Supply-Side University Economics Lesson #11
To: SSU Students
From: Reuven Brenner
Re: Politics and the market
[SSU welcomes back for his third guest lecture Professor Reuven Brenner of the McGill School of Management, Montreal, who will discuss politics and the market. As you know, I consider Reuven the best economist in the world, as he stands on the shoulders of his mentor, Robert Mundell. The lecture is a long one, written especially for SSU, borrowing from selected essays and books he has written over the years on the intersection for public policy and the financial markets. We are honored and privileged that Reuven has done this for us. JW]
THE VALUE OF FINANCIAL MARKETS, AND FINANCIAL MARKET VALUES
Perhaps the most inane economic notions are those that have been disproved by the marketplace but are still blindly recommended by die-hard policy-makers. Chief among these is the assumption that a nation's current account figures should drive economic policies. The fatal flaw that allows for this slavish attachment to an arbitrary measure is a mistaken notion about the nature of wealth - what it is and how it is created.
The ability to produce wealth is far more important than wealth derived from occasional high prices of exportable natural resources. Recall earlier discussed examples of places around the world, past and present. The Netherlands has been below sea level, with few natural resources. Yet this did not prevent it from becoming the miracle of the 17th century. Korea has no natural resources and the weather is nothing to brag about. Japan is a small island with no arable land, a large population, and no natural resources (in fact, it is well endowed with wealth-destroying disasters). Taiwan, Hong Kong, Singapore are the same. And then Mexico and Venezuela, Brazil and Nigeria had rich land, mines, oil, beaches, mountains, Aztec ruins. And, in spite of what many think about the importance of location, though closer to the U.S., Mexico is currently stuck in stagnation.
Or, remember Zaire of the 1970s?
The country had a quarter of the world's copper reserves. With the price of copper high, and President Nixon praising Zaire's future, the banks forwarded credit to President Mobutu. With the easy cash available, he splurged on regal estates, jumbo aircraft, 500 British double-decker buses, and put money aside in Swiss banks - while Zaire stayed one of the poorest countries in the world. When the price of the copper plummeted, Zaire stopped paying the debt. The banks, having the loans on the books extended credit. When the debt became $3 billion in 1979, exports helped make the payments (half of the exports going through the President's family and friends). The country stayed poor.
So, a lack of natural resources does not make countries poor, and an embarrassment of natural riches does not make countries wealthy. Brains and bull markets should not be confused. The key variables for wealth creation are whether a country's resources are open for competition and whether competitors can rely on secure rules of the game, which have frequently little to do with mismeasured and misinterpreted current accounts.
Currency and Current Accounts
That said, once one solved the problem of creating political institutions which give wealth creation a higher priority than the maintenance of an inefficient elite with the help of cash flows coming from natural resources, other variables concerning the creation of wealth must be addressed.
Establishing transparent financial markets is the crucial next step.
Remember that the South of the United States was largely undeveloped and sparsely populated until the 1950s. Since then, the Southern states averaged annual employment growth rates far above the national average. The reason? An innovation: the air conditioner. Although offices and department stores had been installing them in the rest of the U.S. during the 1930s and 1940s (where they significantly increased productivity i.e., people coming earlier to work and leaving later), it was not until after World War II that air conditioning spread. This allowed industries to move to hot and humid places, people to relocate and retire there, and the rise of the South began.
There are no regional accounts to see how long these Southern places had large current account deficits with the Northern states: within the U.S. with a stable currency, it did not matter. Now let's say that Mexico, with its approximately 95 million people, imported 1 million air conditioners before the peso crisis in 1994. Many industries cannot operate in hot and humid places, and people have difficulty thinking and concentrating when it is 100 degrees Fahrenheit and higher (now you know why civilization developed in relatively moderate climates). To develop its human potential, Mexico needed cooler heads and bodies. People installed air conditioners in schools, houses, workplaces. These large investments would eventually be paid off over many, many years.
The resulting large current account deficits of the Southern states did not necessarily imply that people were on a consumption binge. Air conditioners, like computers, can be long-term investments. Yet, because of inherited erroneous, abstract economic theories and ways of calculating numbers, they are not counted as such.
