Tag Archives: financial crisis

How the economic machine works

This video by Ray Dalio is probably one of the most informative I have seen for a long time and it gives those without a background in economics a very simple and easy to understand model of what has been driving the recent financial crisis. It should be noted however that the model is very simplistic and doesn’t take into account a number of other factors such as international trade.

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When Economists Get It Wrong! The Worst Economic Predictions Of All Time

Economics is often described as the ‘dismal science’. Unlike other traditional sciences, economics rarely provides a simple solution to present day issues. Furthermore economists have a poor record of predicting the future. Even notable economists such as Joe Stiglitz agree that economists only get it right at best around 3 or 4 times out of ten. However it should be acknowledged that economic forecasting is a difficult art at best – human behavior is forever changing and the economy is a complex mechanism with many working parts. Nevertheless I thought it would be entertaining to highlight some of the most wildly inaccurate forecasts in recent times. Here are some of the best…

1. The Great Depression

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Almost every economist failed to predict the great crash of 1929. Most famously the economist Irvine Fisher (who Milton Friedman regarded as “the greatest economist the United States has ever produced”) predicted that stock market prices had reached “what looked like a permanently high plateau”. A week later the stock market crashed and didn’t bottom out until 1932, with the Dow Jones recording a 88% total loss in value.

Even the great John Maynard Keynes failed to see the fore-coming shock allegedly stating in 1927 that “We will not have any more crashes in our time.” 

2. The Japanese Automobile Industry

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In 1968 the BusinessWeek magazine stated that, “With over 15 types of foreign cars already on sale here, the Japanese auto industry isn’t likely to carve out a big share of the market for itself.” Fast forward to the present day and Japanese car manufactures now account for around 36% of the total US car market. Add in other Asian car makers and this figure jumps spectacularly to around 49.9%

3. The Soviet Economy

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In 1989 nobel winning economist Paul Samuelson asserted in his best selling textbook Economics that, “The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.” Two years later the Soviet economy collapsed.

4. Dot Com Bubble

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Numerous predictions failed to foresee the dot com bubble. For instance in 1999 Smart Money magazine highlighted AOL, Yahoo and MCI WorldCom as some of its top picks for the forthcoming year. By 2001 AOL had lost 70% of its stock value after its merger with Time Warner. Later in 2002, MCI WorldCom became involved in one of the largest bankruptcy cases the US had ever seen.

However no prediction about the Dot Com boom was as profound as that made by James Glassman and Kevin Hassett in 1999. In their book, “Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market”  Glassman and Hassett argued that the Dow Jones Industrial Average may rise to 36,000 within just a few years.  After reaching an initial high of 1,750.28 in January 2000, the Dow Jones fell to a low of low of 7,286.27 in October 2002. Even today the average remains still below 15,000. Glassman and Hassett’s book can now be found on Amazon for $0.01.

5. The Credit Crunch and Financial Crisis.

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In 2008 the sub prime mortgage crisis led to the collapse of a number of financial institutions and a global economic recession. However before 2008 many economists had an optimistic outlook for oncoming years, growth had been steady and inflation was finally under control. Despite the impending financial crisis many economists and policymakers were contend with the health of the banking sector. 

For instance in 2005 Alan Greenspan declared, “The use of a growing array of derivatives and … more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions … Derivatives have permitted the unbundling of financial risks”.  

Similar optimism was forwarded by individuals such as David Lereah, chief economist for the National Association of Realtors, who in February 2006 published “Why the Real Estate Boom Will Not Bust,” which was essentially a guide for homeowners on how to profit from the expanding real estate market!

However these predictions fall short in comparison to the statement made by Federal Reserve Chairman Ben Bernanke  in 2007 who famously declared that, “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

 

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What do all those numbers mean? Stock markets and their importance

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They feature in nearly every news bulletin, paper and website. Their ups and downs, bubbles and crashes are reported on a daily basis. Yesterday for instance saw a dramatic plunge in the values of stock markets across the world. However the reality is that for many people unfamiliar with the world of finance, ‘a one point increase in the NASDAQ’ remains an alien phrase. This post will attempt to provide a basic understanding of what stock markets are and what the indices mean for you and me.

