Authored by James Grant, originally posted Op-Ed via The FT [20],
The modern financial animal is wont to assume that he or she lives in an age of science. Just peruse the economic research that the great central banks produce. Even the titles of the papers are incomprehensible. Surely, the wit of man and woman has conquered the mysteries of money.
So much for appearances. The truth is we live in an age of pseudoscience. The central banks’ forecasting models have failed to predict the future. Quantitative easing and zero per cent interest rates — policy centrepieces of the post-2008 era — have failed to restore what we used to call prosperity.
Far from dealing in science, central bankers, and, to a degree, investment bankers and security analysts, employ magical thinking. What they have conquered is scepticism.
The tip-off of impending trouble in the Chinese stock market came on June 15, according to Ruchir Sharma, Morgan Stanley’s head of emerging markets, when Shanghai prices registered a 2 per cent loss. It was President Xi Jinping’s birthday, and so widely expected that the market would rally. China’s leaders had sponsored the past year’s share-price levitation; did they not therefore control it?
Half a world away, a different set of authorities has sponsored flyaway markets in property, stocks and bonds. The object of the sponsorship, near and far, is to boost aggregate demand by raising asset prices. Feeling richer, the asset-holding portion of the community is expected to act the part. Never mind that, by definition, the prices thereby raised are distorted. The more they rise, the more disconnected they become from the economic value to which they are supposedly tethered. Many a market, like many an exchange rate, is today an instrument of national policy.
Ten years ago, Greece sold 30-year bonds at a price that yielded 4.45 per cent, just a quarter percentage point higher than the prevailing yield on German debt of the same maturity. Spanish and Italian bonds were quoted at the time at yields identical to Germany’s. Even then, Greek finances resembled an unmade bed; Jean-Claude Trichet, then European Central Bank president, protested that Greek recalcitrance on meeting the requirements of the EU stability and growth pact stretched fiscal rules “to the limit”. Still, “convergence” was the cry, and bond prices obediently soared, without regard to the heterogeneous merits of issuing governments.
Lamentable, we may all agree. Prices should be discovered in the market, not administered by a government. Actually, we do not all so agree. In response to the incentives set before them, investors pursue the main chance. In the case of European sovereign debt, they continue to buy, more or less without regard to the underlying strength (or lack thereof) of debtor states. They buy because the ECB has pledged to buy.
The phenomenon goes further — much further. Be it the US Federal Reserve, the People’s Bank of China, the Bank of Japan or the ECB, central bankers’ first financial-markets objective is not the integrity of prices and exchange rates. It is rather crisis prevention — to keep the bouncing bond and stock market balls moving in their sanctioned orbits. (For an individual to fix Libor is a crime. For a central bank to suppress European bond yields is an act of financial statesmanship.)
You would think the value of those securities would ultimately be reconnected to the reality of future income. And you would be correct — “ultimately” being the operative word. “Income” is a term of art. Accountants, using generally accepted accounting principles (GAAP), tend to define it more conservatively. Managements of public companies and their Wall Street and City of London minions, seeking the appearance of greater profitability, tend to define it a little more generously.
A team led by Ben Whipple at the University of Georgia sifted through 130,000 earnings announcements US companies filed with the Securities and Exchange Commission in the 10 years till 2013. They found a persistent rise in unorthodox reporting. In 2003, 22 per cent of the filings featured “pro forma”, non-GAAP measures of financial performance. By 2013, 49 per cent did. Rising share prices create a demand for the earnings with which to rationalise them.
So it is that one kind of magical thinking begets another. The central bankers, putting the cart of bond and stock prices before the horse of enterprise, create artificial bull markets. Investors, not altogether unmindful of rising valuations, demand rising profits. These the companies strive to deliver, either according to GAAP or otherwise.
What is to be done? Why, restore the integrity of prices and of accounting conventions. Simple as that.
