Ponzi

How Chidambaram, UPA have turned India into a ponzi scheme

congress-party-symbol1Vivek Kaul 

The Congress led United Progressive Alliance (UPA) government has turned India into a big Ponzi scheme. Allow me to explain.
Most governments all over the world spend more than they earn. This difference is referred to as the fiscal deficit and is financed through borrowing. Any government borrows by selling bonds. On these bonds a certain rate of interest is paid every year by the government to the investor who has bought these bonds.
The bonds also have a certain maturity period and once they mature the money invested in the bonds needs to be repaid by the government to the investor who had bought these bonds.
The trouble is that India has reached a stage where the sum of the interest that the government needs to pay on the existing bonds along with the money the government requires to repay the maturing bonds is greater than the value of fresh bonds being issued (which is equal to the value of the fiscal deficit).
Take the current financial year 2013-2014 (i.e. the period between April 2013 and March 2014). The interest to be paid on existing bonds amounts to Rs 3,80,067 crore. The amount that needs to be paid to investors who hold bonds that are maturing is Rs 1,63,200 crore. This total, referred to as the debt servicing cost, comes to Rs 5,43,267 crore (as can be seen in the following table).
ponzi ratioThe ratio of the debt servicing cost divided by fiscal deficit(referred to as the Ponzi ratio in the above table) for the year 2013-2014 comes to 1.04 (Rs 5,43,267 crore/ Rs 5,24,539 crore). What this means in simple English is that the government is issuing fresh bonds and raising money to repay maturing bonds as well as to pay interest on the existing bonds.
This is akin to a Ponzi scheme, in which money brought in by new investors is used to redeem the payment that is due to existing investors. So investors buying new bonds issued by the government are providing it with money, to repay the older investors, whose interest is due and whose bonds are maturing. The Ponzi scheme runs till the money being brought in by the new investors is greater than the money being paid out by the existing investors.
In the Indian case, the Ponziness has gone up over the years. In 2009-2010, the Ponzi ratio was at 0.70. This means that money raised by 70% of the new bonds issued by the government went towards meeting the debt servicing cost. In 2013-2014, the Ponzi ratio touched 1.04. This means that the money raised through all the fresh bonds issued were used to pay for the interest on existing bonds and repay the maturing bonds.
In fact, the projection for 2014-2015 (i.e. the period between April 2014 and March 31, 2015) puts the Ponzi ratio at 1.28. This means that all the money collected through issuing fresh bonds will go towards debt servicing. But over and above that a certain portion of the government earnings will also go towards meeting the debt servicing cost.
The increasing level of the Ponzi ratio from 0.70 in 2009-2010 to 1.28 in 2014-2015, is a clear indication of the fiscal profligacy that the Congress led UPA government has indulged in over the last few years. This has led to a situation where the expenditure of the government has shot up much faster than its earnings. This difference has been financed by the government issuing more bonds. Now its gradually reached a stage wherein the government needs to issue more and more new bonds to pay interest on the existing bonds and repay the maturing bonds.
This is nothing but a giant Ponzi scheme. To unravel, this Ponzi scheme the next government will have to cut down on expenditure dramatically. At the same time it will have to look at various ways of increasing its earnings.

The article originally appeared on www.firstpost.com on February 18, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek)

