It is customary to criticize speculation or rating agencies in explaining crises in the markets or market movements that are disconnected from fundamentals.
Certainly, it has often witnessed significant deviations of asset prices relative to fundamentals, with consequences often destabilizing for the economy : excess volatility of asset prices with some heritage impacts risks; excess volatility able to turn quickly the excess of debt in credit crisis. Three of the most intense crisis of the past 12 years speak for themselves.
- 1999-2000 We remember the share price of over-indebted telecoms company in 1999-2000 with the bursting bubble that followed;
- 2004-2006 We also remember subprime loans to US households over-indebted in 2004-2006 and structured products backed by these loans "rotten" as an outcome with an unprecedented crisis of securitization and impressive contagion effects.
- The end of 2009 Since the end of 2009, we are dealing with a different type of indebtedness, that of some sovereigns from the Euro zone and their insolvency since the growth led in the past by debt is no longer possible
It is often assumed that the markets have absurdly overvalued some financial assets prices and then accelerated the crisis when they realized the glaring disconnection between the economic reality and the valuation of financial assets in question. The buzzword today often used here and there to describe this phenomenon is the term self-fulfilling prophecies.
How can we simply define this phenomenon ? We say that this phenomenon is equivalent to the change from a brutal economic and financial equilibrium to another, not because the fundamentals of the macroeconomic environment would justify it, but because there was a change for good or bad reasons of market expectations. This move to a new equilibrium is therefore confirming de facto the changing expectations, which is why we talk about self-realization.
At this point, we see that things are more complicated that it seems for two types of reasons. First, some self-fulfilling prophecies are justified from a fundamental point of view (see the tech bubble in the early 2000s or the bursting of the subprime bubble of 2006). for the current crisis of sovereign subprime, our opinion is more nuanced and we will come back to this.
We review in this paper five examples of self-fulfilling prophecies in the financial markets in recent years, we observe if these crises would have occurred anyway without these prophecies (which is to justify the self-fulfilling prophecies in such cases). Otherwise, we present the mechanisms to implement to evade the attacks of the markets because in this case, they are wrong from a fundamental point of view
1. Capital flows to emerging countries
Capital flows to emerging countries were massive from 2005 to the summer 2008, and then the Lehman Brothers bankruptcy happened, leading to large withdrawals of capital and increasing risk aversion, investors looking for refuge investments such as the dollars, Swiss franc and Yen.
This phenomenon has significantly altered the macroeconomic situation of emerging countries, just because there was a change in perception of risk in emerging markets. So here, we were in the presence of self-realization of investors’ expectations.
This example is part of self-fulfilling prophecies, not justified by fundamentals and the best defense to counter the markets self-fulfilling expectations is to make sure that emerging countries are developing their savings surplus and reduce their vis-a-vis of foreign capital, highly volatile in the short term. We can say that is largely the case for the big emerging countries, as for the others the situation of dependence has absolutely nothing to do with the situation of 1990s: 1994 Mexican crisis, Asian and Russian crisis of 1997-1998.
2. The Banks solvency perceived by the markets
If the markets anticipate that states will not be ready to recapitalize banks if necessary (unlike what happened in the fall of 2008), then we will witness a real liquidity crisis preventing financial institutions to refinance their activities(no possibility of entering markets, closing of the interbank market, leakage of customer). this is self-fulfilling as banks stop lending and we are observing the real economy and the prices of many financial assets collapsing; that is also self-perpetuating the problem of bank solvency (assets write-downs and provisions hitting the equity).
As was seen during the stress tests carried out in July 2010, the latest ones published by the European Banking Authority on the 15th of July 2011 do not include a proper measure of market systemic risk. This hinders their (...)
the markets self-realizations here, are excessive as they are unable to discriminate between institutions and they underestimate the pooling arrangements and guarantees or state interventions. Although this last point the budgetary strike force available to government is no longer what it used to be in 2008. As we wrote in the paper devoted to the bank stress-tests, "if we stress violently systemic risk, it creates self-realization and it can be counterproductive, but if we don’t, we completely lose credibility and the trust that we have been trying to save at all costs, will not be restored however. Establishing more credible stress assumes that we take into account the systemic dimension of market crises and that we also associate strong policy and institutional responses that will avoid any phenomenon of self-fulfilling prophecies".
3. Financial market liquidity
When investors think rightly or wrongly, that there will be no buyer for an asset, the natural reflex is primarily not to buy the asset (that is rational and cannot be objectionable from the standpoint investor). Consequently, the market for the asset in question becomes illiquid and prices fall, that was initially anticipated by investors.
Some markets have been exhibiting dysfunctions for nearly 4 years. The flight to liquidity and compliance with solvency requirements of banks and states with financial issues, have been - and still is - only ensured by non-conventional financing provisions and emergency (...)
