Have Expectations Become the Real Drivers of the Economy?


Reading the daily media reports on the economy, one is struck by the fact that it is not “reality” which drives the economy, but rather “expectations”. Especially, the daily stock exchange news propose ever novel changes in “investor expectations”. It is ludicrous, how economics journalists invent new quasi-explanations every day on why a certain stock has gained or fallen, why one country’s aggregate stock market index or its sovereign bond spread has gone up or down. Individual events, be they economic, social or political, scandals, corruption convictions, or natural disasters – all purportedly drive the stock market, and – this is not my own reading, but that of journalists and analysts – the economy. Actual economic data, the growth rate, the unemployment rate, profit reports, banks failing, new businesses created, purchasing power developments, investments – all these take second place to expectations and events. If this is really true, the world has been turned upside down.

This is not to deny that expectations about future developments are important. Businesses make predictions about future demand for their products in order to be able to plan investments, consumers make plans which determine their savings/consumption decisions, etc. Rational expectations hypothesis invented in the 1960’s is based on the statistical relevance of economic actors’ expectations and has become a cornerstone of neo-classical economics. But what we see today, surpasses all these “rational” projections of the future at the expense of today’s situation.

It is primarily the preponderance of the financial over the real economy which is responsible for that. Trading in equity and bond markets is no longer based on the strength of a firm’s strategy, its market position, its long-term development plans, but on second-to-second differences of perceptions on this firm’s performance between different investors. Semantically, today an investor is not the manager or owner of a firm purchasing new plant and equipment or replacing obsolete ones, but a financial speculator who moves his money around the world in search of the highest return, exploiting “investment opportunities” generated by his/her deviations of perception from that of others (arbitrage). Where business firms for their financing are dependent on the “markets”, instead of their “house bank”, they need to humor the perceptions and assessments of myriads of financial investors, instead of convincing the credit officer of their bank to trust in their business model in the medium to long run.

In the bad, old days, at least in Continental Europe, credit was granted to firms, both for current expenditures and long/term investment on the basis of the soundness of their business model. Very short-term developments, especially negative ones (e.g. on account of a negative business cycle, or short-term loss of market share), were important for banks’ extending further credit, but as long as the medium to long-term prospects were convincing, credit was extended and the viability of the business enhanced. When most of the financing comes from the equity and bond markets, day-to-day, minute-to-minute, second-to-second assessments are being conducted by the financial markets, the second-to-second traders and their computerized models spitting out sell or buy recommendations by the second – the main task of business managers is no longer the long-term viability and profitability of their company, but the creation of a minute-by-minute positive mood/assessment by their investors. Myopia results, investment in R&D, in the long-term viability of the company are neglected to the benefit of dividend payments and the short-term gratification of the borrowers.

The flooding of the markets with liquidity by the National Banks during the recent crisis, the lowering of equity ratios, the deregulation of financial markets have reinforced this tendency. Too much money is floating around the globe, always in search of maximum profit. This is a perversion of the “market discipline” argument extended by financialization aficionados, a perversion of the efficient market hypothesis, a perversion of Adam Smith’s tenet about the positive signaling provided by the “invisible hand”. Short-term financial flows of massive magnitude destabilize economies. The recent outflow from emerging economies, after Fed President Ben Bernanke announced that “tapering”, i.e. reduction of the 85 billion $ a month asset-purchasing program might soon come to an end, speaks for itself. Is that how we all want the global economy to develop? If the answer is yes, this is very cynical, because the wellbeing of billions of emerging country citizens is sacrificed to the benefit of several thousand (rich) “investors”.

Financial markets undoubtedly play an important, and sometimes even positive, role for the global economy. Their market efficiency argument is based on the belief that the combined net perceptions of millions of investors are an important signal to the to-be-financed businesses. But when we look at the conflicts of interests of the reigning rating agencies, the power of large institutional investors, but even more to the actual reality of how stocks and bonds are traded, i.e. not by individual brokers who act on behalf of their customers, but by computer models which lead to herding behavior – then we realize that we have introduced a massive amount of volatility, irrationality and individual rent/seeking behavior into the most dominant, powerful and largest “market”.