This is not to say that Mexico would have necessarily been in better shape since the 1994 devaluation if people had known more about what current account deficits really (mis)measure, and the link between climate, measurement and performance. To finance long-term investments, the importing country must keep confidence in its currency so that investors are ready to buy long-term bonds, which Mexicans would use to purchase the air-conditioners. (This is, in part, why "current accounts" between the Southern and Northern states in the U.S. have not been a problem.) If that confidence is shattered, working capital dries up and the country stays poor.
The problem that precipitated Mexico's crises were: 1) two years of holding back the country's growth potential through delays of needed tax and regulatory cuts; and 2) the central bank's secretly loosening its monetary control prior to the general election, which, once known, raised expectations of devaluation; 3) behind both is the fact that a powerful and rich elite does not want to give up power, even if on paper it did.
In other words, the peso had already lost value because of efforts to lower the current account deficit by artificially slowing down a generally healthy economy, where people wanted to invest. Then, an artificial stimulus at election time helped seed the clouds. These two technical issues combined with the signal that the much publicized unsolved political murders conveyed regarding Mexico's political landscape, suddenly renewed investors' suspicions that Mexico is incapable of maintaining an environment in which enough wealth would be created to provide a reasonable return on investment over long periods of time.
Once the credibility of political institutions was destroyed, people -both Mexicans and foreigners - withdrew their savings from Mexico, and the peso fell. But it does not make sense to discuss the value of the peso in terms of "monetary policy," the "current account deficits" or "lack of savings" by Mexicans. Mistakes in monetary policy are committed all over the world. And they do not have the consequence that Mexico's currency suffered. Countries have current account deficits for years. However, most currencies, unlike Mexico's, do not crash. The Mexicans even saved - they just no longer wanted to put their savings to work in Mexico. Mexicans withdrew US $21 billion from Mexico before many foreign investors did when the country's reserves had fallen from $30 billion before Luis Donaldo Colosio's assassination in March 1994 to $6 billion in December 1994, when the Chiapas rebellion restarted.
Investors, Mexican and foreigners knew that unless credibility was restored quickly, there would be liquidity problems since there were about US $17 billion dollar-indexed bonds outstanding as well as $20 billion in Mexican debt obligations. But credibility was not restored. Until December, judging from the Mexican stock market, investors still believed that President Zedillo would keep his campaign promise and not devalue the peso, although it was known that the central bank exchanged its dollar assets for interest-bearing assets denominated in pesos. The bank had the option of selling them for pesos to reduce the money supply. This might have prevented the devaluation, although it would not have restored the credibility regarding institutional changes. Of course, once people's faith in wealth creation as well as in Mexico's central bank were shattered, Mexicans would save much less because they became poorer. Indeed, four years later, average Mexican wages in U.S. dollars are at about half the value they were in 1994, as is the Mexican stock market - the best indicator of wealth creation.
And governments and the IMF hold up the Mexican 1994 bail-out as a success! Who are they fooling?
Whatever will happen to the mismeasured and misinterpreted current account, it will give no indication where the peso is headed. In fact, Mexico's current account has been improving. But this had not prevented the country from becoming poorer in terms of U.S. dollars. Many Mexicans hit hard by the continuing peso devaluation are being forced to sell off their hard assets at deflated prices to foreigners looking for "cheap-peso" bargains. These hard assets sales are decreasing the wealth of the nation, because many of these assets were initially bought to improve the nation's productivity. But they are lumped together with all other exports and show up as an improvement in the country's current account figures.
Many economists have misled the public into believing that once the current account was turned around, Mexico's currency would regain its value. But the currency continued to slide. A floating currency's value is derived from how much capital flows into a country and how much flows out. A country can export much, even have trade balance surpluses, and yet see its currency depreciate (the Canadian dollar is proof for that) if it is not a good place to invest because of high taxes or expectations of devaluations.
However, a stable currency should not be confused with prosperity, which is reflected in stock market valuations. Even if the Mexican central bank reduced the supply of pesos to match the falling demand for them around the world, prosperity would not have returned -unless there were significant, credible changes in Mexico's political institutions, and taxes and regulatory burdens were lowered, to bring significant capital flows to the country - including, perhaps, the $20 billion of the Mexicans' own savings.
