding up prices when the news is good and bidding them down when the news is bad. As a consequence, security prices incorporate all the available information almost immediately.’ Even if many investors are not rational (in this sense of making informed calculations), their trades will tend to cancel each other out, leaving asset prices close to fundamental values. Finally, to the extent that investors are irrational in similar and not offsetting ways (they all read the same horoscopes when making their investments), they will be met in the market by rational arbitrageurs who eliminate their influence on prices. This function of ‘arbitrage’, originally emphasized by Milton Friedman in 1953, is the key link in the chain. Shleifer explains: ‘Suppose that some security, say a stock, becomes overpriced in the market relative to its fundamental value as a result of correlated purchases by unsophisticated or irrational investors. The security now represents a bad buy . . . Noticing this overpricing, smart investors, or arbitrageurs, would sell or even sell short [selling an asset you’ve borrowed rather than bought] this expensive security and simultaneously purchase other “essentially similar” securities to hedge their risks.’ In effect, such agents are buying cheap and selling dear—the age-old way of making a quick buck. The effect of such selling by arbitrageurs is to bring the price of an overpriced security down towards its fundamental value. Even if their percentage return is rather small, the overall profit can be magnified by making huge trades financed by borrowing. The irrational investors on average make lower returns (by buying overpriced and selling underpriced securities) than the smart arbitrageurs and are therefore weeded out by a kind of natural selection. After conceding that ‘it is hard not to be impressed with the full range and power of the theoretical arguments for efficient markets’, Shleifer then devotes the rest of his book to developing formal models capable of showing how apparently irrational sentiment builds up (for example, as investors extrapolate past increases in stock prices into the future), and how under these circumstances arbitrage may no longer act to anchor asset prices to underlying values.
During the 1980s and 1990s the volume and sophistication of arbitrage operations increased apace, aided by increasingly complicated formulae for assessing risk, developed by financial specialists in the universities. So confident was the hedge fund Long-Term Capital Management that its ‘money machines’ (as its complex trades were called) could insulate it from risk that it paid back $2 billion of its capital less than a year before it collapsed. This left its borrowing at nearly $30 billion for each billion of capital subscribed by its investors. LTCM’s fatal mistake was that its deals still left its operation highly vulnerable to unlikely outcomes. Its fund managers might be both buying and selling assets that were ‘essentially similar’, but extreme circumstances—like Russian debt default in August 1998—could reveal that essentially similar was not similar enough. As Shleifer explains, the quite unanticipated combination of a default on Russia’s ruble-denominated debt, non-default on its dollar debt and a moratorium on dollar payments by Russian banks destroyed LTCM’s cunningly contrived hedges. This was one of a number of trades that went disastrously wrong and brought LTCM down. Nicholas Dunbar’s account of its demise in his recent book Inventing Money offers entertaining side-lights on the history of the Fund, one of whose founders, Nobel Prizewinner Robert Merton, told the Nobel Foundation: ‘It was deliciously intense and exciting to have been part of creating LTCM . . . The distinctive LTCM experience from the beginning to the present characterizes the theme of the productive interaction of finance theory and practice’. But its fall was no joke for investors at large. Testifying to Congress on the Federal Reserve-backed rescue of LTCM, Alan Greenspan declared that if its failure had ‘triggered the seizing up of markets’, this could have ‘impaired the economies of many nations, including our own’.
But if arbitrage cannot ensure that the relative values of individual assets are appropriately aligned, still less can it guarantee that the stock market as a whole is appropriately valued. For there are no other assets ‘essentially’, or even very closely, similar to the US stock market as a whole, on which arbitrageurs can hedge. So they are left making bets on what will happen just like other investors. But are their bets well judged? Is the present level of the Dow warranted by economic circumstances? The only plausible justification for it is that the ‘New Economy’ in the USA has boosted prospects for the growth of profits to unprecedented levels, and it is these much higher future profits that are being anticipated in share prices. Over recent years corporate profits have been lifted by a combination of some (fairly modest) acceleration of the underlying growth rate and a cyclical upswing which, as Robert Pollin argued, always has a disproportionate effect on profitability. For such increases in the rate of profit to continue into the indefinite future requires either a further strong acceleration in the underlying rate of growth of the economy, as the impact of new technologies widens, or a rise in the share of profits to quite unprecedented levels. The tightness of much of the US labour market makes the latter highly implausible. Shiller—who cites an estimate that even with 4 per cent growth of GDP, the profit share in 2010 would have to be twice as high as at any time since 1948 to generate the rise in profits necessary to justify the current level of share prices—is scathing about talk of a ‘New Era’, furnishing rich examples of similar pronouncements during earlier booms (in 1929 one justification for high stock prices was the soundness of judgement encouraged by Prohibition!). He suggests that implausible stories about the economic importance of the internet are more easily believed since the internet itself is so visible.
If developments in the real economy have not changed sufficiently to explain the equities boom, perhaps investors now value equities more highly because they have learned the true facts—that stocks always go back up after they go down, or that they must always outperform other investments like bonds? Shiller’s attack on such arguments is devastating: ‘when the facts are wrong, it can’t be called learning’. A large part of his book is an attempt to understand how the stock market has reached its present dizzy heights. He suggests that a range of precipitating factors, including the growth of mutual funds, the internet boom, capital gains tax changes, and even growing confidence in capitalism following the demise of Communism, have combined to push prices up. He stresses the tendency people have to extrapolate recent trends (in share prices, for example) and the role of the media in reiterating the significance of these trends. So when prices rise, investors pile in and the initial increase is amplified (Shleifer calls this ‘positive feedback trading’). Sophisticated arbitrageurs can then destabilize rather than stabilize prices because they anticipate this positive feedback trading and so exacerbate price movements. However sceptical such agents may be about long-run trends, it is better to pile in than hold back. Anybody who bet against the US stock market at the beginning of 1997, after Greenspan uttered his warning, would have lost 33.4 per cent that year before losing 28.6 per cent the next! Shleifer says the price of equities ‘can be just about anything’.