Debt ceiling: Why the Great American Ponzi scheme might just keep running

 
3D chrome Dollar symbolVivek Kaul 
Governments typically spend more than they earn. This difference is referred to as the fiscal deficit. The government of the United States (US) is no different on this front. It has been running fiscal deficits greater than a trillion dollars every year since 2009. It makes up for this deficit by borrowing. It borrows money by selling bonds on which it pays interest.
Currently, the US government has sold bonds close to $16.69 trillion. Of this, around $4.8 trillion worth of bonds have been bought by agencies of the US government which primarily run pension funds and retirement funds. The American households own around $1.2 trillion or around 7.2% of the total outstanding bonds of $16.69 trillion.
This is not surprising given that the savings rate in America has averaged at around 4.6% of the disposable income over the last 10 years. In July 2005, it had fallen to as low as 2% of disposable income. It has since recovered and since the beginning of 2013, it has averaged at 4.4% of the disposable income. The moral of the story is that the average American doesn’t save enough to be able to lend to his government.
So who are the other lenders to the US government? As I explained in detail yesterday the Federal Reserve of United States, the American central bank, is a major lender to the government. Currently it holds bonds worth $2.086 trillion or around 12.5% of the total outstanding bonds of $16.69 trillion.
This lending has gone up by 434% over the last five years. On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion.
The Federal Reserve doesn’t have any money of its own. It basically prints money and uses that money to buy government bonds. This money printing adds to the money supply. This excess money can ultimately lead to high inflation with excess money chasing the same amount of goods and services.
Hence, the Federal Reserve printing money to buy US government bonds is something that cannot continue forever. In fact, Ben Bernanke, had indicated in May-June 2013, that the Federal Reserve will go slow on money printing in the months to come. Since then, he has gone back on what he had said and indicated that the money printing will continue for the time being.
But even with that change in position, the US government cannot continue to rely on the Federal Reserve to finance a significant part of its fiscal deficit by buying its bonds. As I mentioned yesterday, between 2009 and 2012, the US government ran a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
So the question is who will the US government have to ultimately borrow from? The answer is other countries.
As of the end of July 2013, foreign countries held a total of $5.59 trillion of US government bonds. Of this China was at the top, having invested $1.28 trillion. Japan came in a close second, with $1.14 trillion. How has this holding changed over the years? As of September 2008, the month in which the current financial crisis started with the investment bank Lehman Brothers going bust, the foreign countries held US government bonds of $2.8 trillion. Hence, between September 2008 and July 2013, their holdings have doubled (from $2.8 trillion to $5.59 trillion).
Given this, what it clearly tells us is that the foreign countries have helped by the US government run its trillion dollar fiscal deficits by buying its bonds.
Let us look at this data a little more closely. As of the end of December 2008, the foreign countries held US government bonds of $3.07 trillion. By December 2012, this had gone up to $5.57 trillion. This meant that during the period foreign government bought bonds worth $2.5 trillion. During the period the US government ran up a fiscal deficit of $5.09 trillion. The foreign governments financed around 49% of this, by buying bonds worth $2.5 trillion($2.5 trillion expressed as a % of $5.09 trillion).
During this period, some of the bonds that foreign countries had bought would have matured. The US government spends more than what it earns. Hence, it does not have the money to repay the maturing bonds from what it earns. Given this, it needs to sell new bonds in order to repay maturing bonds. A part of these new bonds being sold over the last five years have been bought by the Federal Reserve. The Federal Reserve has done this by printing money.
Hence, the US government has paid for a part of its maturing bonds by simply printing dollars. This is similar to running a Ponzi scheme, where the government is paying off old bonds by issuing new bonds. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
Despite this, foreign countries have been more than happy to buy US government bonds. As we saw a little earlier in this piece, they have doubled their holding of US government bonds between September 2008 and July 2013. In short, foreign countries along with the Federal Reserve have helped the US government to keep running its Ponzi scheme.