Stock markets fulfill two main roles. Firstly they allow companies to raise extra funds by issuing shares without the need for commercial loans. The stock market brings together companies wishing to expand their operations and potential investors looking to gain a return on their savings. Stock markets are therefore an important source of investment for firms. Historically they have allowed for the expansion of today’s largest corporations such as Coca Cola, Microsoft and ExxonMobil.

Secondly stock markets act as a platform for individuals to buy and sell shares through the use of stock brokers. The ease at which shares can be brought and sold is one of the main attractions of the market. This is in contrast to other less liquid forms of investment such as real estate – which can not always be as rapidly sold without loss of value.

Stock markets therefore have a positive effect on the economy in a number of ways:

  • Firstly they allow companies to expand, creating jobs and new products for the real economy.
  • They mobilize savings by allowing private individuals to invest their idle cash or bank deposits into profitable enterprises.
  • Stock exchanges facilitate improved corporate governance. This is because public limited companies have to meet the demands of a more diverse range of shareholders and the regulations set out by the stock exchanges themselves to remain listed.
  • Stock markets allow for governments to raise capital by issuing government bonds (government loans in the form of an IOU) to fund different economic development programs such as infrastructure building.

An economy with a growing and sophisticated stock market is therefore generally associated with a highly developed industrial and service sector.

So what do those numbers in the news mean?

Generally in the news you will see a list of the differing indices which are used to gauge trends within the stock markets. Instead of looking at the value of just one company, indices attempt capture the value of a number of companies or a sector listed at the stock exchange. It therefore allows us to see any movements in the combined aggregate value of these companies. The value of such companies or sectors is measured in two ways.

The first most common method measures total market capitalization (the total market values  of all the shares of the companies e.g. price of share x number of shares) and then uses a mathematical transformation to bring the number into a more manageable range. This is because many companies have market capitalization values listed in the range of tens of billions of dollars. The impact of the change in a companies share price on the index is therefore proportional the companies overall market value.

The second less common method only takes into account the price of the shares. In this type of index each company makes up a fraction of the index proportional to the price of its stock. This type of measure however ignores the size of each company and has therefore been subject to criticism. The Dow Jones Industrial Average is an example of this type of index.

Now I am not going to become bogged down explaining how these indices are mathematically calculated as many methods exist and all are subject to their different critiques. The main point to take from this is that an index reflects a transformed aggregate value for a number of companies within the stock market with reference to a base year.

A rise in a stock market index therefore reflects a increase in the total market value of the companies in the index. Similarly a fall in the index reflects a decline of a the total market value of the companies in the index.

Indices also differ in their coverage. Some attempt to capture the trends of the global market such as the S & P Global index. Other measures attempt to capture the performance of national stock markets. For example, in the UK the main index used is the FTSE100. This index measures and weights the values of the countries top 100 companies. Inaugurated in 1984 at the base level of 1000, the graph below shows the various progression in the value of the UK’s top 100 companies since the index began.

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 Some indexes go further and attempt to capture the whole market. The Wiltshire 5000 index represents the market value of all publicly traded stocks in the US. Such an index is known as a total market index. Lastly, some indexes measure specific sectors such as biotechnology or real estate.

Interpreting the indices for the wider economy

Generally stock market indices are regarded as a barometer of economic development. When the economy is strong and growing, the stock market is assumed to be flourishing. Similarly when the economy shrinks, it is assumed the stock markets will be struggling.

However although this makes sense logically for many reasons this is not always the case and it should be remembered that the stock market and the economy are not the same thing.

For these reasons it is entirely possible that you may have a booming stock market within a struggling economy. This has been the case recently in the UK where the stock market has seen an upward trend whilst the economy has been sluggish. Consequently we must be very careful when interpreting the stock market and utilizing it as a barometer for the economy.

Instead the stock market indices reflect the views of investors and these views are hard to interpret. As Adam Davison of the NY Times rightly states a stock purchase form does not come with a ‘reason’ field. This problem is further compounded by the existence of ‘herd’ behavior in markets which can lead to market bubbles. Investors may purchase stocks just because they see others doing so thereby increasing the price of the stock. This in turn inflates the index of the market and if investors find they have invested in an bad asset (such as with the sub-prime mortgage crisis) it can lead to crash.

In summary, stock markets are an important mechanism for facilitating investment in the growth of firms. Stock indices commonly reflect the performance of a specific sector, a whole market or a number of influential companies. However due to the nature of trading and the narrow scope of many indices caution must be taken when relating such markets to the wider economy.

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