1.4.1 Some fundamental theory
In principle, as we have seen, the international financial markets have evolved as the intermediary between those who possess surplus funds and those who wish to borrow. The view that the market, rather than the state for example, is the best performer of this role is most famously expressed in the Efficient Market Hypothesis (EMH), which underpins many of the assumptions made about how markets, particularly financial markets, work.
The hypothesis postulates that capital markets will be optimal in terms of allocative efficiency if prices fully and accurately reflect all the relevant infor- mation, thereby ensuring that price signals correctly direct equilibria. There are three levels of efficiency in this respect:
1 The first is the ‘weak form’ of the EMH: this requires prices to fully reflect historical performance and volatility; it renders ‘technical analysis’
(market actors obtaining abnormal profits through the analysis of histor- ical price trends) impossible, since all this information is already fully reflected in the market price.
2 The second level is the ‘semi-strong form’ of the EMH: this requires prices to reflect all the information contained in the weak form as well as all currently available information; it thus renders ‘fundamental analysis’
(market actors obtaining abnormal profits through the analysis of cur- rent information such as balance sheets or dividend payments) impossible.
3 The third level of efficiency described is the ‘strong form’ of the EMH:
this requires all the information which is known to any market actor to be fully reflected in the price; it renders all abnormal profits unobtainable since not even those with inside information are able to capitalise as the information is already reflected in the market price.
Malkiel (1987) assesses the evidence on the EMH, and concludes that the
weak form is completely confirmed by the evidence and is widely accepted as valid. Whereas some studies have contradicted the semi-strong form, the great majority support the view that new information is incorporated into prices with great speed. The strong form in its pure sense is rejected, however, since it is clear that traders with inside information are able to make abnormal profits.
However, for Malkiel, the evidence suggests that the market overall comes quite close to strong-form efficiency and he concludes that:
If there is truly some area of pricing inefficiency that can be discovered by the market and dependably exploited, then profit-maximising traders and investors will eventually through their purchases and sales bring market prices in line so as to eliminate the possibility of extraordinary return.
(1987: 122) This argument echoes a seminal contribution in this area by Milton Friedman (1953), which contends that the arbitraging activities of rational investors will ensure that prices cannot deviate from equilibrium levels to any significant degree. In practical terms, the argument is that investors will sell overvalued assets and buy undervalued assets, thereby ensuring that market prices reflect fundamental or ‘fair’ value. This was a key argument used by those arguing for floating exchange rates in the late 1960s and early 1970s, where it was argued that floating rates would not be excessively volatile, but would tend towards equilibrium fair value due to the activities of rational investors.
Numerous challenges have been made to the widespread acceptance of the EMH. Tobin (1984) is highly sceptical on the efficiency of the financial mar- kets. He distinguishes four efficiency tests that can be levelled at the financial markets:
1 The first is Information-Arbitrage Efficiency, which asks whether all pub- licly available information is reflected in market prices: in this sense Tobin agrees that financial markets are indeed highly efficient.
2 The second test is Fundamental-Valuation Efficiency, which asks whether prices fully reflect future expected earnings: he concludes that, in this sense, the financial markets are not efficient as they fluctuate far more than can be justified by changes in fundamentals.
3 The third test is Full-Insurance Efficiency, which assesses whether market actors are able to fully insure for themselves the delivery of goods and services in all future contingencies: again, Tobin concludes that financial markets in this sense are not efficient.
4 The final test is Functional Efficiency, which asks whether markets per- form their functions efficiently: Tobin asserts that, in contrast to the ostensible purpose of the financial markets – as described by Bagehot –
‘very little of the work done by the securities industry, as gauged by the
volume of market activity, has to do with the financing of real investment in any direct way’ (p. 11).
Tobin (1984) ultimately concludes that: ‘we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activ- ities that generate high private rewards disproportionate to their social productivity’ (p. 14).
In many ways this distinction is the key theoretical dividing line. Supporters of the EMH see the financial markets as optimally efficient processors of information, senders of price signals and allocators of global capital. To the extent that this is not the case, however, this is seen as primarily a function of government restrictions and controls that prevent the system playing its optimising role.
Others argue that whilst financial markets may be efficient in some senses, they are a long way from the benign vision set out above. Moreover, the reason for this shortfall is not the result of controls placed upon the system, but is an inherent feature of the financial markets themselves. This emphasis on the perfectibility of markets on the one hand is contrasted with the view of those who stress the prevalence of market failure and the potential for government to correct these failures, such as Stiglitz (1994) for example.
For supporters of the EMH, therefore, the international financial system could function in an optimal manner if allowed to develop without distorting interventions. For those who stress the importance of market failure and market inefficiency, however, this is an illusion. Rather, the negative features of untrammelled financial markets need to be restrained and positive features actively promoted by interventions by government and other official agencies.
