It’s All About The Price

By Paul Warner, 7 December, 2017

This year has marked three anniversaries. The first was the 100 year anniversary of the Russian Revolution. The second was the 30 year anniversary of the 1987 crash. The third was the 10 year anniversary of the financial crisis. Not that many people would be celebrating these anniversaries. Even the Bolshevik Revolution of 1917 received little celebration in Russia. During the Soviet period the 7th of November was a public holiday, but now it is a normal working day. Some Communist party members still celebrate it privately, but there was nothing like the state celebrations of yesteryear.

The 1987 crash and the 2007 financial crisis would only have been celebrated by a limited number of people who benefited financially by being positioned to profit from the drops in the markets. Why are we linking these three events in this blog? The answer is that all three demonstrate flaws in human nature, which most economists would say don’t exist. These flaws link the three events together from a political as well as an economic perspective. These are very relevant today, especially in the UK, where the opposition party is very much of the old “communist/socialist” school.

The Russian Revolution was not itself a communist uprising, it was an insurrection by workers and soldiers, which overthrew the Provisional Government that was set up after the February 1917 revolution, which had led to the overthrow and abdication of Emperor Nicholas II. This was followed by a Civil War, which was won by the ‘Reds’. The simple premise of the Communist Soviet Empire was one of equality and ownership by all. In an ideal world the concept of fairness and equality sounds like utopia. Unfortunately, in order for it to work you have to put systems in place, especially if you’re talking about large numbers of people. This then leads on to centralised planning, which in turn leads on to putting people in charge. In a very short period of time you then have an elite who are controlling everything. At the same time it becomes perfectly clear that central planning becomes inefficient.

Enter into the argument, Friedrich von Hayek. The Austrian economist pointed out that socialism’s pretence to create equality, did so by “restraint and servitude”. He said that Socialism’s ‘humanitarian’ goals were hypocritical, because they could only continue by suppression. It requires a propaganda machine by which it persuades people that the state’s goals are theirs’. Once that fails it leads to brutal methods of suppression to maintain state control. We only have to look at Venezuela now, to see how prescient his views were. By the way, Hayek also pointed out that it was not just socialism that led down this route, so too did Fascism, in fact, any ‘ism’ that had centralised planning as a core part of their system. We are paraphrasing a lot of what Hayek said here.

Apart from the political inevitability of socialism the other thing that Hayek pointed out was that an economy needs flexible market prices. These provide more information than any central planning mechanism could hope to gather. If you think of all the moving parts within an economy, just think of the different sectors that are part of an economy, there is no way a central government would be able to be experts in all those fields. A good demonstration of this is when the state tries to cap the price of goods. It sounds a good idea to those that are buying those goods, but what you find is that the suppliers of these goods will no longer supply them. The empty supermarket shelves in former Soviet countries were a perfect demonstration of this effect. As soon as the state tries to affect prices, or the supply of goods, it inevitably leads to unintended consequences.

The other end of the spectrum from socialism is logically capitalism. The crash of 1987 has impinged deeply upon the memories of those working in the industry at that time, but it had little immediate economic impact. There were many articles written this year about what caused such a sharp drop in prices in such a short period of time. Whilst there were many reasons why things unwound so quickly, the main cause of the falls were that prices had risen too quickly, and were therefore expensive. If you look at a graph of the main indices of the day, many merely returned to where they were earlier in the year. Remember also that it was share prices that were expensive. Fixed interest had been falling in price through the year as yields rose, which was another reason why equities were beginning to feel the strain.

Arguably, the events of October 1987 lead towards the events of 2007, as it was probably the precursor of the ‘Greenspan put’. The thought that a central bank would come to the help of an ailing market introduced moral hazard into the market pricing mechanism. This was crystallised in 1998 when the US Fed came to the market’s help after the LTCM collapse.

That leads us on to the financial crisis of 2007. Here again prices had moved too high and had stopped reflecting proper value. In this case it was not just equities but property as well. Much of the blame for this crisis has been laid on the shoulders of evil bankers. The problem is that they were being rallied onwards, not only by markets themselves, but also by the politicians of the time. Remember Gordon Brown’s assertion that the times of economic boom and bust had gone. As he was happy knighting the incumbent bankers of the time, he was also wallowing in the economic growth that their lending was producing. However, as we found out subsequently this was all built on sand. What made it worse was that the lending of bankers enabled economic participants to bring forward their purchases of tomorrow to then. This is one of the main reasons that economic growth has been so anaemic since the crisis. Economic growth based purely on increased borrowing is an illusion. All it is doing is bringing forward tomorrow’s growth to today. We also had moral hazard here. Because of deposit guarantees made by governments, the banks had asymmetric risk.

The problem that we now have is that the reaction of central banks to the crisis in 2007 has in itself created false prices. By printing money that has not gone into the real economy, they have pushed the prices of nearly all assets up too high. In the case of property this has compounded the problems that non-holders of assets have. For example, in the UK, although prices fell after the financial crisis they in no way dropped back to the levels seen when Gordon Brown became Chancellor in 1997. According to FE, the Halifax Property Index rose 190% whilst Brown was Chancellor, and fell back just 22% in the two years to the bottom in 2009. This has increased the divide within society, which in turn has led to the rise of the left wing in the Labour party.

We are therefore at potentially a tipping point both economically and politically. Economically the world’s central bankers will have to start withdrawing their supply of new money to the markets and then start to withdraw that which they have already printed. The US Federal Reserve is already starting to withdraw its money. The European Central Bank have said they will stop buying assets next year. Some market participants think they may run out of bunds to buy by the time they get to their September deadline. The Bank of Japan has yet to indicate its plans to reduce buying assets. How long this process will take to normalise is anyone’s guess. As the Soviet Union demonstrated, the fallacies believed by humans can be perpetuated for a long time. The omnipotence of central banks is one such fallacy that is still believed. From a market perspective, the fear of a Corbyn led Labour government will not just impact the currency, as John McDonnell expects. Gilt yields would likely rise rapidly and the stock market would follow gilt prices downwards.

Overall these events demonstrate that capitalism has its faults as well as socialism. Whether today’s leaders can come up with any sort of viable combination of state intervention and capitalism seems unlikely. In fact, to be fair to capitalism (see blog Mis-Selling Capitalism) the intervention of governments, regulators, and central banks have produced unintended consequences, which have stopped capitalism from working as it should. At some stage market forces will reassert themselves, and as long as the aforementioned keep out of the way, capitalism and prosperity will return.