What to do ? Here we are faced with a rational self-fulfilling prophecy and financially optimal. We can limit this type of self-realization only with a better development of accounting and prudential rules.
It is the central bank or the regulator responsibility to limit the disruptive effects of change in assets prices on the economy. This assumes a counter-revolution in terms of accounting standards (probably IFRS backwards) with the renunciation of the mark to market for certain types of financial instruments and certain types of markets practitioners.
In the same vein, the assets actually made to be held for a long term investment should not be traded in continuous time ( we should think about other methods to display prices)
Otherwise, there are needs for genuine long-term investors such as buyers of last resort for securities "unfairly" discounted (we know it has always existed, and even more in times of stress, assets terribly undervalued for non-economic reasons: forced sales, mimetic, illiquidity, risk aversion, prudential rules, memory effects, historical correlation to distressed assets...)
4. The capital transfers on the foreign exchange market
We think about two types of situation
a/ the behavior of Japanese investors transferring funds at the end of the semesters tax in March and September tend to anticipate those periods of rise of the Yen against all currencies, which has a natural tendency to self-perform the Japanese currency appreciation; as well, the anticipation of funding needs to rebuild a country devastated by the tsunami of Mach 11, 2011 could suggest that there would be large repatriation of capital and therefore Yen purchases by Japanese institutional, this again validates the yen’s appreciation
There are at least four new structural risks to consider: regulation, Middle East, euro zone’s crisis, and again the idea of a change in growth model of emerging countries.
b/ As long as many emerging countries and oil exporters peg their currency to the dollar and other emerging countries want to avoid the appreciation of their exchange rate against the dollar, the central banks of these countries are bound to accumulate currencies reserves in dollars, then issuing their own currency for selling and buying the equivalent of securities denominated in dollars. When you follow a regular regularly the progression of the balance sheet from several central banks in Asia, you end up having a better view of certain trends in exchange rates parity and US government10 years rates than if you were focused on fundamentals.
What would happen if we anticipated that the central banks in many emerging countries decide to change their foreign exchange model (breaking the link with the dollar and/or economic model based on domestic consumption and no longer needs to fight against the currency appreciation)? well, that would probably lead to violent correction in the dollar’s decline against emerging currencies but also a considerable upward adjustment in US bonds yields.
In these two situations (Japanese savings, foreign exchange model for emerging countries) , we are dealing with self-fulfilling prophecies against which we cannot do much since they answer to anticipated capital flows justified by economic policy choices or changes in behavior (central banks, institutions...)
5. News from the sovereign debt crisis
This is where the recent case with rating agencies resurfaces. Consider the possibility of a sovereign default in the Euro area, even if the devices EFSF-IMF-EU allow to remove the short term risk is necessary self-fulfilling with the rise in interest rates it causes.
Back on bailout plans granted to countries in the Euro zone encountering severe fiscal deficits since May 2010. How are tens of billions Euros raised, what are they for, and mainly, are those amounts enough to re-establish the public finances and stabilize those countries (...)
Even today thanks to support plans , Ireland, Portugal and Greece who have no regular access to markets can finance their activities at subsidized rates for the time making the debt sustainable.
We remember the EMS crisis of 1992-1993 (at the time, I was managing large interest derivatives positions in Francs) and the market beliefs in the inability of some countries to maintain a peg between their currencies and the Mark. This anticipation has become self-fulfilling with the following sequence: a decline of the national currency against the mark, rising interest rates to protect it and economically unsustainable; leading many countries to leave the EMS in 1992-1993 : Great Britain, Italy, Spain and Portugal and leading to reform the EMS in July 1993 with margins fluctuations between the currencies of the system in the order of +/- 2.25 to +/- 15%
How to avoid self-realization in the sovereign debt crisis today?
We need to establish a true system to supervise fiscal policies (Maastricht should have been used for this instead of dogmatically focusing on convergence criteria, only quantitative)
We should also consolidate what has been set up since May 2010 with the creation of the EFSF (European Financial Stability Fund) and assistive devices for the countries and actors facing a liquidity crisis, when it comes to a real liquidity crisis.
By cons, if we are dealing with a solvency crisis (which is often the case), if there is a self-fulfilling prophecy or not, we are unable to prevent anything because the problem is structural. It is then necessary to implement strong structural solutions and I see only 4 with different probabilities of occurrence
- Policies to enhance potential growth(long-term solutions)
- Establishment of a true fiscal federalism with the pooling of national debts and the establishment of program listings of Eurobonds (politically difficult for Germany especially)
- Debt restructuring or partial defects (trying to avoid systemic risks and drawing on successful examples in emerging countries since 1998: Russia, Argentina, Uruguay, Ecuador)
- Temporary exit - with the risk that the temporary drag on - from the Euro zone for some countries : devaluation of the new national currency, inflation tax to reduce the debt (electorally rewarding but economically suicidal)