It was strange then to hear U.S. Deputy Treasury Secretary Lawrence Summers declare in September 1995 that the financial program for Mexico is working, indicated by the fact that the Mexican stock market had recovered almost all the losses it suffered in the crises. Either he did not understand what he was talking about, or he made statements with political goals in mind.
For, although it is true that in peso terms Mexican stocks went up, in dollar terms, as mentioned before, they were still worth less than 50% of their pre-devaluation value (and by October 1997 only 40 percent). Meanwhile, the U.S. government aid might have made it easier for the Mexican ruling elite to slow the speed of carrying out political, fiscal and regulatory changes. That's called "success"? The fact that Mexico repaid its loan to the U.S. in 1996, and the situation has been improving slowly for the last two years does not imply that either the U.S. aid package or the devaluation were the proper things to do.
The aid package helped insulate a group who, without it, might have been forced to do more drastic regulatory and fiscal changes that were needed. There is plenty of evidence that drastic political, fiscal and regulatory changes around the world happen when governments find themselves in a fiscal crises, as noted in the lecture on direct democracy but worth repeating.
Joseph Schumpeter, the Austrian born economist, was among those who noticed that when rulers' or governments' coffers were empty, the existing political institutions crumbled, and new ones replaced them. It happened in the distant past when the Parliament in England acquired greater powers, leading in the English case to the Glorious Revolution in 1688, to the triumph of the Parliament, to fiscal responsibility and prosperity. A century later, French commentators correctly identified the origins of the British success with this transfer of power from an absolutist to a constitutional monarchy. At the same time, the French monarchy was no longer able to secure new loans based on anticipation of future tax revenues, bringing the monarchy to its knees.
This sequence of events is similar to those that took place on the North American continent at that time. The finances of the new nation became chaotic after the peace of 1783, and the government authorized expenditures, without having the power to tax. The financial and political system broke down in 1786 when, in spite of the new country's potential, the government could not secure loans abroad or at home. This crisis led to the Constitutional Convention of 1787 and the new nation two years later.
The events in Japan of the 1870s, leading up to the Meiji revolution, fit into this pattern. And we know the Soviet Union had large government deficits - in part, once again, because of its attempt to prevent its military power from declining. The resulting fiscal and political changes brought the communist rulers to their knees, putting the fall of the USSR into a well-known, long-identified pattern - even if the precise timing and consequences of such falls remain unpredictable.
Although a regularity behind the causes of crumbling regimes can thus be simplified, the emergence of specific democratic institutions, in particular referendum and initiative, cannot. The end of communism, or the inability of some Western governments to secure loans, do not by themselves induce a drastic change in political institutions, such as the constitutionally-guaranteed referendum and initiative would require. Historical evidence suggests that only when governments' cashflow and credit problems led to significant political changes did people despair of the system and no longer see the fiscal problems as consequences of wars, accidents, or corruption. This is, in fact, the definition of fiscal crisis. Foreign aid can postpone such crises.
Briefly: A country's wealth is not measured by stock market values in local currencies, and certainly not by numbers that statistical bureaucracies are publishing with religious regularity. Even in the U.S. these numbers are unreliable. In Mexico and other Latin American countries, as well as some European ones, it has been officially acknowledged for years that these, as well as gross national product and other numbers, are practically pulled out of a hat.
The information on the unreliability of aggregate figures has been available for years. In 1987, Italy's statistics office revised the country's national income upward by 18%. Vietnam considers whatever numbers it has as state secret, and it is known that since the 1994 devaluation crisis a significant part of the drug trade moved to Mexico - although it did not draw much attention until recently.
Let us hope that both the present public debates on the unreliability of the consumer price index in the U.S., and the doubts provoked by the October 1997 stock market crashes among Asian "tigers" about what their numerical prosperity reflected until the crash, will bring attention to the fact that all aggregate figures are unreliable, and should be discarded for guiding either U.S. government or International Monetary Fund policies.
The Best Measure
These policies should be guided by measures provided by markets and competing, private statistical bureaus.
