May 14, 2012
When I was a boy, there was a very popular game played by all the kids on our road. It was called “clackers”. It involved two plastic balls on two strings tied together at the top. The balls hit off each other with force making a “clack” noise. Once one ball hit the other, the other would whip back and hit the other and so on, back and forth. This could go on indefinitely if you didn’t touch them.
It was only years later that a science teacher explained to me what was driving the clackers. It was apparently something called Newton’s Cradle. It explains how momentum and energy can be transmitted.
Newton’s Cradle is a construction of five steel balls. You might see it on executives’ desks from time to time. The balls are suspended from a beam and they just touch each other – barely “kissing” each other, as snooker players would say.
If you draw back the outer ball and hit the other four, the last ball will move on its own and then swing back and hit the four stationary balls with almost the same force. The energy will pass through the balls and the last one will swing out, taking the energy from the others and the outside ball swing back and forth and so, on and on.
This Newtonian Cradle is a nice way of looking at the financial markets right now. The global financial markets are being hit by two opposing forces, and it is leading to strange, unstable outcomes that might explain why JP Morgan lost â‚¬2 billion on bad trades over the past six weeks.
This is a phenomenal amount of money to lose, and the very erratic nature of the losses and the way the markets are moving right now might help us to figure out what is going to happen next in European politics – and why there is little point trying to make the irrational rational by voting on anything in the next few weeks.
The two forces hitting the financial markets – and thus the European economy – are totally opposed.
The first is the long-term force of deleveraging and deflation. These are the results of the unwinding of the huge borrowing we saw in the past ten years. As people save and pay back their debt and as companies do the same, the natural tendency for financial markets is to consolidate, because the outlook for growth is poor. But these forces are now bumping into recurring, dramatic and quite erratic rounds of bailouts, liquidity injections and special lending funds like the ESM and the EFSF.
All the interventions drive the markets in the opposite direction to the direction that deleveraging and deflation tends to drive them.
Now, how do these two countervailing pressures affect financial markets and risk?
They make things very unpredictable. That is because the clash of the forces injects far too much risk, and things don’t return to normal.
All of us like things to return to normal after a shock. We can deal with a world where the risk of things being out of our control is modest.
Let’s take a real world example of human nature and explain how people – even people with different attitudes to risk – like things to return to normal.
Imagine two people make a doctors appointment for three o’clock. Mr “Risk Averse” might be the type of person who turns up at quarter to three; just to be sure, he is there on time.
Now, consider Mr “Risk Taker”. He might be the sort of person who has had to wait in a doctor’s surgery for a little while because the last patient is taking more time than expected. So he might just arrive at three on the dot. Therefore, of the two types of people, one arrives at 2.45 pm, the other at 3pm.
That is the risk they are taking. One person takes no risk by assuming that, if the doctor is early, he’ll be there. The other takes the risk that, if the doctor is there a bit early, the doctor will see the next person in the queue and he will lose his place, but he will be next in the queue so he will have to wait only a little while. One takes no risk, the other takes some.
But the key thing is that both are fairly sure that they will see the doctor in or around three. They are fairly sure that this is normality, and they adjust their behaviour accordingly.
Now consider what would happen if the doctor said that the appointment would not be at three, but would be sometime between 8am and 8pm, but they’d just have to show up and see. Now everyone is confused and freaked out because normality has been messed with.
Something similar is happening with European financial markets because these two forces – deflation versus intervention – are keeping everything from settling down into a predictable path.
So the risks are much bigger. Take the example of Spanish bonds; the natural tendency is for Spain to default because it has too much debt and not enough growth, so the market goes one way. Then the ECB comes in and injects huge amounts of liquidity into Spain and the bonds rally. The market gets caught and allegedly very clever people get caught on the wrong side of the market and get squashed, like the people at JP Morgan.
Now, I have no problem with that because they are in the game, and if they can’t figure out where the risk is, that’s their problem. But the policy implications are very clear. The first is that these jokers should be severed from the very core of banking. The JP Morgan statement explaining what happened last week referred to “excess deposits” being used by the traders who lost â‚¬2 billion. This should never be allowed to happen.
Depositors’ money should never be gambled in such a way, particularly because of the volatility described above.
The other point is that, with these two massive forces at play (deleveraging on the one hand and massive intervention on the other), the signals coming from the markets are not really telling us anything about the underlying strength or weakness of an economy.
Therefore, when Germany responds to a bond crisis on the periphery by trying to force through a ‘fiscal compact’ that has nothing to do with what is going on in Italy, Spain or Ireland and everything to do with the basic of physics of the Newtonian Cradle, it is being disingenuous.
In fact, when the global markets are exhibiting such volatility, you would be mad to hold a referendum on fiscal policy, the results of which will ultimately be judged by the same erratic markets.
Not only would you be mad, you’d be clackers.