By Jeffrey Sachs *
Financial Gazette
July 4, 2002
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 75 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 United States 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 scrutinise 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 behaviour now. Investor, beware!
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