Why is that the case? The United States with nearly 25% of the world GDP is the biggest economy in the world. By virtue of that it is also the world’s biggest market where China, Japan and countries from South East Asia and South America, sell their goods and earn dollars in the process.
The way things have been evolved, the US imports and countries like China, Japan, Saudi Arabia etc earn dollars in the process. These dollars can either be kept in the vaults of central banks of these countries or be invested somewhere.
Hence, over the years, these dollars have made their way to be invested in US government bonds, deemed to be the safest financial security in the world. With so much money chasing them, the US government, has been able to offer low rates of interest on them.
This has helped keep overall interest rates low as well. It has allowed American citizens to borrow money at low interest rates and spend it on consuming imported goods. So the Americans could buy cars from Japan, apparel and electronics from China and countries in South East Asia and oil from Saudi Arabia. And so the cycle worked. The US shopped, China and other countries earned, they invested back in the US, the US borrowed, the US spent, China and the other countries earned again and lent money again.
The way this entire arrangement evolved had the structure of a Ponzi scheme. China and other countries invested money in various kinds of American financial securities including government bonds. This has helped keep interest rates low in the US. This helped Americans consume more. The money found its way back into China (like a return on a Ponzi scheme), and was invested again in various kinds of American financial securities, helping keep interest rates low and the consumption going. Like in a Ponzi scheme, the dollars earned by China and other countries has kept coming back to the US.
Hence, foreign countries have an incentive in keeping this Ponzi scheme going. Earlier, it was important for them to keep buying US government bonds to keep interest rates low and help American consume more. It was also important to keep buying these bonds to ensure that the US government had enough money to repay them. Now it has reached a stage, where the US government is repaying them by simply printing dollars.
But even with this foreign countries are likely to continue lending money to the US government by buying its bonds. Sanjiv Sanyal, global strategist, Deutsche Bank Market Research makes this point in a recent report titled Bretton Woods III and the Global Savings Glut.
As he writes “The basic idea is that, when people are young, they have little savings and may even need to borrow in order to spend on consumption and/or build assets. However, as they grow older, their net savings rise as they build up a stock of wealth that is later run down in very old age. The same dynamic can be said to broadly hold for countries as they experience demographic transitions although there are nuances that vary according to cultural context and fiscal incentives of individual countries.”
Basically what this means is that as a country ages (with the average age of its population rising) it tends to save more. Sanyal expects many developing countries to age at a very fast pace over the next two decades. As he writes “The link is even clearer if one considers the pace of aging by comparing the current median age with the expected median age in 2030. For instance, Japan will then have a median age of 51.6 years while China will go from being significantly younger than the US in 2010 to becoming significantly older after two decades. The aging of South Korea is even faster.” He expects these countries to have a median age of 40 by 2030.
Given this, it is likely that as countries age, they will keep generating excess savings. A lot of this money is likely to find its way into the United States, feels Sanyal. As he writes “we know that lenders do not just care about high returns but about policy risk, property rights, corporate governance and the overall ability/willingness to the borrower to return the money. Thus, aging current-account surplus countries may prefer to park their funds in safer countries even though returns are higher in certain emerging markets.”
And this will help the American government to continue borrowing. It will also keep interest rates low and help Americans keep their excess consumption going. “The next round of global economic expansion may require the US to revert to its role as the ultimate sink of global demand,” writes Sanyal.
And so the Great American Ponzi scheme might just continue for a while.
The article originally appeared on www.firstpost.com on October 18, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