A related distinction is the role played by the price mechanism. For sup- porters of the EMH, prices in free and open markets reflect ‘true’ or funda- mental values, which is based upon all relevant existing knowledge, and will only change when new information appears or old information is revised.
Unfortunately, however, this view does not seem to square with the observ- able volatility of financial markets. This is the primary basis of challenges to the EMH position: economic fundamentals – of companies or countries – do not change to anything like the extent that market prices do. This is true of all markets, but is particularly the case in emerging and developing countries.
Whilst this may appear a rather abstract distinction, it has wide-reaching implications. If one accepts some version of the efficient market position, then countries wishing to access the international financial markets should, in addition to ensuring that their economies are organised in a sustainable man- ner, adopt international norms of regulation and supervision to ensure that their markets are compatible with the international system. In addition, relevant data should be released in a timely and accurate fashion, thereby enabling the markets to take a balanced, rational view on the basis of the best possible information. From this perspective, emerging and developing
markets would represent only one part of a globally diversified portfolio: that is, the asset class is no different from any other. Furthermore, from this perspective, incidents of turmoil or financial crises are largely a rational response to deteriorating fundamentals in the economies concerned, with the catalyst being new information that highlights this point.
Alternatively, if one accepts that the (perhaps excessive) volatility of financial markets is not simply the rational response of investors to new information, but an inherent aspect of the international financial system, then developing and emerging economies should exercise caution. In particu- lar, in the absence of fundamental reforms to counteract these tendencies, countries should be wary of completely liberalising their financial systems with respect to the financial markets. Rather, they would be better advised to adopt a selective approach, wherein flows that contribute towards develop- mental objectives in a sustainable manner (i.e. stable, longer-term flows) are encouraged, whilst short-term, reversible flows that could contribute towards instability and crises are discouraged.
Domestically, the same issues apply. A belief in the inherent superiority and efficiency of the market mechanism suggests that government should (a) concentrate on establishing the ‘rule of the game’ in terms of a level playing field for market participants, (b) ensure obstacles to financial and private sector development are removed, and (c) avoid further interventions in the economic or financial sectors, which by definition will be sub-optimal when compared with the ‘invisible hand’ of efficient markets.
In many ways, this distinction describes the debate over virtually all aspects of financial markets (and perhaps economics in general) today. However, as we shall see, the distinction and the debate are far from new.
1.4.2 Some history
(a) John Maynard Keynes
Before Keynes, the assumption had been that, whilst markets can fail, these failures were anomalous events – indeed, the late nineteenth century is often cited as the last great period of free capital movement globally and general optimism about the nature and role of free markets.
In contrast, Keynes (1936) argued that imperfections are inherent in mar- kets and that there is no innate tendency towards the production of optimal outcomes – aggregate demand is just as likely to be such as to produce a low-growth, high-unemployment equilibrium than any other. Therefore, to ensure the desirable outcomes of high levels of growth and employment, it is necessary for governments to intervene in the economy. It seems probable that in the absence of the global effects of the Great Depression, Keynes’s views would not have had the impact that they did.
For Keynes, changes in market structure and the nature of economic activ- ity had created a highly precarious environment. Originally enterprises were
owned and run by the same entrepreneurs. In these times investments were commonly irrevocable. However, the divorce between ownership and control and the emergence of stock markets altered this situation radically.
Stock market valuations offer the investor the opportunity to reappraise her investments on a daily basis as prices fluctuate both absolutely and rela- tive to each other. This introduced liquidity into the economic system, enabl- ing investors to withdraw their investments at any stage.
For Keynes, these developments had a number of significant consequences:
• Firstly, the quantity of real knowledge of the businesses concerned – in terms of their genuine long-term prospects – is inevitably reduced; inves- tors may know little or nothing about a venture other than the value of its stock.
• Secondly, and as a result of the first consequence, day-to-day fluctuations in profits have an unwarranted impact on the share price.
• Thirdly, ‘a conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield’ (p. 154).
• Fourthly, Keynes argues that although one would expect these destabilis- ing forces to be offset by the activities of professional and knowledgeable investors, this does not occur because investors: ‘are concerned, not with what an investment is really worth to a man who buys it for keeps, but with what the market will value it at, under the influence of mass psych- ology, three months or a year hence’ (p. 155).5
Keynes describes the activity of forecasting the ‘psychology of the market’ as speculation and the long-term forecasting of future yields as enterprise. It is not seen as inevitable that the former will predominate in the market, but Keynes predicts that, as markets develop, this will increasingly be the case.
‘Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation’ (p. 159).
(b) Irving Fischer, the Great Depression, Bretton Woods and the Keynesian consensus
Another strand of thought to emerge at this time focused on observable real- world impacts of the Great Depression. The approach viewed financial crises as an integral part of the business cycle – not anomalies or a rational response to deteriorating economic circumstances as had previously been assumed.
