The recent financial crisis ended the Great Moderation and pushed the world economy into the worst downturn since the Great Depression. Market crashes, government bailouts, and the collapse of Wall Street colossi marked the period as one of unprecedented turmoil. In an effort to explain how we arrived at such a pass, Financial Times columnist John Authers examines the growth in prominence of the financial markets in The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How to Prevent Them in the Future, a big-picture view of some of the main events of the past few decades that contributed to this growth.
Back in the 1950s, Authers reminds us, the stock market was owned predominantly by people investing on their own behalf. At the time, the average investor did not have access to commodities, emerging markets, or foreign exchange. Then, as the Baby Boomers started to increase their savings, the profile of investment institutions began to grow. Fidelity launched the Magellan Fund, and John Bogle of Vanguard established the first index fund aimed at individual investors.
That era also witnessed the start of the usurpation of banks by money market funds, which were free of regulation and the expense of Federal Deposit Insurance Corporation fees. The consequent loss of deposits forced banks to seek out new—and often riskier—areas of business. Meanwhile, the postwar period of stability under the Bretton Woods Agreement ended when President Nixon withdrew the United States from the gold standard, which resulted in gold becoming the first bubble of the postwar era.
Other innovations included bond issuance by emerging markets (previously known, unflatteringly, as “less developed countries”) and the popularization of junk bonds, which were synonymous with Drexel Burnham Lambert’s Michael Milken. The seeds of future destruction were sown in 1984, when the Reagan administration allowed the securitization of mortgage-backed securities (MBSs). As Authers notes, the key ingredients of junk bonds and MBSs were now in place. All that was required was to combine them to create junk mortgage bonds, constructed on a base of subprime mortgages. Significantly, securitization separated risk from the initial lender and distributed it throughout the financial system.
The vast expansion of financial markets was also evident in other areas. Asset classes grew increasingly correlated as they came to be dominated by the same investors. The Glass–Steagall Act was repealed, and megamergers created banks that were to become “too big to fail.” Alan Greenspan, the chairman of the Federal Reserve Board, complained of “irrational exuberance” and then came to the banks’ rescue following the 1998 bailout of Long-Term Capital Management. The notorious “Greenspan put,” whereby speculators came to expect the Fed to step in and provide liquidity whenever stock prices fell, set the markets up for the greatest bubble of all time: the dot-com craze of the late 1990s. The bursting of that bubble brought hedge funds to the fore as they delivered solid performance from 2000 to 2002. A new bubble was needed to sop up the liquidity, and one was found in the rebranding of certain emerging markets as the BRIC countries (Brazil, Russia, India, and China). Commodities and credit default swaps (CDSs) also became hot areas for investing.
After the rise came the inevitable fall. Early 2007 brought the “Shanghai Surprise”: The sudden, sharp drop in Chinese stock prices marked the beginning of a tumultuous two years of severe strains in the money markets. In October 2008, all the markets crashed together, with the subprime crisis widely viewed as the cause. Once again, the U.S. government was forced to bail out certain financial institutions considered ineligible for failure by virtue of their size and global interconnectedness.
Authers sheds useful light on both the failure of diversification to provide the safety net ascribed to it by theory and the reasons that the BRIC countries did not decouple according to plan. Describing what he labels the “paradox of diversification,” he writes that “the more investors bought into assets on the assumption that they were not correlated, the more they tended to become correlated.” In addition, he helpfully recommends thinking of diversification in a new way: Investors should invest in assets not according to asset class or location but, rather, according to the risks to which they are prone.
With the markets once again receiving a helping hand from the Fed, another boom did not take long to arrive. This time, emerging markets led the charge, with some returning more than 100 percent in 2009, thanks in no small part to huge capital inflows. Rallies also occurred in foreign exchange, equities, credit, and commodities. Clearly, the markets had left the dark days of 2008 behind, and investors were all herding into the same investments once more.
Looking beyond 2010, Authers says that the markets are “hopelessly synchronized.” In a small twist, he not only sees the rise of the markets as fearful but also (apparently) welcomes the markets’ becoming even more fearful to investors—which, he hopes, will make the markets more efficient. Unfortunately, the conditions that brought about the fall are still menacingly in place.
Authers concludes by discussing ways to diminish the risk of repeated crises. His wish list includes minimizing moral hazard and letting entities fail when necessary. If companies are considered too big to fail, the solution should be either to make them smaller or to regulate them closely enough so that they do not fail. (The recently enacted Dodd–Frank legislation should help curb some of the investment banks’ risky activities and reduce trading in CDSs.) Authers further contends that the shadow banking system should be regulated as the banks are. Reforms are needed to ensure that loan originators retain a significant portion of risk as opposed to selling it. Finally, the compensation structure for investment fund managers must be changed to prevent herding, and new theories of diversification must be developed.
Well written in a nontechnical style, The Fearful Rise of Markets includes ample references. Authers divides the narrative into short, highly readable chapters, each containing both an abstract and a summary. The introduction contains a very useful timeline of important events.
In short, I would recommend this book to anyone interested in understanding how the financial markets came to play such an important role in our lives.