Debt ceiling absurdity: US Fed will now repay itself by printing money

 
Federal-Reserve-Seal-logoVivek Kaul 
It was widely expected that the Democrats and the Republicans will finally strike a deal and extend the debt ceiling of the government of the United States(US). And that’s precisely what happened.
A few hours before the US government would have reached its debt ceiling, both the houses of the American Congress, passed a short term bill, allowing the government to suspend the debt ceiling until February 7, 2014. The Senate passed the bill, 81:18. The House of Representatives passed the bill 285:144. The bill will also end the government shut-down in the United States and allow it to operate till January 15, 2014.
Governments around the world spend more than they earn. They make up for the difference by borrowing money. The US government is no different on this front. The only trouble is that it is not allowed to borrow beyond a certain limit. This limit is referred to as the debt ceiling and till yesterday was set at $16.69 trillion.
If the bill suspending the debt ceiling had not been passed, the US government would not have been able to borrow more. And given that it would have become difficult for it to meet its expenditure from its income. Today, i.e. October 17, 2013, the US government will have around $28 billion of cash on hand. The treasury secretary Jack Lew had suggested in early October that expenditure of the US government on certain days could touch even $60 billion.
Given this, it would be able to meet only a part of its expenditure and hence, someone was not going to get paid.
The tricky question for the government would have been to decide who that someone would be. Would the government decide not to pay out the pension cheques? Or would it be unable to pay salaries of its employees? Would it default on the interest payments that are due on its bonds? Or would it be unable to repay maturing bonds? The American government like other governments around the world makes up for the difference between what it earns and what it spends, by selling bonds.
Interest payments of around $6 billion are due before the end of October. Also, bonds worth around $90-93 billion need to be repaid between October 24 and October 31. A default on this front would be catastrophic. The US government bonds (or treasuries as they are more commonly referred to as) are deemed to be the safest financial securities in the world. And if the security deemed to be the safest financial security in the world is not safe, what is?
But these are points that I have made before (you can read them here). The US government’s current debt stands at around $16.69 trillion. It has borrowed this money by selling bonds. Of this nearly $4.8 trillion is held by various agencies of the US government. Most of the US government agencies holding US government bonds are pension funds and retirement funds, which need to make payments in the years to come. To be able to make these payments, they need to invest now. Hence, they invest money in US government bonds deemed to be the safest financial security in the world.
The remaining US government debt of around $11.89 trillion ($16.69 trillion – $4.8trillion) is referred to as the debt held by the public. Of this, foreign nations hold around $5.7 trillion. China holds around $1.28 trillion and Japan $1.14 trillion.
What is interesting is that the Federal Reserve of United States, the American central bank, holds US government bonds worth $2.086 trillion. On the whole, this is only 12.5% of the total US government debt of $16.69 trillion. But what is interesting is that over the last five years the holding of the Federal Reserve has risen by 434%.
On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion. In comparison the debt held by foreign nations has gone up only marginally.
In the last one year, this holding has gone up by nearly $433 billion. What is happening here? The US government is spending substantially more than what it is earning. Since 2009, it has been running fiscal deficits of greater than a trillion dollars. Between 2009 and 2012 the US government ran a total fiscal deficit of $5.09 trillion. In 2013, it is expected to run a fiscal deficit of around a trillion dollars. Fiscal deficit is the difference between what a government earns and what it spends.
In a situation like this, if the US government would borrow all the money from the public, interest rates would shoot up, given that there is only so much amount of money that can be borrowed. And if the government borrows more, then there would be lesser amount of money for others(primarily the private sector) to borrow. This crowding out would lead to a situation where other institutions like banks would have had to offer a higher interest to borrow.
If a bank borrows money at a high rate of interest, it would have to lend it out at a still higher rate of interest, in order to make a profit. Higher interest rates would mean, higher EMIs. This would discourage the average American from borrowing and spending money, something which the US government believes is very important for reviving economic growth.
This is where the Federal Reserve stepped in. It has been buying the bonds being sold by the US government to finance its fiscal deficit. Where does the Federal Reserve get this money from? It simply prints it and hands it over to the government.
As we saw earlier, between 2009 and 2012, the US government has run a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
Hence, the US government financed nearly 23.6% of its fiscal deficit by selling bonds to the Federal Reserve. Federal Reserve handed over this money to the US government by simply printing it. This has helped keep interest rates low in the United States.
And that is the real story. A lot of the US government borrowing over the last few years has been directly from the Federal Reserve. And now that the debt ceiling has been raised, this will continue.
The money that is borrowed by the US government from the Federal Reserve and other sources, is used to fund its expenditure. A substantial part of the expenditure is repayment of past debts as bonds mature, as well as payment of interest on these bonds.
In the year 2012, the US government paid a total interest of around $359.80 billion on its bonds. The fiscal deficit of the US government was around $1.08 trillion. Hence, nearly one third of the fiscal deficit was because of interest rate payments.
The US government does not earn enough to repay maturing bonds. Hence, it has to borrow money to repay bonds. This is a perfect Ponzi scheme where the government is paying off old debt by issuing new debt. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
In fact, as bonds being bought by the Federal Reserve from the US government, come up for maturity they will be repaid by getting the Federal Reserve to print money and buy new bonds. Hence, the Federal Reserve will be printing money to repay itself. If that isn’t absurd, I don’t know what is. The US Federal Reserve is currently helping the US government run its Ponzi scheme by printing money and buying bonds.
Having said that, increasing the debt ceiling was important given that even a whiff of a default would have caused a global financial crisis. First and foremost investors would have started selling out off US government bonds. This would have driven bond prices down and bond yields up, in the process pushing up interest rates first in the US and then globally. This would have put the entire plan of the US government to revive economic growth by maintaining low interest rates in a jeopardy. It would have also led to investors all over the world selling out of various financial markets. The logic would have been that if the security deemed to be the safest financial security in the world is not safe, what is?
Of course, the trouble is that the US government will breach its debt ceiling again in a few months time. What happens then? The debt ceiling has been in place in the US since 1939. Since 1960, the American Congress has increased the ceiling 79 times. So what stops it from doing it the 80th time as well? Nothing really. But till when can this Ponzi scheme go on? Ultimately all Ponzi schemes collapse. The only question is when. And for that I really do not have an answer.
The article originally appeared on www.firstpost.com on October 17, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

