Wed, Sep 05, 2001 page9

• Capital markets fail to impress with booms, busts and unreality

  Capital markets can work well, but four instances of hard luck have affected financial markets lately. Five reforms would take care of financial instability

  • By Jeffrey Sachs
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  A central argument for capitalism is that capital markets efficiently channel savings to the most profitable investments. Similarly, one argument for global capitalism is that global capital markets efficiently allocate savings from anywhere in the world to investments anywhere in the world. Yet the performance of global financial markets has been unimpressive in recent years, displaying booms, busts, and unrealistic pricing of stocks, bonds, and exchange rates.

  Capital markets work well if investors understand the future profit streams of alternative investments and then channel savings to the most promising of them.

  Legendary financier Warren Buffett carefully examined the long-term prospects of companies and chose correctly a high proportion of the time.

  Many other investors, however, target the short-term investments that they believe other investors will find promising instead of the best long-term prospects. With some luck, it can come to the same thing. But too often markets dance to fad and illusion, if not outright fraud.

  We have seen at least four kinds of mishaps recently.

  The first is panic, typified by the flight of investors from East Asia in 1997. Investors suddenly abandoned the region not because it was collapsing but because other investors were fleeing. Like an exit from a stadium that turns into a tragic stampede, financial panic resulted in the failure of many worthwhile investments when loans were recalled.

  The second kind of mishap is a bubble, such as that which brought down Japan in 1990 and the US's dotcoms last year. A bubble begins with some fundamental good news (such as Japan's manufacturing prowess in the 1980s or the US's Internet advances of the 1990s) that becomes exaggerated beyond recognition. Funds flow euphorically into favored sectors; for a time, asset prices soar. Early investors make a fortune, drawing other investors in. Eventually, the latecomers lose out, buying at top prices and then seeing their investments crumble.

  The third kind of mishap is moral hazard, when investors are indifferent to the fundamental profitability of an investment because they expect to be bailed out by the government or the International Monetary Fund (IMF) if something goes awry. In 1998, investors poured money into Russia not because of the underlying strength of that economy, but because of confidence that Washington would rescue them. Recently, investors held on to risky Argentine peso securities (albeit at astronomical interest rates) in the belief that the IMF would provide new emergency loans.

  The fourth kind of mishap occurs when investors lack a framework for evaluating the long-term value of an asset, such as a currency. Exchange rates, for example, are frequently influenced by empty policy announcements such as the US' much-discussed "strong dollar policy" -- a "policy" that isn't really backed by actions of the US government or the US Federal Reserve. Exchange rates can thus assume unrealistic values for long periods or change course overnight even if underlying conditions change little.

  Experience and economic theory tell us much about the long-term value of exchange rates. We know, say, that currency values tend to adjust in the long run to re-establish relative prices across major markets.

  If international capital flows to the US stock market bolster the dollar, rendering the prices of US products expensive relative to European products, the dollar will tend to weaken so as to re-establish the original relative prices. If investors remembered this, they would not bid up the dollar's value so sharply in the first place. They would sell dollar assets and buy euro assets whenever the dollar rose too far from its long-term value.

  For a few years, evidence has suggested that the dollar is too strong relative to the euro. Furthermore, the yen is too strong relative to both the dollar and euro, contributing to Japan's ongoing stagnation. The recent weakening of the dollar has been predictable and long overdue. But the continued strength of the yen is mystifying. With the Japanese economy in the doldrums, the yen should be much weaker, closer to ?140 to the dollar rather than ?120. But of late the yen has strengthened rather than weakened, a direction that is nearly inexplicable given the underlying conditions.

  Sadly, all of these financial mishaps are exacerbated by widespread lack of professionalism in the investment banking and stock-broking communities. Too many so-called analysts have no training in economics and finance and are basically salesmen rather than real analysts.

  They are accorded a measure of attention in the financial press disproportionate to their actual knowledge.

  Many cases of investment advice do not reflect an attempt to assess market trends but rather the commercial interests of their firms, which aim to sell the shares of their corporate clients.

  Despite the problems, market allocations of capital are superior to government allocations, which often compound ignorance with political considerations but we need not stand idly by as repeat victims of financial market instability.

  Five reforms would help:

  -- Financial market regulators should enforce stringent disclosure rules to prevent outright fraud, as well as booms and busts based on fads rather than data;

  -- Financial intermediaries such as banks should be regulated to ensure that they cannot gamble with their depositors' funds;

  -- The financial industry should adopt tougher codes of conduct to avoid conflicts of interest in financial advising;

  -- The financial industry should overhaul its training so that analysts understand the economics of the markets in which they operate;

  -- Most importantly, policymakers should stop catering to the whims of short-term investors and should impose regulations that favor long-term investor relationships rather than volatile short-term capital flows.

  Jeffrey D. Sachs is Galen L. Stone professor of economics, and director of the Center for International Development, Harvard University.

  Copyright: Project Syndicate
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