Irrational expectations

Financial market theorists, or at least capitalist ones, profess to believe that the market prices of securities, either equity or debt, reflect a distillation of all market participants' knowledge about the state of the world and prospects for the future. This viewpoint, known as the efficient markets hypothesis, has become very hard to sustain this year, as global markets have oscillated wildly, often in response to little or no new information. Investors have been behaving less like the rational players that the theory demands, and more like schizophrenics who just dropped some bad acid.

Consider recent events relating to the Eurozone crisis. Wednesday's coordinated move by the major central banks to free up dollar liquidity was certainly a Big Event, but most pundits were quick to point out that it was no more than a sticking plaster, with the fundamental causes of the crisis still to be addressed. So how come stock markets rallied so massively? How come France and Spain have today been able to issue bonds at much lower interest rates than would have been the case a couple of days ago? If we rely on financial markets theory, those developments surely suggest that investors see the central banks' action as more than just a palliative.

In contrast, look at how markets have reacted to events that really might portend fundamental change. Over the past month, governments have fallen (or been voted out) in Greece, Italy and Spain, in each case to be replaced by new regimes committed to pushing through the reforms that the markets (and Frau Merkel) seem to be demanding. Markets wasted no time delivering their reaction to this news, in the form of further enthusiastic selling that has carried secondary market bond yields to new Euro-era highs.

One explanation that has been offered for this apparently irrational behaviour is that investors have realised that austerity might make it harder rather than easier for indebted countries to meet their obligations. This is very much the lesson that can be drawn from the experience of Italy, which has consistently maintained a primary budget surplus (government revenues in excess of spending other than interest payments), but has seen its debt/GDP ratio swell as a result of persistently low growth. Canada's escape from its debt problems in the 1990s is the flipside of the same coin: it was growth that fixed Canada's ills, not austerity. Even so, it would be a brave country indeed that tried to test investor sentiment by announcing a "go-for-growth" strategy as a means of getting out of debt.

Reverting to this week's coordinated central bank action, it seems reasonable to suggest that the positive reaction of markets reflects relief that at least someone was taking action to address a situation that, it seems, nobody fully understands. That reaction suggests that it would still be possible for Eurozone leaders to reassure markets and stabilise the situation, if only they could bring themselves to agree on a strategy, rather than perpetually bickering and procrastinating. We should all hope that they get on with it.