The God of Market Fundamentalism died in 2008.
The God that failed” was a book written by former believers in Marxism, about how Marxism, as practiced in the communist countries, was altogether different from what their belief held dear and valuable. Would future economic historians consider 2008 as the year in which the God of market fundamentalism failed? The issue has several dimensions — efficient markets and price volatility; nationalisation of enterprises; the need for regulation and intervention in the market; and, indeed, the ethical and religious issues involved. Will Keynes triumph over both the ideological extremes: Marxism on the one hand, and the doctrines preached by Milton Friedman, the Austrian School, etc. on the other? Or has he already?
Let us start with efficient markets and price volatility. Since 1957, when I joined a bank, I hardly re-call a time when prices of commodities and currencies were as volatile as they have been last year. To quote a few examples: copper has crashed from very close to $9,000 a tonne in July 2008 to less than $3000 a tonne by the end of the year; crude oil from $145 a barrel to less than $40 over the same period. Mid-year, Goldman Sachs had forecasted the price of oil to rise to $200 — GS was as right our own stock market forecasters who were looking at the Sensex going to 30,000 by the end of 2008. This record of forecasting is no different from what happened in 1929. Just before the crash, the Harvard Economic Society had opined that “a severe depression (of equity prices) is outside the range of probability”. As Galbraith wrote in his book on the stock market crash, one of the lessons “is that very specific and personal misfortune awaits those who presume to believe that the future is revealed to them”. This does not seem to have changed despite the far superior computing power forecasters now command.
Currency markets have been no less volatile. Over the year, the pound dropped from EUR 1.36 to very close to parity, and from over $2 mid-year, to less than $1.5. The euro, in its turn, peaked at $1.60 drop to a low of $1.25 in late November.
Modern financial markets are supposed to be “efficient”. Professor Eugene Fama of the University of Chicago, who coined the term “efficient market”, has defined it as follows: “A market in which prices always ‘fully reflect’ available information is called ‘efficient’ “. The forex market clearly fulfills at least two of the conditions prescribed by Fama for market efficiency: low, if not quite zero, transaction costs, i.e. bid offer differences; all available information accessible to market participants. (The third, namely agreement on the implications of current information for the distribution of future prices, is more debatable, but is not a necessary condition.) In efficient markets, prices are expected to change to incorporate almost instantaneously, all relevant information. A corollary is that it is not possible to predict future prices. One of the more pernicious side effects of the efficient market hypothesis is that too many people have been led to believe that whatever the prices arrived at in an efficient market, they are “correct” in terms of the then available information. Given the kind of gyrations that have taken place in both commodity and currency prices, it requires a great deal of faith to believe that they correctly reflected the fundamentals throughout 2008. In fact, while one is fully convinced about one corollary of efficient markets, namely that they cannot be predicted, one remains agnostic on the subject of the prices being correct in the sense of reflecting economic fundamentals. As Keynes said a long time back, the market can remain irrational far longer than the ability of the participant to remain solvent.
The volatility is clearly the result of the huge amount of speculative transactions in both currency and commodity markets. In retrospect, it is difficult to deny the contention of Opec that it was speculation which had taken oil prices to very high levels, and not any genuine, significant gap in demand and supply. Speculation on a gigantic scale has become an accepted way of earning huge wealth. As Keynes said “Speculators … may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation”. The position has become serious, and speculation has started affecting the real economy in ever more pernicious ways: the sub-prime crisis in the US resulting in a global recession is only the most visible of them. But more on this next week.