The Rise of Fearful Markets

How jittery investors and a reckless Wall Street caused the Great Recession—and why they will probably cause the next.
Global markets are a focal point for international affairs today. The tension surrounding fragile global markets has affected relationships between allies and adversaries alike. Pick up any newspaper and you are bound to find two nations at odds over each other’s economic policies. For instance, member nations of the EU heatedly debate the best way to pursue economic austerity. Similarly, Chinese and U.S. policy makers publicly rebuke each other over their respective market policies. Today, understanding the inner workings of the market is one of the most coveted skills in international affairs.The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How to Prevent Them in the Future, by John Authers, does a marvelous job at giving us insight into the challenges facing international markets at the core. Authers may not be a household name, but he is in a perfect position to articulate these key issues. As an investment columnist and editor for the Financial Times, Authers has spent the last 20 years covering the industry around the world. One of his greatest skills is to look beyond economics or finance for answers. Instead, Authers examines the behaviors that investors exhibit and the way such behavior has changed everything we know about the market. Fortunately for the reader, Authers takes the extra time to make a discussion of these complex issues readable for the layman. For this reason, the reader is likely to find this work an informed yet accessible look at the challenges facing our markets today.The investor’s role and plight in today’s market is a key focus of the book. Authers does not let the investor off easy. In the first few chapters, Authers points out that today’s investors are likely to panic at the first sign of bad news, sending markets spinning before having a chance to reach resolution. Furthermore, they make the issue worse by dumping their investments en masse. For Authers, this makes investors’ access to financial news a threat to global markets. This new dynamic has left markets in an imbalanced state. This does not mean that individual investors are the problem. However, their behavior has changed in ways that are difficult for the market to respond to adequately.A misconception among investors is that Wall Street has mastery over market science. Authers believes that if the 2008 crash revealed anything, it was to show that financial science, and those on Wall Street who wield it, are not able to deliver on their promises to investors. Most market science is based on mathematical equations that have not been able to avert or predict financial crises in times of crisis. Moreover, the changes in financial markets’ structure have made it difficult for Wall Street to use market science even to make investment decisions. Today, investors have taken it upon themselves to question their Wall Street fund managers’ decisions based on their opinions of the market. Wall Street, in turn, now makes investments to satisfy investor opinions. As bad a guide as equations can be, they are at least better at informing investment decisions than investors’ whims.In the modern market, investors and Wall Street firms are subject to a number of subtle forces that create further complications. Authers uses a number of technical phrases to describe these influential paradigms. These phrases prove insightful at describing Wall Street behavior. One such phrase is the “principal/agent split,” meant to explain the great divide between Wall Street fund managers and their ties to the money they manage for customers. In Authers opinion, a Wall Street investor is more inclined to make high-risk investments decisions because it is not their own money that they manage. Furthermore, investors are subject to the phrase “moral hazard,” which has the effect of strengthening Wall Streets resolve. Moral hazard suggests that Wall Street is willing to take risks because they believe that governments will bail out investment firms should the worst occur. Taken together, the principal/agent split and moral hazard create a troubling climate for investors. Since each quarter Wall Street is under intense scrutiny to make greater profits, fund managers are more inclined than otherwise to make high-risk investment decisions. The investor thus subjects his or her money to being invested in ways they would never risk themselves. This is of little concern for the Wall Street firm because, despite poor judgment, they feel assured that the government will come to the rescue if necessary.A number of examples support Authers’ narrative. One is the housing bubble. Authers’ analysis of the rise and fall of the housing market follows the discussed sequence. Under great pressure, banks found a way to make money to meet investor’s demands through the housing market. The Wall Street firms invested others’ money through publicly traded stocks. Since it was others’ money, Wall Street was not afraid of losses, and it believed in a government bailout if anything went wrong. Investors found themselves reacting to the changing dynamics of the market. They went from buying sprees to selling sprees based on the headlines of the day. The process continued until the bust, and the rest is history.By the end of the book, the reader will likely feel troubled about the direction global markets are taking. As Authers points out, there has been a fundamental change in behaviors by investors and Wall Street fund managers. Unless new ways are devised to account for these changes, the market is likely to be vulnerable from the dynamics described in the book. At present, government market reform does not appear to focus on these issues. Instead, reforms have focused largely on increasing regulation on Wall Street. As Authers would suggest, this is only half of the problem.

About the book: The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How to Prevent Them in the Future by John Authers. FT Press, 2010; 228 pages.

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