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The high road or the low road
on 29 March 2010
The Trouble with Markets: Saving Capitalism From Itself,
Nicholas Brealey Publishing
Review by Richard Whelan
We are at a crossroads worldwide. One road requires a massive cleanout of old ideas and people, a new paradigm for our financial markets. We need a better understanding of economics and finance as well as a significant increase in consumption in Asia to lift us out of our current depression into a hopeful recovery phase.
But if we don't take the high road, the low road will take us back to the 1930s, generated out of a total collapse of confidence in democracy itself. It is a deep irony of the current economic/financial quagmire that the cheerleaders in Goldman Sachs, AIG, etc who brought the free market capitalist system to its knees, could turn into the "useless idiots" (to paraphrase Lenin) who in their denial of their role in these multiple failures, could deliver the coup de grace to the system itself. The growing chorus of those who think the current democratic system cannot solve these problems, and who point to the need for a "Chinese model", may be the first signpost on this lower road. If you think such an eventuality is inconceivable, impossible, or unlikely you really do need to read this book.
Bootle is one of the City of London's best-known economists and commentators having worked in or around the financial markets since 1978. He has challenged prevailing orthodoxy frequently, his 2003 book Money for Nothing correctly anticipating the current financial crisis.
He takes no prisoners in setting out how we got into the current mess: "The Great Implosion has laid bare several different kinds of failing. First, it has revealed just how fragile the financial system is. Second, it has demonstrated the markets' excessive risk-taking. Third, it has shown how bloated the financial sector has become. Fourth, it has exhibited a failure of the market with regard to the setting of executive remuneration in general, and pay in the financial sector in particular. Fifth, it has uncovered a deep-seated failure of the corporate system, arising from the separation between owners and managers..."
He is not afraid to point the finger at his own caste - not just the bankers, developers, or regulators - but the economists who he shows are ultimately responsible. Particularly those based in Chicago university (and influenced by the philosopher and novelist Ayn Rand) , they went out of their way to emasculate the lessons of Keynes and led the way in popularising worldwide the key underlying ideas and beliefs that got us into this mess: that markets are efficient and know best; that there is no need to be concerned at the level or structure of financial market remuneration; that bubbles cannot happen; that human beings behave rationally in economic and financial matters; and finally that excessive savings in Asia are not a problem.
The Madoff scandal is a prime example of the efficient markets theory in action. Supposedly sophisticated investment houses (HSBC, Santander, Bramdean, etc etc) got it totally wrong, assuming that someone else in the market had done the required due diligence (they hadn't), and/ or that they could follow the other sophisticated investors who invested with Madoff, and/or that if there was any issues the regulators would have picked it up. And so they charged huge fees for doing nothing.
We now face an extended period of weakness, a Depression, with the possibility of seriously damaging deflation, as the root cause, the underlying imbalances, still has not been sorted out. Simply put the West has been and is living beyond its means on borrowings from the East (particularly, but not exclusively, China).
But why did all this happen now?
Bootle attributes it to two key factors that were ignored -- the lessons of Keynes and the way human nature really works in economic and financial matters. Both are interlinked. The lessons of Keynes in three areas are now being relearned by most economists and unfortunately by the rest of us: economic activity is permeated by fundamental uncertainty; thus many of the major factors that hit the economy are psychological and depend critically on the level of confidence, which is not readily analyzable or predictable; consequently the modern economy is inherently unstable and fragile, particularly in a globalised world with instant communications of good and bad news.
This leads Bootle to a conclusion which is clearly correct, but only dimly being understood now by investors, members of pension schemes, and property owners. There is no determinate value for "real wealth". How wealthy a country is depends on its feelings and expectations. So far from being real, real wealth is in fact completely psychological: " Our wealth is simply what we collectively think it is. As such, it can go up and down with our whims and emotions-and it does." As he brilliantly puts it, is now well past the time when we should lay "Homo Economicus" to rest.
Noting Keynes famous aphorism that "the market can stay irrational for longer than you can stay solvent", Bootle shows how one can survive the downturn and prosper in the hoped for recovery. He quantifies the likely movements in house prices (for Ireland a fall of apparently something between 50% and 60%) with an eventual 15% temporary price drop below fair value. He clearly does not think a Nama- type solution will succeed - it breeds uncertainty and a lack of confidence, which inhibits recovery, leaving the taxpayer effectively holding the banks' liabilities but not fully sharing in the upside.
He predicts low interest rates for some time, notes the dangers of corporate bonds and the risks to indexed bonds, the attractiveness of equities (other than the US) longer term but possibly not now, with their performance fundamentally dependent on how the world and local economies develop (which is very uncertain).
He does not see commodities as a good bet for a number of reasons including his expectation of how China will develop, and possible restrictions on using commodities as a vehicle for investment.
Finally here his key moral is that minimising charges and costs on all investments is not some marginal extra but the sine qua non of successful investing. The other side of this cost issue is the investment industry which he sees as due for a shakeup, too many people earning too much money, and delivering poor service to their clients.
There is much else in this must- read book if you wish to understand our likely future.
(Richard Whelan is a commentator on international financial and political affairs