Fisher (1933) attempted to determine the root cause of the length and depth of the Great Depression, where he saw the crucial factor as the level of
debt in the economy. Fisher argued that upswings in the economy, instigated by some exogenous event, encouraged increasing levels of indebtedness as greater investment opportunities emerged.
Higher levels of investment are then financed through higher levels of debt, which also funds the growth of speculation in asset markets with the aim of obtaining capital gains through rising asset prices. The increase in borrowing raises the money supply and therefore the rate of inflation. This rise in prices reduces the value of the debt, which encourages ever more borrowing.
At a crucial point a crisis is provoked when the level of debt becomes
‘overindebtedness’ and borrowers are no longer able to meet their liabilities.
To overcome this problem ‘distress selling’ occurs where borrowers liquidate their assets in an attempt to meet the demands of creditors. If selling of this kind is widespread enough, the previous inflation becomes deflation and the cycle reverses itself. Falling prices then cause the level of outstanding debt to increase and, as the value of collateral falls with the price level, creditors call in loans and fears of bank insolvencies trigger off bank runs.
This process continues, economic activity declines and unemployment rises.
Ultimately, bankruptcies rectify the excessive levels of debt and recovery can begin.
The key point to make is that the Great Depression shook people’s faith in the ability of free financial markets to deliver optimal outcomes. Further- more, many commentators believed that the international financial and economic effects of this event led directly to the onset of the Second World War. Consequently, when representatives of forty-four countries gathered at Bretton Woods in New Hampshire in 1944, the aim was to construct an international economic system that would reduce the instability of the finan- cial system. Unlike what had preceded it – and the situation today – the time was one of faith in the power of the state to achieve desirable goals that the market, left to itself, was now seen as incapable of producing: the goal was stability and the establishment of confidence in future events.
The reforms instituted at Bretton Woods ushered in a long period of stabil- ity, with currencies holding to their pegs (other than infrequent realignments) for the better part of thirty years. International movement of capital was greatly restricted in relation to what had existed previously. Indeed, at Bretton Woods Keynes had argued that the imposition of stringent capital controls should be obligatory on all countries, not least because of the damage he thought that unfettered capital flows could do. In this, he was overruled by the US representative Harry Dexter White, and the final outcome was that the IMF would allow such controls but not insist upon them.
(c) Structuralism
The distrust of markets that encouraged the post-war Bretton Woods reforms was not restricted to industrial countries. In Latin America the structuralist school of thought began to develop within the Economic Commission for
Latin America (ECLAC) from its launch in 1947, and under the leadership of its first executive secretary, Raul Prebisch.
The structuralist approach to development was focused on the ‘centre- periphery’ paradigm, which sought to explain the unequal nature of the world economic system. In a radical departure from classical trade theory, structur- alists did not view developing countries that focused on primary commodity exports as rationally exploiting their comparative advantage in these sectors.
Before the 1930s, the dominant development position had been one of export- led growth – not unlike today – but the global recession of the 1930s greatly reduced export markets, and led to a questioning of this approach.
The structuralists argued that the industrial revolution in the ‘centre’ had dramatically increased the productivity of the factors of production (land, labour, capital) in these economies. In contrast, the industrial sector in the periphery was tiny and was reliant on the import of capital goods from the centre. Furthermore, the Prebisch-Singer hypothesis (the ‘decline in the net barter terms of trade’) suggested that the prices of primary commodities were falling relative to manufactured goods and would continue to do so.
Consequently, developing countries had to export more and more commod- ities simply to be able to import the same quantity of capital goods. Wages in the periphery were kept low by a large pool of surplus labour in agriculture and the lack of unionisation, whilst wages in the centre were driven up by unionisation and productivity improvements.
The upshot of all this was that the periphery was trapped in commodity production and export to serve the centre and had no prospect of developing the vibrant industrial sector needed to get out of this situation. To address this, the structuralists proposed ‘import-substitution industrialisation’ (ISI) where high tariffs were placed on industrial imports, except for the essential hi-tech capital goods needed to drive the industrialisation process. The aim was to move the economy onto a virtuous circle of industrialisation, rising productivity, wages and employment.
Initially, structuralists encouraged capital inflows to fund at least part of this development. However, as the fruits of the ISI process failed to develop, the structuralist position came in for strong criticism in the 1960s, not least from within its own ranks. The position on foreign capital inflows accordingly began to change, with some arguing that foreign investors ended up control- ling the key industrialising sectors of the economy. This led to restrictions on capital flows into the Latin American region. For structuralists, therefore, the external system – both trade and financial – did not represent an opportunity for poorer countries to develop, but rather was a constraint on this development.
Structuralism (and the related ideology of ‘developmentalism’) had much in common with the Keynesian consensus that dominated the industrial economies in the post-war period. However, like them it was ultimately swept away in the 1970s. For the structuralists in Latin America, the emergence of authoritarian military regimes in the southern cone countries was the