US govt reduced to live on borrowed time

3D chrome Dollar symbolVivek Kaul
Governments spend more money than they earn and finance the difference through borrowing. The government of United States(US) is no different on this front. The trouble is that it cannot borrow beyond a certain limit. This limit, known as the debt ceiling, was set at $16.69 trillion.
This ceiling should have been breached in May 2013, a little earlier this year. Since then, Jack Lew, the American treasury secretary, has taken a number of extraordinary measures like delaying public employee pension fund payments, in order to ensure that the government expenditure remains under control. Lesser expenditure meant lesser borrowing and hence, the government managed to keep its total borrowing below $16.69 trillion.
Today i.e. October 17, 2013, the government would have run out of the extraordinary measures that it has been taking. Given this, the treasury department would have exhausted its borrowing authority.
Hours before this would have happened, the leaders of the Democratic Party and the Republican Party in the American Senate stuck a deal, suspending the debt ceiling. This will allow the US government to borrow beyond $16.69 trillion, till February 7, next year. The will also end the current government shut-down in the US and keep the government running along till January 15, 2014.
This is not the first time that the US government came close to its borrowing limit, given that the debt ceiling has been in place since 1939. Since 1960, the debt ceiling has been raised 78 times by the American Congress. But this time around the Democrats and the Republicans left it too late, each waiting for the other to blink first.
If the ceiling had not been extended the short-term repercussions would have been terrible. The treasury secretary Lew had said in early October that the US government “will be left…with only approximately $30bn” come October 17. This would not be enough to meet the expenditure of the government, which can be as high as $60 billion on some days, Lew had pointed out.
Interest payments of around $6 billion are due on US government bonds before the end of this month. Along with that, bonds worth between $90 to $93 billion need to be repaid between October 24 and October 31 (Source: www.thefinancialist.com) Governments issue bonds to borrow money.
The US government has reached a stage wherein it does not earn enough to repay the money it has already borrowed by issuing bonds. Hence, it has borrow more money by issuing fresh bonds to pay off the older bonds. If the debt ceiling had not been extended, it would have become very difficult for the US government to repay the money it had already borrowed.
More importantly, the US government bonds are deemed to be the safest financial security in the world. If the US government defaulted on paying interest on its bonds or repaying the principal, there would have been mayhem in financial markets, all over the world, including India. It has even been suggested that the crisis that could have unfolded would have been bigger than the crisis that followed the bankruptcy of Lehman Brothers in September 2008. Investors would have sold out of US government bonds driving up global interest rates.
The US government would also have had to prioritise its expenditure. Does it make pension payments? Does it pay its employees and contractors? Does it pay interest on its bonds? Does it repay maturing bonds? These are the questions it would have had to address. Also, there are no legal provisions guiding the government on who to pay first. Hence, any prioritisation of payments could have led to a slew of lawsuits against the US government.
Given the negative repercussions of the debt ceiling not being extended, the markets were positive that a deal reached would be reached. Stock and bond markets around the world have been stable. And gold, looked at as a safe haven, is quoting at levels of around $1280 per ounce (one troy ounce equals 31.1grams).
The trouble is that the US government will cross its debt ceiling level again in February, 2014. What happens then? How long can the American Congress keep increasing the debt ceiling? The basic problem is that the US government has borrowed too much money, and continues to do so, and if it doesn’t default today, it will default in the years to come.
The article originally appeared in the Daily News and Analysis dated October 17, 2013
(Vivek Kaul is the author of Easy Money. He can be reached at [email protected]) 