The best measure of changes expected in a country's wealth is given by the total value of a country's marketable securities; stocks and bonds, the latter being issued either by companies or governments, all measured in terms of a relatively stable currency, and by real estate values. When such total market values go up, it means expectations of more wealth creation. The value of real estate depends on the value of future rents. The increase in the value of obligations also shows that there are expectations for fewer bankruptcies and fewer chances of governments defaulting on their obligations.
But why do stock markets reflect expectations of wealth creation? Before answering this question, let us explain why it is NOT true to say that stock markets always reflect expectations of wealth creation. And why, if real estate is controlled too, those values will not reflect expectations of future rents either.
Financial markets must be deep and transparent to play this role. Let us explain why by looking closer at some recent cases.
Thailand's central bank president, Vijiy Supinit, put before the parliament U.S.-style banking laws four times between 1991-96, which would have put an end to such trading. Each time he was defeated by Thailand's leading families "those evil, politically protected monopolies," as he characterized these families to a journalist. Thailand excluded foreigners from banking, and limited their participation in other financial services. Banking licenses were kept in short supply - to offer favors to political favorites. The country's political system continued to consist of an arrangement by which commercial interests purchased enough seats in parliament to veto any measure which might break their powers. Although this arrangement veils the Thai's system for outsiders, it does not mean that it precludes a measure of prosperity - up to a point. The elite can throw a few bones around, while keeping the best steaks for themselves.
Yet, since the country maintained a stable exchange rate against the dollar for a generation, until 1997, it attracted direct investment, indirect equity investment, and short-term market investments with, on the surface, little apparent exchange-rate risk. (The Thais offered higher short-term yields than did the U.S. Treasury in 1995-6.) Western investors flooded markets with capital. Local banks expanded credit to favorite projects, real estate prominent among them. But, without democratizing access to capital - financial and human (education, that is) - what could the country do with the inflows?
As in many so-called "emerging economies," much of Bangkok's available land was in public or quasi-public hands, and real estate valuations depended on zoning. Although some economists are very good in rationalizing such interventions in terms of abstract models (of "public goods," "externalities," etc.), in practice these regulations had one goal: to offer politicians opportunities for patronage. Bangkok's streets, highways, mish-mashed apartments and factories on one block, look exactly as one would expect a city to look if managed by short-term political calculations. The fact that it takes about four hours in a car to cover a few miles, is just another reflection of such calculations. Combine this with the fact that banking also reflected the patronage principle, that the central bank did not prevent devaluation (by absorbing unwanted currency), and the events of 1997 are no longer surprising.
Thailand's and the other Asian countries' weakness lie not in export markets, but in the failure of domestic policies to foster capital formation - human and financial - combined later with the error of favoring devaluation to the alternative of absorbing liquidity. Yet capital formation, by households in particular, requires a large market for debt secured by households assets, of which home mortgages are the most important. To offer mortgages, not only must people's future incomes become more reliable, but also the legal market must be expected to work reasonably well; bankruptcy laws must be accurately designed, and financial institutions must expect access to collateral backing loans, rather than being frustrated by sudden political and legal changes altering the rules of the game. All these conditions are necessary to the development of deep and transparent capital markets.
With so much misinformation and exaltation about capital markets, it is useful to restate their most basic feature: corporate stocks and bonds "capitalize" - turn into wealth, that is - part of the expected revenues of companies issuing them, the part which is not expected to be paid out in operating costs, interest payments and taxes over a long period of time. Companies whose managements are expected to commit less mistakes will create more wealth than others. Stock markets prevent the persistence of mistakes by continuously re-pricing stocks as information flows in. The next section shows how this happens.
Public debt capitalizes a portion of household income (generated, in part, by the aforementioned companies) backed by expected taxes. Since the discounted value of future incomes defines wealth, as capital markets become more "efficient" (that is, when these markets discount more future incomes), they become better in reflecting expectations of wealth creation. For example, in 1997, U.S. home mortgages comprised the largest single bond market in terms of U.S. dollars, with more than $4 trillion (against government outstanding debt of $3 trillion), half of which is being repackaged as bonds. This high percentage is due to the fact that with a 5% down payment, U.S. citizens can buy a house. The capital market transforms people's expected incomes over ten, twenty, or thirty years into a home.
