15.12.12
We argue that the present crisis and stalling economy continuing since 2007 are rooted in the delusionary belief in policies based on a "perpetual money machine" type of thinking. We document strong evidence that, since the early 1980s, consumption has been increasingly funded by smaller savings, booming financial profits, wealth extracted from house price appreciation and explosive debt. This is in stark contrast with the productivity-fueled growth that was seen in the 1950s and 1960s. This transition, starting in the early 1980s, was further supported by a climate of deregulation and a massive growth in financial derivatives designed to spread and diversify the risks globally. The result has been a succession of bubbles and crashes, including the worldwide stock market bubble and great crash of October 1987, the savings and loans crisis of the 1980s, the burst in 1991 of the enormous Japanese real estate and stock market bubbles, the emerging markets bubbles and crashes in 1994 and 1997, the LTCM crisis of 1998, the dotcom bubble bursting in 2000, the recent house price bubbles, the financialization bubble via special investment vehicles, the stock market bubble, the commodity and oil bubbles and the debt bubbles, all developing jointly and feeding on each other. Rather than still hoping that real wealth will come out of money creation, we need fundamentally new ways of thinking. In uncertain times, it is essential, more than ever, to think in scenarios: what can happen in the future, and, what would be the effect on your wealth and capital? How can you protect against adverse scenarios? We thus end by examining the question "what can we do?" from the macro level, discussing the fundamental issue of incentives and of constructing and predicting scenarios as well as developing investment insights.
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As such, the constitution of
the financial markets is fundamentally changed from an ensemble of individual networks to a closely linked network-of-networks configuration. Very recent research in network theory has shown that, when different networks become linked, the overall structure loses resilience. Indeed, due to diversification, there are less minor events but, due to the stronger coupling, there are more catastrophic events.
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Using models specifically designed to quantify the degree of endogeneity (called “reflexivity” by Georges Soros) in the markets, defined as the fraction of transactions that are triggered internally or are self-excited, like aftershocks of an earthquake, and that are not the result of some new external information, we recently quantified that this degree of reflexivity increased from 30% in the 1990s to at least 80% as
of today. This proves, in hard numbers, that markets increasingly live a life of their own, disconnected from the real economy, activated by machines and the algorithms that compete to trade in milliseconds, a process also facilitated by massive injections of liquidity and the low interest rate policy operating at a different time scale. As a consequence, the bubbles and crashes, that we have become accustomed to, now develop and evolve increasingly over time scales of seconds to minutes.
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We do not expect that the technological race will provide a stabilization effect, overall. This is mainly due to the crowding of adaptive strategies used by algorithmic agents, which exhibit pro-cyclical properties (for instance via a preference in socalled momentum trading) and a propensity to herd that is even larger than found in human beings. No level of technology can change this basic fact, which is widely documented for instance in artificial worlds populated by software-agents that simulate financial markets on computers. New algorithms that exploit the high volatility periods associated with distress and crashes are been vigorously developed.These are really worrying trends.
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