Guest article written for AllAboutAlpha.com – the official publication of the Chartered Alternative Investment Analyst (CAIA) Association
Analysis of any economic and financial system requires an understanding of two key factors; information and momentum.
Understanding the information content of a system means having knowledge relating to the fundamental nature of what is being observed and its context. What are you seeing? why does it behave as it does? what influences its behaviour? what will it do next? what is the nature of the system and its participants? Momentum is an emergent property of the fact that economic and financial systems are behavioural in nature. In context, this is a function of the size, speed and direction of that which is being observed. If you were observing the FTSE for example, you would want to know the size (price), speed (rate of change of price) and direction (whether the price is moving up or down).
Information is subjective, and asymmetries in the information held by observers and participants in any market are the fundamental source of profit opportunities and- of course- problems. A lack of information can manifest as uncertainty. The Economist noted Ben Bernanke who, in a 1980 paper stated that since most investment is irreversible, uncertainty “…increases the value of waiting for new information [and thus] retards the current rate of investment…” Many would also argue that informational asymmetries manifested our economic crisis itself as a small group of individuals manipulated the market while the majority of participants had no idea what was happening.
To learn more about speed and information, I spoke to Nobel Prize Winning economist Prof. Michael Spence.
Michael Spence is a world authority on growth in developing countries and on the convergence between advanced and developing economies. He received the Nobel Prize in Economic Sciences in 2001 for his contributions to the analysis of markets with asymmetric information.
Spence is a professor of economics at the Stern School of Business at New York University, Professor Emeritus of Management in the Graduate School of Business at Stanford University, a Senior Fellow of the Hoover Institution at Stanford and a Distinguished Visiting Fellow of the Council on Foreign Relations. He has also served as the Dean of the Faculty of Arts and Sciences at Harvard and the Dean of the Stanford Business School. Among his many honours, he was awarded the John Kenneth Galbraith Prize for excellence in teaching and the John Bates Clark medal for a “significant contribution to economic thought and knowledge.” Spence has published widely and is the author of several books and numerous articles and papers. His most recent publication is The Next Convergence: The Future of Economic Growth in a Multispeed World (May 2011). He is a former Chairman of the independent Commission on Growth and Development, which focuses on growth in emerging economies.
On Multi-Speed Economies
Q: What is the multi-speed economy?
[Prof. Michael Spence] When I coined the phrase ‘multi -speed economy‘ I had a couple of things in mind. I wanted to convey the difference between successful advanced country growth (2.5-3%) and successful developing country growth (7-10%). I also wanted to show that over time, and at any point in time, there are dramatic differences in potential, and led to the notion of convergence. At the end of World War II, you had the had advanced economies in their current state and developing countries which had remained unchanged for 200 years. At the end of this century 40-50 years from now, the proportion of our world’s population who live in the developing world will have gone from 15%, 200 years ago, to over 85% – we’ll be left with a very different planet.
Q: Post convergence, will ‘developing‘ economies accelerate past the incumbents?
[Prof. Michael Spence] I don’t think so. The model I have in my mind is that they will join the ‘advanced’ country group, creating a huge global economy. There will be countries that are more or less successful- but they will be subject to the kinds of constraints that constrain the growth of advanced economies. They will have to invent technology and innovation that enables growth. There’s a limit to capital deepening and labour supply won’t increase forever. A lot of the accelerators for developing economies such as inbound knowledge transfer, capital deepening and so on will go away. You’ll see a whole collection of countries that grow at a trend rate of 2.5%, bursting up to 3% when there are major technological advances.
We’ll see the same patterns that exist in the advanced world… You’ll have a ‘Greece‘ that will fall behind, a ‘Germany‘ who will right the ship… You won’t get growth beyond that 2.5-3% unless there are massive technological advances. In that sense, we won’t pass each other.
Q: Have you seen evidence of different speeds within the same economies?
