Published: April 8 2007 17:27 | Last updated: April 8 2007 17:27
The balance of winners and losers
Suppose for the sake of argument – it is not a prediction – that the financial markets were to fall heavily in the near future. The obvious culprit would be a US recession. But suppose the opposite – that the collapse had no external causes, but was simply the bursting of a bubble. What would that do to the real economy?
Not a lot, according to the prominent academic Willem Buiter. Movements in financial markets create winners and losers in equal measure. Subject to certain conditions – which we shall come to – even a market crash is a zero sum game.
As Professor Buiter is careful to emphasise, this does not mean financial markets are unimportant. They perform a vital economic service in allowing real assets to be efficiently allocated. But it is enough that they should exist. How they behave thereafter is irrelevant.
I have tried this proposition on a couple of fund managers and the response has been apoplectic. This is hardly surprising. As a fund manager, you are paid to make money. If you lose your shirt in the markets, it is small consolation that the cash entrusted to you has been nabbed by somebody else.
Inside and outside
But is that really what happens in a crash? Begin with a distinction Prof Buiter makes between “inside” and “outside” assets. The former simply involve a claim by one party on another. The classic case is derivatives, which really are a zero sum game. One player’s gain is another’s loss and the outcome has no more effect on the outside world than a horse race.
What about a collapse in the price of government bonds? It seems to me – Prof Buiter disagrees – that the effect rather depends on the cause. In the case of runaway inflation, as in the 1970s, wealth would simply be transferred from lender to borrower. Savers would be hit, but the taxpayer would benefit in equal measure because of the lower real cost of repaying the loan.
A more likely cause these days would be a rise in real interest rates from what seem unsustainably low levels.
In that case, investors holding the bonds to maturity – such as pension funds – would be no worse off. They would still get the deal they signed up to – the same annual income and the same lump sum at the end. But once those bonds were cashed in, the fund might then use part of the proceeds to buy new bonds. They would then be better off, since their cash would buy them a larger income stream.
For taxpayers, the reverse would be true. They would be unaffected for the life of existing bonds, but would then have to stump up more to replace them.
In the case of equities, the position is slightly different. Obviously, there is no final lump sum. The whole value of a share consists of its title to a future stream of income. So if you are never going to sell it, you are theoretically indifferent to what the price does.
In reality, of course, investors buy and sell equities all the time. If they did not, the markets would not do their job of establishing prices. But this can still be seen as a zero sum between buyer and seller. If I sell to you at a loss, you gain to an equal extent through securing the same income stream at a lower price. Or perhaps the share price has fallen because the income stream is impaired – that is, the company is in trouble. If so, bad luck. But there is still a matching winner – whoever sold you the share for more than it was worth in the first place.
Back to the real world
So far, so theoretical. But from the viewpoint of the whole economy, as Prof Buiter says, this all assumes the behaviour of winners and losers is symmetrical. If winners bury their winnings at the bottom of the garden, so much the worse for the economy. The same is true if – as is more likely – losers go bust.
Even that need not be a calamity. If a manufacturer goes under, a rival benefits by taking market share and perhaps by picking up assets cheap from the receiver. But if a big investment bank were to go bust there could be all kinds of behavioural effects, including a reduction in the propensity of borrowers to borrow and lenders to lend.
The other big real-world losers from a market crash, of course, would be pension funds. Under today’s accounting rules, a fall in the price of equities (though not of bonds) creates deficits. Companies are under various pressures, some of them regulatory, to make those deficits good. So far, there is no real evidence this has weakened their ability to invest in the business, but that plainly cannot be ruled out in future.
So we cannot afford to be complacent. But on the whole, it seems to me Prof Buiter’s argument stands. If the market dives because of a repricing of risk, the effects will with luck be contained. And conversely, if the US economy really does hit trouble, the market reaction could be the least of our problems.