Correcting Mistaken Pricing
Stock markets, economists are apt to say, perform two primary functions: sites for the investment of savings, and signaling how capital should be allocated among companies. By comparison, Mr. Warren Buffet, the legendary investor, has said that: "As far as I am concerned, the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish."
These two views, at first, would appear contradictory. In reality, though, there is no conflict because the search for "foolishness" by he likes of Mr. Buffet leads to actions that redirect credit toward lectures companies better at creating wealth, by preventing persistent mistakes - "offering to do anything foolish."
At any moment of time, managements are making mistakes - mistakes that must be uncovered, even when company's officials are praising their strategies to the skies. To make such discoveries, however, takes serious detective work. This means scrutinizing annual reports, comparing one company's management and internal organization with others', having a broader vision where society is heading, evaluating what demands are of a more permanent nature and which ones are merely temporary, who hires the new talent, etc. Just as there are few entrepreneurs with the vision to not follow herd instincts, rare too, are the financial detectives able to consistently evaluate companies not by their market value, but by judging the respective managements' ability to solve problems, and having the correct interpretation about where society is heading.
The intervention and interpretation of financial detectives - there is no such thing as objective "information" in the case of financial markets, contrary to what some "efficient markets" theorists assume - coupled with the subsequent redirection of savings, leads to the adjustment of stock and bond prices, preventing persistence in error. In other instances the introduction of a financial innovation brings about the adjustment of stock and bond prices. Take, for example, Michael Milken's high-yield bonds, which financed such defining companies as Turner, Medco, MCI, Mirage, McCaw Cellular. Before having access to credit raised through his financial innovation, these companies' market valuations were "foolishly" low.
Mispricing by Some, Opportunities for Others
The implication of these observations is that since the few good detectives do not have time to look at the valuation of all companies, the discovery of mistakes takes time.
In the interim, some stocks will trade at "foolish" prices, either much too low or much too high. During such times the two "primary functions" that academics attribute to stock markets are not fulfilled. Such periods are of limited duration, although "limited" may mean decades, as the 1970s have shown, when many companies' managements, swimming in cash, invested in low-return investments with impunity until innovations were made in the ways corporations' managements could be controlled.
When innovations - such as junk bonds and LBOs are used - investors adjust the market values of the companies in question by buying and selling their stocks. These innovations achieve the financial markets' "primary" goals. In correcting the mispricing, they help redirect the flow of capital.
Mr. Buffet thus is quite right: An increase in a particular stock price does not necessarily imply that the company in question will create more wealth, just as a drop in stock price need not imply that the particular company will now create less wealth. However, when there are many sources of information, many players, and they are free to act, the buying and selling of stocks and the introduction of financial innovations will correct the mispricing. When a stock price drops once, investors discover that other investors have mispriced it, savings are better allocated, and capital flows less toward companies whose managements made repeatedly poor decisions (i.e., those destroying wealth), and more toward the better decision makers, who create wealth.
When Stock Exchanges Help Create Wealth and When They Do Not
What about market value as a whole? Why do stock markets sometimes crash, and at other times boom?
The answer is that stock exchanges also reflect expectations about the persistence of error by decision makers in government, including the central bank, whose laws, regulations and policies affect companies' managements.
When the expectations are for government policies to change more quickly, and get rid of errors, market capitalizations go up. When market capitalization goes down, the drop implies that either a greater rigidity has appeared in one of the spheres. For example, high capital gains taxes, which have the effect of locking in capital, and high income taxes, which prevent people from accumulating significant savings, (savings which would allow for more entrepreneurial experimentation), both lead to greater rigidity. Investors then expect greater persistence in error, and thus less wealth creation. Deeper information markets can diminish the duration of such persistence of mistaken, wealth-destroying strategies. Let us see how.
Charles Dow and Edward Jones, the creators of the Dow-Jones index and company, detected a few opportunities a century ago. They had realized that when sources of information are few or are controlled, or when players' hands are tied, stock markets will not fulfill their primary roles and will become decapitalized. It is easy to see why: Such conditions impose rigidities and lead investors to expect frequent and significant mispricing because of greater persistence in error. As the persistence of error destroys wealth, people will invest less in these stock markets unless somehow entrepreneurs overcome the problem.