[Prof. Michael Spence] You can see clear differences across countries. For example, if you look at the income distributions across advanced countries- they are startlingly different when you consider they operate with similar technological and market forces. Growth will create differential impacts with subsets of people experiencing varied growth.
In the advanced countries, it is a very challenging time for people in the middle-income and middle-education range. They are being subjected to greater competition from labour saving technology. These are long-term trends, and not permanent. Eventually we will run out of surplus labour….
Q: Why do economies slow down?
[Prof. Michael Spence] There are two basic underlying reasons. Firstly dysfunctional politics and secondly economic mistakes.
Political and governance failures have a dramatically negative impact. You may find dysfunctional democracies and autocracies and all kinds of other pathologies. To give you an example from my own life… I grew up in Canada and have a lot of friends in Argentina. In the early part of the 20th Century, Argentina was wealthier and had a higher per-capita income than Canada. The country had severe governance issues which impacted economic and social development. It’s still a great country to be in, but has had too many mishaps along the way.
The classic case of economic mismanagement is Brazil. This is a country that grew at over 7% per-year for a quarter of a century after World War II and then more-or-less stopped for 20 years. There was virtually no per-capita income growth, they turned inward with an import substitution policy… they lost control of the monetary system… they experienced hyper-inflation… the government was running large deficits…. they had political instability which led to a dictatorship and more. Research over the past 60 years means that these economic mistakes will be fewer- particularly at the basic level where you may see a country mismanaging at a macro level, closing economies and so on.
You must also remember there are differences of scale. Economies of small islands are very different to countries like China and India. The same is true of landlocked countries surrounded by dysfunctional neighbours versus somebody on the coast.
On Information Asymmetry
Q: What is information asymmetry, and how does it impact markets?
[Prof. Michael Spence] The way to think about informational asymmetry is market by market. If you’re in a supermarket buying lettuce, there are potential informational asymmetries. Someone may have used a bad fertiliser… even a toxic one… and you wouldn’t know it staring at a piece of lettuce. That would be an example of information that is automatically complete on the supply side of the market. People know about this! We have regulations that we take for granted that essentially close informational asymmetry. We have food safety regulations, we have disclosure regulations in finance and so on. Their purpose is to close very large informational gaps.
Informational asymmetries are relatively ubiquitous and their impact varies from market to market. They certainly cause markets to underperform relative to the hypothetical standard of perfect information that we all learn in price theory. If very damaging, asymmetries can destroy markets- causing them to unwind from the top- this is the adverse selection problem. In this case you have an informational asymmetry that manifests with significant quality differences between supply and demand side. Product differentiation disappears, prices will reflect the average quality rather than differential quality… People with high quality products remove them from the market due to the price being an average… the quality drops, then the price drops again.. and you end up with a cycle. This is selection from the top and can, in its extreme form, cause an entire market to drop.
Q: Is signalling clearly understood?
[Prof. Michael Spence] To have signalling, you have to find an activity (be it an investment or otherwise) that has two characteristics. It has to be visible for a start! To carry information in equilibrium, its costs have to be negatively correlated with the underlying quality attributes…. in other words… Luck!
This is not just limited to markets. There are a lot of interesting social situations that have the same characteristics. There are cultures in which a young man, to signal his interest in a woman, would camp outside her house for any number of days. The ones who aren’t really interested say, “…to hell with it, it’s not worth it!” – In this sense, signalling screens people out.
Signals don’t perfect markets. The activity of signalling has two components of the return. First is the impact on quality (e.g. education in theory makes people more effective), and next is the more zero-sum component which compares “Person A” who is more talented to “Person B” who is not. This latter component diminishes the efficiencies of markets.
Q: Do asymmetries and signalling create power within markets and their outcomes?
[Prof. Michael Spence] There’s nobody big enough to have any power, the market creates signals with returns… but nobody individually is big enough to adjust the behaviour on the signalling side of the market. There are some cases where that’s not true. Governments can influence the behaviour of markets by intervening in markets based on signals they receive. This can make the markets more efficient.