To go forward and to put our economies’ financing on a more stable, more rational, less self-interested (i.e. profit-seeking) basis, some of the following steps are necessary:

  1. Excess liquidity and money supply of the global economy must be reduced. In times when national banks keep pumping more liquidity into the markets in order to stabilize the financial systems, this seems ludicrous. However, when we realize that most of the excess liquidity does not stimulate the real economy, but is invested in government bonds and other low-risk assets, we need to see the danger of this – by now – doubling of the balance sheets of national banks in Europe and the US. Just staring at inflation, is not enough. Equity and real estate bubbles are the dangers.
  2. Most of new money supply is not created by national banks, but by commercial banks. With leverage factors of 30 or 40, they have become the major money suppliers to the economy. These high ratios have the concomitant effect of requiring too low equity ratios, thus in case of default having to rely on taxpayers, rather than owners and depositors for rescue. Thus, in a “double-whammy”, an increase in the capitalization (equity) ratios of banks far beyond what Basel III requires them to do (4%, up to 8% for systemically relevant banks), to the order of 15% to 20%, would be in order.
  3. Financing government debt should be removed from the private financial markets. If the gap between social relevant government expenditures and taxation requires debt financing (at cost), it should be an equally socially accountable institutions which provides the relevant finance. In Europe, this could be the ECB, the ESM, or a new agency. Its task would be to regularly assess the economic and political strategy of all member countries, their tax and expenditure structures and sizes, their need for financing and – in case of request – provide financing, cheaply, but definitely at different costs from country to country, depending on these assessments. Very short-term events would also enter into these assessments, but medium- and long-term structural issues, influencing the countries’ developments, would predominate. Since this agency would have access to ECB money, it would have very low refinancing costs, would not have to make a profit (see Ackermann’s 25% minimum!!!???), would have to justify its lending decisions to the European Parliament, and thus would be much, much less subject to the day-to-day volatility of today’s sovereign bond assessments. This “public financing of public tasks” would be fashioned after the IMF’s short-term balance-of-payment loans. Whether it would require conditionality, like the IMF’s neo-classical based “structural adjustment” conditions, or rather based on a long-term assessment of the government economic strategy, should be decided in favor of the latter.
  4. In order to break the power of the financial markets and “reduce” them to their socially valuable function, capitalization issues, too-big-to-fail issues, separating commercial from investment banking, and many other reforms need to be enacted. For Europe, the full completion of the 4 pillars of the so-called Banking Union (Common Regulation, Single Supervision, Redemption (?) Fund, Single Deposit Insurance) is necessary. The introduction of a Financial Transactions Tax at global or European Level would be a “market” instrument in order to discourage excessive short-term financial flows, and thus could contribute to stabilizing our economies.
  5. Many banks have been nationalized during the actual crisis, but in not a single case has the new public owner used his/its ownership to get credit flowing to cash/strapped business, especially SME. It is high time that the public owner uses his ownership rights to direct managers to make it easier for business firms to obtain credit. The fear of finance ministries of “interfering into the actual business of the banks” is anachronistic and a derogation of the legitimate ownership rights of the public. The fact that this influence on the banks’ business model has not been used, shows once more the political clout which banks have on politicians. This is the tail wagging the dog.
  6. Europe so far has neglected to draw up a plan of how the European financial sector should look like 10 or 20 years from now. This severe flaw leads to each bank being “rescued” by its taxpayers, reinforcing the pernicious nexus between banks and their sovereign: banks hold most of their home countries’ bonds, thus being vulnerable to downgrading of their ratings, and having to be rescued by their taxpayers. This nexus needs to be broken, in favor of a European supervision and potentially rescue, assuring also more (personal, functional and geographic) distance between the banks and their supervisors.

Once the dominance of the financial sector over the economy is reduced, a more service-oriented approach towards financing the real economy by private financial markets and banks can take hold. This would also enhance the workings of the monetary transmission channels, thus making prudent monetary policies by the national banks, together with the fiscal authorities, more effective. The irrationality of having jobs, incomes, investments being run by “expectations” of financial markets participants, rather than by sober medium-term assessments of managers and workers in the businesses, would come to an end. This would not be the paradise, but would make room for assessments of business opportunities, labor market conditions, incomes and investment needs. This is not a reversal towards to “good old times”, but a move forward towards a more rational socio-economic model.

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Filed under Crisis Response, European Union, Financial Market Regulation

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