The theory that caused the financial crisis gets a Nobel prize

alfred nobelVivek Kaul
Do financial markets have bubbles? Like most things in economics, the answer to what seems like a rather straightforward question, is yes and no. It depends on which economist you are talking to.
Eugene Fama and Robert Shiller are two of the three economists(the third being Peter Hansen) who have won the Nobel Prize in Economics this year.
When it comes to the bubble question Fama feels there are no bubbles. Shiller, on the other hand, has done some of his best work in economics around financial market bubbles. In fact, he was one of the few economists, who predicted both the dotcom bubble as well as the real estate bubble. Ironically enough, both of them have won the Nobel Prize in the same year.
Eugene Fama, who teaches at the University of Chicago, came up with the efficient market hypothesis(EMH), sometime in the 1960s. A lot of financial theory that followed was built around EMH.
Benoit Mandelbrot, a mathematician who did some pioneering work in economics, was Fama’s thesis advisor. As Mandelbrot (along with Richard Hudson) writes in The (Mis) Behavior of Markets – A Fractal View of Risk, Ruin and Reward “It (i.e. EMH) became the intellectual bedrock on which orthodox financial theory sits.”
So what is the EMH? As Mandelbrot and Hudson write “At its heart: In an ideal market, security prices fully reflect all relevant information…Given that, the price at any particular moment must be the “right” one.”
And how is that possible? How can the price of a financial security( lets say a stock or a bond) at any point of time incorporate all the information?
Mark Buchanan explains this through a small thought experiment in his book Forecast – What Physics, Meteorology and Natural Sciences Can Teach Us About Economics “Let’s do a thought experiment, which I’ll call the 5 percent problem. Suppose that on Tuesday morning everyone knew for sure that the markets would recover, stocks gaining 5 percent(on average) in a big rally in the final half hour at the end of the day. Everyone in the market would expect this rise, and lots of people on that morning would be eager to pay up to 5 percent more than current values to buy stock, as they would profit by selling at the day’s very end. Knowledge of the coming afternoon rise would make the market rise immediately in the morning, violating the assumption we made to start this thought experiment; the prediction of a late rally would be totally wrong.” Hence, information about the market rising by 5% towards its close, would be incorporated into the price of the stocks immediately.
Mandelbrot and Hudson give another similar example to explain EMH. “Suppose a clever chart-reader thinks he has spotted a pattern in old price records – say, every January, stocks prices tend to rise. Can he get rich on that information by buying in December and selling in January? Answer: No. If the market is big and efficient then others will spot the trend, too, or at least spot his trading on it. Soon, as more traders anticipate the January rally, more people are buying in December – and then, to beat the trend for a December rally, in November. Eventually, the whole phenomenon is spread out over so many months that it ceases to be noticeable. The trend has vanished, killed by its very discovery,” write Mandelbrot and Hudson.
And this happens primarily because the market is made up of many investors, who are all working towards spotting a trend and trading on it. As Buchanan explains in Forecast “In this view, a market is a vast crowd of investors with diverse interests and skills all working hard to gather information on every kind of manufacturing company, bank, nation, technology, raw material, and so on. They use that information to make best investments they can, jumping on any new information that might affect prices as it comes along, and using that information to profit. They sell currently valued stocks, bonds, or other instruments, and buy undervalued ones. These very actions act to drive the prices back toward their proper, realistic, or “intrinsic” values.”
Given this financial markets are correctly priced all the time. Robert Shiller summarises this argument best in Irrational Exuberance. As he writes “The efficient markets theory asserts that all financial prices accurately reflect all public information at all times. In other words, financial assets are always priced correctly, given what is publicly known, at all times.”
And if financial assets are correctly priced, there is no question of any speculative bubbles occurring. As John Cassidy writes in How Markets Fail – The Logic of Economic Calamities “During the 1960s and ’70s, a group of economists, many of them associated with the University of Chicago, promoted the counter-intuitive idea…that speculative bubbles don’t exist. The efficient market hypothesis…states that financial markets always generate the correct prices, taking into account all of the available information…In short financial prices are tied to economic fundamentals: they don’t reflect any undue pessimism..If markets rise above the levels justified by fundamentals, well informed speculators step in and sell until prices return to their correct levels. If prices fall below their true values, speculators step in buy.”