Signalling models have multiple equilibria. There are reasons for that which have nothing to do with informational asymmetry. Beliefs and expectations when they shift, have a big effect on incentives, behaviours and market outcomes. You get multiple equilibria due to differing beliefs and expectations which are self-fulfilling in the marketplace. You are seeing an awful lot of that now.
We simply do not have the structural configurations to tell us when we get multiple equilibria. Instead, we have examples… If you have an economy that begins to leverage- you get expectation shifts that will demand a movement in the market which are self-corrected. The underlying target begins to move. If you take that same system and leverage it further, you will get expectation shifts that cause asset-price shifts. This creates massive balance sheet effects in the financial system and huge wealth effects in the economy which affect investment, unemployment and so on. In fact.. that’s what we saw in 2008/9 – a highly leveraged system that was in an unstable configuration due to being at the point where a relatively modest shift in expectations and prices caused a cascading effect.
On the Economy
Q: What do you see as the biggest risks in the global economy?
[Prof. Michael Spence] There is a huge amount of macro-systemic risk. The centre is clearly in Europe.
The Greek situation is containable, but if they fall asleep- the contagion could kill us. There are circuit-breakers in the economy just like a bank which should in theory stop this. If you turn to Italy and Spain- the Euro Zone simply could not survive if these guys don’t get their fiscal situation and growth on a different trajectory. The rest of the Euro Zone core including Germany will not continue to intervene if they do not reform. The remainder of the Euro Zone problem comes down to buying enough time to allow these ideas to work… That’s where multiple-equilibrium comes in. If the IMF, ECB and Euro Zone Core play a hands-off approach and allow yields to roll up above 7%, the structure of the game will change in the wrong direction. If that happens, you tip to the chaotic unwinding scenario. This is no good for anybody. I spend a lot of time in China, and if you ask people there what the main risks to their economy are they will tell you “internal and external” If you ask which are bigger, they would say “external” and if you ask where they are? they would say “Europe…” The Euro Zone situation is having an adverse affect on growth in China, India, Brazil and elsewhere in the developing world. Let’s not forget that Europe is the United States’ biggest trading partner which is causing headwinds in the US. The fact is, everyone’s interests are aligned… If you go to anywhere in the world and ask what people would like most, they would want America to return to a sustainable growth pattern and Europe to stabilise its economy. This is not a zero sum game, it’s not even close.
There are other pockets of risk. There’s worrying lot of reform in India which, unlike China, does not have a huge balance sheet to use as a buffer. China has more ammunition, but has a very complex middle-income game plan to execute which will involve significant system changes and overriding of many forms of vested interest and political system.
In America there is political gridlock. The debt ceiling issue is raising its head again, and the Bush tax-cuts are going away along with extended unemployment benefits and payroll tax holidays. You don’t have much sense of convergence amongst political and policy people about the way forward – we’re not trying for a perfect plan, but merely for some sensible divisions. The US economy is quite far along deleveraging but has many structural headwinds. The economy (like Europe) is running on excessive consumption and deficient investment. You can’t fix these things overnight. You must allow markets to work themselves out.
Globally, there are a lot of what people refer to as “known unknowns”
What does this mean for Investors & Risk Managers?
The last quarter century has seen an astonishing technological leap in our ability to observe financial and economic systems. More so than ever before we are able to produce and analyse data on every facet of markets, getting a deep sense of the complexity and interdependencies that exist.
This capability has introduced what could be described as an ego-paradox into our system. While we may feel we are now more intelligent and capable than ever before, the fact is- we are simply hiding behind information without really understanding what it means. If nothing else- the increased rate and severity of extreme market events is surely testament to this. As George Bernard Shaw himself said, “…beware of false knowledge; it is more dangerous than ignorance…”
Investors and risk managers have to understand this disconnect between having information and having understanding knowledge. Our markets are too fast and too connected for us to remain complacent in this regard. The payoffs for those that understand this are huge.
As Sir Francis Bacon said, “Knowledge and human power are synonymous”