Groundhog Day or a 'New Paradigm'?

‘Madness is doing the same thing over and over again and expecting a different result…’

The great physicist Albert Einstein is credited with the above quotation which is perhaps as apposite a starting point as any for the lemming –like conduct of the markets since first we started chronicling their behaviour. From Dutch tulips to South Sea Bubbles to buying on the margins in the 1920s, the history of the markets is an all too predictable narrative of dramatic crashes, punctuated by periods of fear, greed and denial.

But if we’re looking for market-appropriate aphorisms, perhaps we should also be looking to the Russian dissident Aleksandr Solzhenitsyn who warned us that if ‘we forget the past then we lose both eyes’.

In their recent publication Economists' Hubris - The Case Of Risk Management, Shahin Shojai, global head of strategic research at Capco and George Feiger, CEO of Contango Caoital Advisors, highlight that ‘madness’ and ‘blindness’ through their analysis of risk management in the run-up to the most recent crash (the one future historians will probably describe as the Great Depression of the 21st Century).

From the outset, the authors highlight the shortcomings of academics and practitioners in the field of risk management and financial engineering. “Financial economists have focused on things that they can ‘quantify’ rather than on things that actually matter”, is one of their more astute observations.

Their prognosis is not encouraging: “the tools that are currently at the disposal of the world's major global financial institutions are not adequate to help them prevent such crisis in the future and that the current structure of these institutions makes it literally impossible to avoid the kind of failures that we have witnessed”.

The authors highlight the CDO (collateralised debt obligations) markets as a key problem, and in particular, assign blame to those that rate them. The problem, as they see it, is that initial fallacy of believing “that complex financial assets, such as CDO's or other scrutinized assets, could be accurately valued using scientific methods.”

The hypothesis of the efficient market is also called into serious question. “The sad fact is that academic finance has failed in its efforts to even provide valuation models that can price simple assets, such as equities, with any degree of accuracy. Expecting these models to perform any better for highly complex instruments is nothing more than wishful thinking”.

So if we cannot reasonably expect an efficient of valuation of assets in the markets, it would appear that there is little hope of efficacious risk management. “For centuries, valuation bubbles funded by excess credit creation have occurred in all economies for which we have decent records. Why do investors not simply recognise these and ‘trade them away,’ as the efficient markets hypothesis would imply? It is not so easy, because while the bubbles are ‘obvious,’ when they will bust is not”.

This is the eternal game of chicken that the markets insist on playing and this is the endlessly replayed scenario that we are subjected as economists and traders tell us mathematical and technological advances have led us to a new paradigm.

Of course the term ‘paradigm shift’ has entered the derisory jargon of the markets by now and its credibility is frankly frayed.

The shortcomings of Value -at-Risk (VaR) is central to their arguments. “The reality of the situation is that VaR, and all other risk management methodologies, are relying on data that is backward looking, is incomplete, and fails to account for the important events that financial institutions really need to look out for”.

But VaR aside, there are major structural issues with the global financial system that make risk management a near impossibility. “Because of the silo structures many firms will find that they have assets that are highly correlated with other but sitting in different silos”. They finally conclude that “during the downturn the firm might find itself significantly more exposed than it thought and not as capitalized as necessary”.

So while Shojai and Feiger lay out the unappetising prospect of an economic ‘Groundhog day’ scenario, playing itself out endlessly, Richard Heinberg in his latest work The End of Growth: Adapting to Our New Economic Reality, posits that “economic growth as we have known it is over and done with”. This view is the glass-half empty perspective on paradigm shifts.

In the run-up to the Lehmans Brothers watershed, we were being told constantly by bullishly inept economists, bankers and politicians that we had broken free of the old boom and bust cycle. Apparently we have and Heinberg identifies the ‘new normal’ as stalled never-to-recover economic growth. He investigates likely future scenarios but also proposes various solutions – some of them radical and unfashionable.

Perhaps the most interesting of Heinberg’s proposed solutions to our current woes is a massive global negotiated default on debt. He characterises this as “modified debt jubilee where – similar to proposals to address the Greek debt crisis - all individuals debts and assets are immediately subject to a universal ‘haircut’. Moving the decimal point by one place sees savings (or pension pots) of £100,000 become £10,000; while debts (or mortgages) of £250,000 become £25,000.” He does admit that this radical “re-set” policy would be hugely “controversial, confounding… and painful”.

Heinberg believes that the “economy of the future will necessarily be steady-state, not requiring constant growth. It will be based on the use of renewable resources harvested at a slower rate than that of natural replenishment; and on that use of nonrenewable resources at declining rates, with metals minerals recycled and re-used wherever possible.”

He believes that there are three primary factors that stand firmly in the way of further economic growth. The first being the depletion of important resources including fossil fuels and minerals. Secondly. the proliferation of negative environmental impacts arising from both the extraction and use of resource and finally, “financial disruptions due to the inability of our existing monetary, banking, and investment systems to adjust to both resource scarcity and soaring environmental costs — and their inability to service the enormous piles of government and private debt that have been generated over the past couple of decades.”

He goes on to study many different cases in which the contracting availability of natural resources is creating uncertain futures for many rapidly expanding economies. China is the subject of many of these studies and he warns that “if growth sputters, this infrastructure overbuild will be a dead weight on the Chinese government”.

He continued; “the property bubble is likely to be China’s biggest short-term problem, and it could have knock-on effects on the nation’s banking systems. The bubble could start to deflate as soon as next year, or the year after that.”

Heinberg also tellingly considers the psychological approaches that we have developed towards consumption. He believes that we are addicted to shopping; “At this point, an “addicted” person is compelled to use the substance not to get high, but just to feel normal – since one’s own body is producing little or no endogenous dopamine response”.

Working from this psychological construct, he argues that “the solution to our growth-based problems involve some form of self-restraint.” But he believe that the depletion of natural resources will not be enough to prompt change; he thinks “revolution will be driven by crisis”.

Heinberg raises some hugely important issues and brings together a myriad of disciplines from economics, psychology, philosophy and geopolitics to arrive at his sobering new paradigm of low-growth. But is this necessarily uncharted territory? After all, a flat-lining world of consumer addicts, sabre-rattling regimes fighting over diminishing resources and spiralling debt doesn’t feel particularly new to this reviewer.

Perhaps we should conclude with another quotation, this time from the great Islamic historian of the medieval period Ibn Khaldun, who reminds us that the past resembles the future more than one drop of water resembles another.


This article was commissioned and written for Investment Week