This ensures that all the available information is priced in. Hence, at any point of time, the market price is the correct price. And given that where is the question of any bubbles popping up? As Fama put it in a 2010 interview, “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”
Robert Lucas, another University of Chicago economist who won the Nobel prize in 1995, reflected Fama’s sentiment when he said “The main lesson we should take away from the EMH for policy-making purposes is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them.”
And this is the view that came to dominate much of the prevailing economic establishment since the 1960s. It is surprising that economists have had so much confidence in a theory for which the evidence is at best sketchy. Raj Patel makes this point in The Value of Nothing “The problem with efficient market hypothesis is that it doesn’t work. If it were true, there’d be no incentive to invest in research because the market would, by magic, have beaten you to it. Economists Sanford Grossman and Joseph Stiglitz demonstrated this in 1980, and hundreds of subsequent studies have pointed out quite how unrealistic the hypothesis is, some of the most influential were written by Eugene Fama himself.”
Also, if EMH were true, prices of financial assets would be right all the time, which is clearly not the case. As Buchanan writes “In November 2010, the New York Times reported on a dozen “mini flash crashes” in which individual stocks plunged in value over a few seconds recovering shortly thereafter. In one episode, for example, stock of Progress Energy – a company with eleven thousand employees – dropped 90 percent in few seconds. There was no news released about the business prospects of Progress Energy either before or after the event…On May 13(2011), Enstar, an insurer, fell from roughly $100 a share to $0 a share, then zoomed back to $100 in just a few seconds.”
Shiller gives the example of eToys and Toys “R” Us, two companies which were into selling toys. As he writes “Consider, for example, eToys a firm established in 1997 to sell toys over the Internet. Shortly after its initial public offering in 1999, eToys’ stock value was $8 billion, exceeding the $6 billion value of the long established “brick and mortar” retailer Toys “R” Us. And yet in fiscal 1999 eToys’ sales were $30 million, while the sales of Toys “R” Us were $11.2 billion, almost 400 times larger. And eToys’ profits were a negative $28.6 million, while the profits of Toys “R” Us were a positive $376 million.”
So a company with no profits had a greater market capitalization in comparison to a company making substantial profits. Now as per the EMH this should have never happened. Investors would have sold the eToys’ stock and driven down its price. But that did not happen, at least for a few years. And the stock price of eToys went from strength to strength.
But despite the weak evidence in support of EMH, the prevailing economic thinking since the 1960s has been that market prices of financial assets reflect the fundamentals, and hence, there was no chance of bubbles popping up. And even if bubbles did pop up, now and then, there was no chance of identifying them in advance. Alan Greenspan, the Chairman of the Federal Reserve of United States between 1987 and 2006, believed that a central bank could not spot a bubble, but could hope to mitigate its fallout, once it burst.
This led to him letting the dotcom bubble run. A few years later he let the real estate bubble run as well. He was just following the economic theory that has dominated over the last few decades. As Patel writes “ Despite ample economic evidence to suggest it was false, the idea of efficient markets ran riot through governments. Alan Greenspan was not the only person to find the hypothesis a convenient untruth. By pushing regulators to behave as if the hypothesis were true, traders could make their titanic bets…Governments enabled the finance sector’s binge by promising to be there to pick up the pieces, and they were as good as their word.”
In the end, Greenspan did find out that the model did not work and that bubbles did occur, now and then. As he admitted to before a committee of the House of Representatives in October 2008, “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak…I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
So Eugene Fama’s EMH doesn’t really work and has caused the world a lot of harm.
Now compare this to Robert Shiller who in the first edition of Irrational Exuberance, which released some time before the dotcom bubble burst, compared the stock market to a Ponzi scheme. As he wrote “Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasise the positive news and give less emphasis to the negative.”
Hence, financial markets at times degenerate into Ponzi schemes, where prices are going up simply because prices are going up. These bubbles can keep running for a while, just as the dotcom bubble in the US and the real estate bubble all over the developed world, did. When these bubbles burst, they caused huge economic problems, as we have seen over the last few years.
The trouble is that the dazzle of efficient market hypothesis has blinded economists so much that they cannot spot bubbles anymore. Hence, it is important that economists junk the efficient market hypothesis, and start looking at a world where bubbles are possible and keep popping up all the time. Else, we will have more trouble ahead.

The article originally appeared on www.firstpost.com on October 15, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)