I dedicate my paper to the Per Jacobsson Lecture by Dr. Reddy dated 24th June, Professor Levine’s seminal paper on lack of independence of the financial regulatory authority and Robert Schiller’s allusion
to the Code of Ethics for financial innovation in providing stewardship to the society’s assets.
Indeed we are in different times and wishful thinking has taken us this far, it wouldn’t any more.
That regulatory capture is pervasive and comprehensive, there is enough evidence both in the run up to the crisis as well as after it had mellowed and even in periods of tranquil. The financial markets helped by
central bank advances have amassed assets that have compounded annual growth rate of 9% (even after the painful adjustments), whereas the world economy has not even grown by 3%. This apparent dysfunctional arrangement had raised the doubt that financial markets instead of propounding systemic stability, consumer protection and risk mitigation practices to benefit large sections of people may have actually not served the lofty goals of bringing financial service access to greater majority of people, who go through the pains of adjustment more than the larger institutions; in providing the balance between serving those sections who have less knowledge of the products on offer that could advance credit and could be actually used judiciously through a mode of smoothening consumption (not excessive leverage), the larger focus had shifted to misallocation of resources to housing and consumer credit at an alarming
rate which is not sustainable. People who need to keep their financial savings in safe custody actually succumbed in this process with large scale erosion of their net worth. But more importantly the competitive efficiency of the global financial markets whose benefits should have flown unequivocally to the larger sections of the society actually petered to an excessive financialization that made some of the sovereign back-stops insufficient. The question of sovereign insolvency, which was never in doubt, has become a very common word and the moral hazard has multiplied its preponderance in recent times.
The over-financialization has led to housing market crash and it is probably going to take a decade to even out the effects of excessive supply stemming from extreme leverage, but the effect of the same in the commodity markets needs a careful scrutiny. The over-financialization of the equity markets may be the next step in the making.
Excessive financialization of the commodity markets as is evident in the component of money supply that moved to this segment had served the dual purpose of creating a virtual demand through credit creation and therefore supporting a real supply that may not be actually consumed. The net
impact of this has left a gaping hole in the balance sheet of large corporations operating in these markets, through erosion of equity and reserves, while the solvency could be maintained through financial instruments.
Research has shown that had this fund flow not happened, the supply would have followed actual demand or vice versa and prices would have stabilized at actual demand-supply play rather than at the virtual; some unsustainable capacity should have been taken out of the system, which is the
normal outcome of any business process and the market would have settled at the right price of the commodity. By prolonging a losing battle, many players in the market have actually brought the entire industry to a questionable situation where the market price is far below the cost of production of the
industry. Conventional wisdom points to the rider that reversion to the mean principle holds good when markets broadly are left on their own.
It is time we look at how the industry could be saved from over- financialization.
The case in point is Aluminum.
The events of the world seem to be over-taking us as we continue to debate around austerity versus monetary easing, or the demise of the euro versus the impending bank runs of the Southern banks, Spanish in particular as the world tries to adjust to the current reality that it is
finally demand and not supply that should be the focus of attention. Every policy instrument of the central banks and the economies, barring a few, had looked at the supply side of the problem. By tweaking
interest rates and by easing money supply every economy worked on what economists call quantitative easing which tries to hold long term interest down, while targeting a low inflation regime, thus hoping that such a ‘supply’ instrument would channelize capital to those productive sectors that would generate employment thus recouping the economies. It is true that such instruments have worked in the short run to stymie the deluge that we experienced in the downturn in the unemployment area, but whether it generated enough long term employment potential which is permanent in nature is the question. It is only in Germany that we saw such a denouement and there the conventional instruments were hardly the ones that were deployed.
Say’s law, supply finds its own demand, while true at the aggregate level, has its limitations in the short run and in specific situations as the ones we are in; there are boundary conditions which cannot be ignored like the rising levels of debts (debt to GDP ratios and government debt to government revenue ratios) which counteract when equilibrium conditions are about to prevail, but do not and one is bound by other factors which have a debilitating influence on the supply model itself as predictability finds a
restraint in the imperfect information as rationality tries not to be attentive to.
Rational inattention, to take refuge from Sim’s original coinage, acts in both directions; first that it applies a higher value to the current statistic, stemming from visionary zeal and second it rationally ignores the changes in the statistic going forward, partially alluding to the rising rhetoric of current times that chooses to play with a back-stop or a non-recourse option regardless of what the general conditions could take shape or what the other participants could or would do as a response in a market where there are more than one limiting factor at play.
Let me take the Aluminum story, I have never found anyone taking a view that the year had Aluminum in surplus, although the price signals were holding the view and this kept on happening from year to year from the run up to the crisis to the post crisis period as well; as we approach the next cycle of activity from the rather indifference that we have seen in the market behavior in the recent times it is only to be expected that deficit, which is seldom the market view, confronts the stark reality that the markets always
rationally ignores or is rationally inattentive to.
Aluminum story needs a further look. The bottom line is catastrophic; the global giants Alcoa, Rusal and Rio Tinto Alcan (in the Aluminum segment) have a combined erosion of 30% of their equity, while they
have produced at 85% of their combined capacity over the last five years. And this while the world demand for Aluminum has grown by 4.5% after netting off the effects of old scrap coming into the market. To complete the picture, we have to bring in the financial product as a demand which has taken out 8
Million ton of world’s capacity over the last five years, which is roughly 8% of the global primary output which is sold in the form of primary metal, not a small number.
The movement of price needs no guesses, while no one has till date made a statement that global output is in excess.
29th October 2012