Recall that in the second half of the 19th century, stock markets in the United States saw spectacular booms and busts for these same reasons. Channels of information were few. Those who had access to information did not always have the incentive to tell the truth, but they did have the incentive to collude. Not surprisingly, people without privileged access to information withdrew from the markets.
The open nature of U. S. society nonetheless allowed people to try and overcome these problems. It was not accidental that following the booms and busts, Messrs. Dow and Jones, along with Charles Bergstresser were among the first to come up with the idea of publishing a financial newsletter in 1880. Nor was it accidental that the stock exchange proposed in 1895 the radical innovation of publishing annual reports. Nor was it accidental that 100 years ago information started to be carried through New York's streets from offices to banks - although by couriers running through streets rather than flowing through satellites, cable and optical fibers. Nor was it accidental that cities with developed stock exchanges also saw the emergence of a critical mass of specialists in the information industry: first newspapers and wire services; later radio, television and Bloomberg, and also financial and political analysts. It is a democracy's information industry that can bring about the stabilization of stock markets - and also the democratization of capital.
Back to the Beginning
Which brings us back to today's emerging markets, Mexico's in particular. Why, for example, have Mexico's or China's exchanges yet to become another Wall Street? What changes must be done in these countries and elsewhere in order to see their stock markets flourish?
Societies which, for political reasons, impede open financial markets and the free flow of information, as Mexico and China have done, will see the same wild fluctuations of their stock exchanges as New York saw a century ago, and more. We saw what Mexican politicians did. In China, Xinhua, the state-run central news agency, set restrictions on all aspects of Dow Jones' business in the country. Local governments collude with local brokerages to protect local monopolies. Central government departments and ministries left over from the central planning era still write regulations to maintain their power. Politicians want to contain the development of financial markets to prevent "chaos."
They want enterprises to be financed by banks, which they can control more easily, rather than by equity markets, which they will not be able to. But bond and stock markets have been better at screening risks than commercial banks because governments have much more power over the latter than the former. (Also, traders have to evaluate businesses by the day, by the hour, whereas bankers do so more rarely). It is not surprising that only about 2.5% of all financing in China is done through the equity markets, and the remaining 97.5% through banks. In the early 1970s, the Philippines had one of the largest stock markets in Asia, but it shrank steadily during the final years of the Marcos regime because of economic mismanagement and theft of company assets by Marcos cronies.
Briefly: by imposing restrictions on financial markets, governments gain greater control, with nationalized industries offering sources of patronage and political power. Thus, it is true that allowing foreign ownership implies loss of control. But contrary to government-sponsored mythologies, there is no loss of control "over the economy," whatever that means, but only loss of their ability to buy constituents.
In Beijing's case, the days of China's stock exchanges (and probably Hong Kong's as well) are numbered, if entrepreneurs - modern-day Dows and Joneses - are prevented from overcoming the government's controls. Only democratization of all forms of capital, information included, can ensure long-term prosperity.
All of which calls to mind the old saying: Clever are they who can learn from others' mistakes, and fools are they who must learn from their own. Unfortunately, there is logic behind the regular foolishness and prejudice expressed in governments' attacks on stock exchanges and financiers, which discourages such learning. For, denying its people access to credit, increases governments' power. And since antiquity those in power have been very good at covering their actions with religious and academic validations of self-serving political philosophies (remember usury laws?), transforming real issues to apparently moral ones.
In the near future, the world will finally, and justifiably, celebrate financiers, investors, traders and stock exchanges for the central, yet frequently misunderstood, role they play of helping to get rid of bad managements and bad government policies - without violence. They will do it just by denying them access to additional credit.
Of course, this is one of the reasons governments are reluctant to give up the right to "monetary policy" - issuing interest-free debt, that is. It gives them cheap and immediate access to credit when credit markets would be reluctant to advance additional credit at the going rates (raising doubts about the government's fiscal policy), and taxpayers would rebel against additional explicit taxes.