A casual investor enjoying strong returns from global asset markets, in other words pretty much everyone these days, would have been left fairly confused with the verbiage spewed by participants at the annual Davos jamboree, whose collective concerns might well have represented another planet entirely. A closer read of the different pontificators suggests that policymakers are simply unhappy at their reduced importance in the new global economy. Much like those of a jilted suitor, their complaints can be categorized under “sour grapes”, and this is in no way a reflection of the facial resemblance of some of the elderly speakers to raisins.
It is a matter of some concern to central bankers around the world that bond yields have simply not reacted much to the continued rise in inflation and economic growth. Even with oil prices rising for the past few years, economic growth has failed to taper off, particularly in the emerging economies of China and India. This is notable because these economies are energy-inefficient, that is, they use more energy per additional unit of output than the more advanced European and US economies. With prices going up, it would have been reasonable to expect that their demand for such energy would cool down, but that has not happened.
Western policymakers made two major mistakes in this assessment. First, the underlying assumption that economies have to generate a profit from every marginal unit of output is plainly wrong. This is especially so when the behavior of non-market economies like China is considered. The Communist Party needs to have economic growth to pull off the greatest development program in history. Thus while the next widget from the production line may not make a profit, the process of producing it allows the hiring of new workers from the countryside, building new factories and collecting taxes from all the activities. That allows the widget itself to make a loss, although as I noted in previous commentaries, someone eventually has to pay for those losses. [1, 2]
The second mistake that policymakers made was to look at market indicators in a closed system, ie, from the narrow textbook perspective so beloved of mediocre economists who invariably end up in government. In this case, the trade deficit of the United States and falling bond yields proved to be two sides of the same coin, as countries with trade surpluses with the US bought its debt obligations. That is the reason rising economic growth has not led to rising bond yields for the US, or indeed even Europe.
Herein lies the quandary for policymakers. Their actions in terms of moderating economic growth and related factors such as inflation are to a large extent offset by the ability of a larger group of investors simply to crowd them out. In other words, as long as investors keep buying securities, yields will remain low, even if the central banks continue to push up nominal interest rates. As I have written previously, this also represents a subsidy that exporting nations pay back to consumers. Think of it as like a bulk buyer’s discount at a sale.
Dinosaurs on display
For reasons as yet unclear to me, the World Economic Forum in Davos, Switzerland, appears to attract more than its fair share of such policy making dinosaurs. Rendered impotent in the face of significant changes to the market’s key variables, policy wonks are instead left frothing at the mouth, discussing vague notions of risks. The usual bromides about investors overpaying for assets is as old as the first central banking conference.
As central bankers, and indeed all politicians, see themselves as the solution to society’s ills, they have a neurotic need to worry. Indeed, it is this very habit that guarantees their jobs. Think about it: if central bankers walked around proclaiming that all markets were fairly priced and all banks well run, the most obvious follow-up question from the assembled public would be: Why then do we need you, chaps?
The point, of course, is that global economies do not really need central bankers, at least not in their current form. Markets have taken over their job by helping to price risk but, more important, in redistributing risk. The primary function of central bankers, which is to maintain a stable and functioning banking system, has thus been rendered obsolete because the very practices that lead to banks failing, such as the over-concentration of risk, have now been largely addressed by the markets.
Take as an example the savings-and-loan crisis in the US, which ensnared a number of larger banks and caused a systemic issue at the time mainly because these institutions were overexposed to certain categories of assets that declined sharply in price during the 1980s. Fast-forward 20 years or so, and it is difficult to find any particular asset class that is too tightly held by a single investor, or indeed even an investor group. The use of innovative financial instruments, such as derivatives and the adoption of transparent pricing techniques, has helped to move risks around the world.
This last point is important, and indeed the primary reason policymakers are increasingly useless. The marginal price of risk is set by the one who takes it, who now resides far away from the tentacles of the central bankers. Thus when a Chinese buyer purchases US risk, he in effect enters a “no man’s zone” between the central bankers of China and the US. As with all no man’s zones, the financial world has its own code of conduct, one that is far removed from the teak-stained halls that the mandarins of Washington or Beijing are used to.
If policymakers from Europe and North America came across as clueless dodos, representatives from Asia did not exactly set the forum on fire, either. In particular, I was disappointed by the performance of the unofficial representatives of both China and India.
China was represented by Zhu Min, a vice president of the Bank of China in Hong Kong. Adding to the platitudes on concerns with respect to the pricing of risk expressed by other panel members, Zhu said “overliquidity in the financial market is pretty tough today” and that despite rising rates, “nothing is happening on liquidity”.
These statements quietly miss the cause and effect of liquidity, which is the accumulation of deposits by Chinese banks as the central bank fails to widen its currency trading band in line with more flexible economic policies that are required.  But it was Zhu’s statement on derivatives that caught my attention: “Credit derivative products, structural [sic] products are everywhere. I’m really concerned because the money has to go somewhere.”
This notion, that derivatives are somehow evil because today’s geriatric bankers did not learn them at school, is simply astounding for someone of Zhu’s stature. His failure to understand the context of using derivatives, and their place in the portfolios of large banks, simply highlights entrenched ignorance. As an advertisement for the quality of China’s bankers, Zhu appeared to have fallen far short of the ideal.
India fared worse. It was represented by Montek Singh Ahluwalia, whose job description itself is a bit mysterious, but I will get to that in a moment. Continuing with the downbeat pattern of policymakers’ concerns on derivatives, he stated that “derivatives demand is a problem because people don’t have much experience of this”. That coming from a novice commercial banker is one thing, but to have a senior government official making silly sweeping statements in another entirely. His ignorance of derivatives and their utility in risk management clearly did not impress the audience, who were perhaps expecting a more appropriate candidate to showcase India’s burgeoning talent in the services sector.
Even more scandalous than his statement was his job description as the deputy chief of the country’s Planning Commission, doubtless a throwback to the good old socialist practices initiated by the likes of prime ministers Jawaharlal Nehru and Indira Gandhi. In this day and age of fluid globalization and efficient markets, why does India need a Planning Commission at all? As an indicator of a bloated bureaucracy that is completely out of touch with both global economic trends and its own people’s requirements for development, India couldn’t conceivably have made a worse choice.
1. The thief and the scorpion, Asia Times Online, January 13.
2. Indian, Chinese banks plunge at different rates, Asia Times Online, August 3, 2006.
3. China’s four-play , Asia Times Online, November 11, 2006.