Why the markets can't fix themselves - Part 1

The whole country is up in arms about corporate abuse and financial wrongdoing. Our outrage is coupled with amazement: How could it have happened? Yet we shouldn't be amazed. The excesses of the 1990s boom and the clamor for reform that has accompanied the current bust are in fact a recurring feature of financial markets. What is truly amazing is that after so many boom/bust cycles we still do not properly understand how financial markets operate.

The prevailing wisdom holds that markets tend toward equilibrium--i.e., a price at which willing buyers and sellers balance each other out. That may be true of the market in widgets, but it is emphatically not true of financial markets. In financial markets a balance is difficult to reach because financial markets do not deal with known quantities; they try to discount a future that is contingent on how they discount it at present. What happens in financial markets can affect the economic "fundamentals" that those markets are supposed to reflect--which is why recent years have produced such a dramatic and seemingly irrational stock market rise, followed by an equally dramatic and seemingly irrational fall. Instead of a one-way connection between supply and demand via market prices, there is a two-way connection: Market prices can also alter the conditions of supply and demand in a circular fashion. In my 1987 book The Alchemy of Finance, I called this two-way connection "reflexivity." And I think it better explains the current turmoil in financial markets than the more commonly accepted idea of equilibrium.

Due to this two-way connection, it is impossible to determine where the equilibrium lies. Participants have to anticipate a future that is not only unknown but unknowable. The theory of reflexivity does not offer a new way of determining the outcome; it holds that the outcome is impossible to determine. For instance, it was predictable that the Internet bubble would burst, but it was impossible to predict when. There is a decision fork at every point along the way, and the actual course is determined only as the decisions are taken. Such a view undermines the scientific pretensions of economists. Scientific theories are supposed to explain and predict. Accepting reflexivity requires acknowledging that social science in general and economics in particular cannot provide scientifically valid predictions. This is a paradigm shift that has not occurred.

But even if reflexivity cannot yield firm predictions, it does have considerable explanatory power. First, it explains how the bias prevailing in financial markets can be either self-reinforcing or self-defeating. To create a bubble, the prevailing bias must be first self-reinforcing until it becomes unsustainable and turns self-reinforcing in the opposite direction (and thus self-defeating). All boom/bust sequences follow this pattern. Second, by recognizing that financial decisions cannot be based on firm predictions of the outcome, reflexivity draws attention to the formative role misconceptions play in the development of boom/bust sequences. In the conglomerate boom of the 1960s, for instance, the misconception was that growth in earnings per share is equally valuable whether it is achieved by internal growth or acquisitions. I remember vividly how, after the conglomerate boom's collapse, the president of Ogden Corporation (to whom I had sold my brother's engineering business) told me at lunch that the company's earnings were falling apart because "I have no audience to play to"--with the stock price down, he could no longer use that stock to acquire companies and thus magically boost earnings.

We are now in a similar situation. During the recent boom, corporations used every device at their disposal to boost earnings to satisfy the ever-rising expectations that sustained ever-rising stock prices. Clever financial engineers invented ever-new devices--and when they ran out of legitimate ones, some corporations turned to illegitimate ones. When the market turned, some of these illegitimate practices were exposed. For instance, Enron, like many companies, used special purpose entities (SPEs) to keep debts off its balance sheets. But unlike many other companies, it used its own stock to guarantee the debt of its SPE. When its stock price fell, the scheme unraveled and Enron was pushed into bankruptcy, exposing a number of other financial misdeeds the company had committed. The Enron bankruptcy reinforced the downtrend in the stock market, which led to further bankruptcies and news of further corporate and individual misdeeds. Both this downtrend and the clamor for corrective action gathered momentum in a self-reinforcing fashion--just as reflexivity envisions.

There is nothing surprising about this course of events. It has happened many times before. The real surprise is that we are surprised. After all, many of the practices that are now condemned were carried on quite openly. Everybody knew that the best companies, such as General Electric and Microsoft, were massaging the numbers to maintain the appearance of a steady progression of earnings. Indeed, investors put a premium on management's ability to do just that. SPEs could be bought off the shelf, and investment banks maintained structured finance departments to provide custom-made designs. Tyco's management proudly proclaimed that they could generate earnings growth by acquiring companies, some of which could be moved offshore by virtue of Tyco's Bermuda incorporation, and investors put a high multiple on its earnings. Stock options were not only accepted but considered a useful device for boosting shareholders' values since they provided executive compensation without incurring any costs and encouraged management to focus on the stock price above all other considerations.

If there is a major difference between today's crisis and, say, the late '60s conglomerate boom--where investors also rewarded per-share-earnings growth without regard to how it was achieved--it is a difference of scope. The conglomerate boom involved only a segment of the stock market--the conglomerates and the companies they acquired--and a segment of the investing public, spearheaded by the so-called "go-go" funds. When the conglomerates began to threaten the overall financial establishment, that establishment closed ranks against them. By contrast, the '90s boom encompassed the entire corporate and investment community, and today's establishment, including today's political establishment, was fully complicit. Enron, WorldCom, and Arthur Andersen could not have gotten away with their nefarious activities without encouragement and active reinforcement from virtually all sectors of American society--their corporate peers, investment professionals, politicians, the media, and the public at large. Whereas the conglomerate boom ended because of resistance from the establishment, in this case the boom was allowed to run its course, and the search for corrective measures started only after the collapse. Even now, a pro-business administration is trying to downplay the damage. In looking for remedies, it is not enough to make an example of a few offenders. We are all implicated and must all reexamine our view of the world.

According to the theory of reflexivity, misconceptions or flawed ideas are generally responsible, at least in part, for most boom/bust sequences. Analyzing what went wrong in the '90s, we can identify two specific elements: a decline in professional standards and a dramatic rise in conflicts of interest. And both are really symptoms of the same broader problem: the glorification of financial gain irrespective of how it is achieved. The professions--lawyers, accountants, auditors, security analysts, corporate officers, and bankers--allowed the pursuit of profit to trump longstanding professional values. Security analysts promoted stocks to gain investment-banking business; bankers, lawyers, and auditors aided and abetted deceptive practices for the same reason. Similarly, conflicts of interest were ignored in the mad dash for profits. While only a small number of people committed acts that actually qualify as criminal, many more engaged in activities that in retrospect appear dubious and misleading. They did so thanks to reassuring legal opinions, Generally Accepted Accounting Principles (GAAP), and the comforting knowledge that everybody else was doing the same. When broad principles are minutely codified--as they are in the GAAP--the rules paradoxically become easier to evade. A whole industry was born, called structured finance, largely devoted to rule evasion. Once a financial innovation was successfully introduced it was eagerly imitated, and the limits of the acceptable were progressively pushed out by aggressive or unscrupulous practitioners. A process of natural selection was at work: Those who refused to be swayed were pushed to the sidelines; those leading the process could not see the danger signs because they were carried away by their own success and the reinforcement they received from others. As a source told The Financial Times, "They couldn't see the iceberg because they were standing on top of it."

Underlying this indiscriminate pursuit of financial success was a belief that the common interest is best served by allowing people to pursue their narrow self-interest. In the nineteenth century this was called "laissez-faire," but since most of its current adherents don't speak French, I have given it a more contemporary name: market fundamentalism. Market fundamentalism became dominant around 1980, when Ronald Reagan was elected president in the United States and shortly after Margaret Thatcher was chosen as prime minister in the United Kingdom. Its goal was to remove regulation and other forms of government intervention from the economy and to promote the free movement of capital and entrepreneurship both domestically and internationally. The globalization of financial markets was a market-fundamentalist project, and it made remarkable headway before its shortcomings were exposed.