Cass Sunstein writes in his book “#Republic: Divided Democracy in the Age of Social Media” of the danger to liberal representative democracy from our increased ability, facilitated by new technology, to filter news and opinions. We favour interaction with like-minded people, and stories that conform with our existing view of the world. Our increased choice of media options and ability to communicate instantly with many people across vast distances has also allowed us to filter out those interpretations of the world we don’t agree with, and reduce interaction with people with different views to our own. This has led to the post-fact world. This is in part because such filtering has led to reinforcement of existing prejudices and reduced exposure to new ideas and experiences. The result is less doubt, less mutual understanding between those with different views, and more intransigent politics, domestically and internationally. Sunstein points outs that the US founding fathers were fully aware, in designing the US constitution, of the destabilisation which comes from populism where individual issues are decided sequentially and out of the wider political context. The result can be unworkable chaos. The compromise is representative democracy where representatives are elected, not to represent electors on every specific issue, but to vote for sets of policies which are not mutually inconsistent and in the overall best interest of the nation and their own electors.
Sunstein’s observations are also pertinent to the world views of investors (and policy-makers and other agents) in financial markets. They too filter information with greater efficiency than they used to be able, and with consequences for overall system instability.
Investors are persuaded by data and do change their minds, arguably much more readily than voters. But they still suffer the same headwinds presented by information filtering and the self-reinforcing lure of knowing they are not alone in their views. They can be unaware of the degree to which their commonly shared views diverge from reality. Consequently, when views do change they can do so belatedly and suddenly for large numbers of investors, causing extreme price movements and financial crisis. Today’s excessive leverage in Western financial markets amplifies further the impact of such shocks.
Where it is a world view which is challenged – in other words the framework (previously unquestioned and assumed stable) within which investment options are considered and decided on – investors can be taken by surprise. They experience uncertainty and shock, where a prior assessment of their assumptions and world view might have led to less surprise and more consideration, in advance, of mitigation.
Widespread oversimplification of risk in financial markets has helped create and perpetuate unsustainable views of the world. That past volatility of asset prices is measurable and additive has led to far too much weight being given to asset price movement and liquidity as risk factors versus less easily observed and measurable sources of risk. This bias has also made investors myopic in their outlook, and relatively blind to slow building imbalances and consequent large structural shifts.
Investors’ typical lack of understanding of global imbalances, relative to other factors impacting their investments, has led to them being largely confused when it comes to international monetary issues and risks, and broad macro-economic trends and imbalances generally.
Investors are however largely aware of their lack of understanding in such matters. The result has too often been a psychological retreat to conservatism. This, it should be noted, is different to prudence, and can in practice lead to vastly different allocation choices. To be prudent is to reduce risk. By conservatism I mean a retreat to the known and comfortable, and the psychologically less threatening, as a means to avoid the intellectually fearsome unknown and the taxing task of understanding the difficult. Conservatism reduces our ability to think beyond one, most likely and familiar, scenario – the status quo. Yet prudence demands that we do think beyond it.
When investing in the known, the close to home, is the riskiest of strategies, then prudence and conservatism diverge the most.
Hence even when investors know, as many now do, that they are confused, over-defensive, and over-reliant on past rules of thumb and prejudices, and that they oversee portfolios far too concentrated in developed economies, yet they stay there out of a lack of courage to do the unconventional. Agency problems and peer pressure add to this resistance to radically rethink allocations.
Those who Know Better
Officials, banks and those investors who do have a good understanding of global imbalances and risks, would, one might suppose, spill the beans or invest in a way which prices in the risks. Unfortunately, though, it would be naive to rely on that. One should not underestimate either the incentives of officials to keep market participants in the dark, or the incentives of knowledgeable investors to do the stupid thing for as long as they think they can reverse positions at the last minute.
Developed world officials (in central banks and finance ministries) are themselves highly fearful and uncertain. They are frightened of the impact on market confidence were they to be more frank about their concerns. They are trying to avoid another major financial crisis (which many of them consider inevitable) and avoid financial disruption more generally – despite having collectively failed over the last decade to use the time for sufficient and necessary bank and financial sector reform. They are also trying, via financial repression, to capture savings (domestic and foreign) at negative real interest rates to reduce their excessive and unsustainable sovereign indebtedness. This requires economy with the truth. It requires keeping investors, and especially savers, in the dark.
Banks are over-levered and over-influential on policy-makers. They are highly resistant to anything but the most gradual deleveraging of their balance sheets as a direct attack on their business model. Arbitraging other people’s money with taxpayers footing the bill post-collapse is still fine by them.
Investors who think they can go with the trend up to the last minute and then switch just before the crisis may or may not be correct – and the more there are of them the less likely they are to succeed. There are scenarios in which a move from deflation to inflation can happen very fast and liquidity collapse almost instantly – we got a flavour of that in 2007/08. The myth of the safety of liquidity is, together with the infantile measurement of risk, a large part of why current conventional wisdom about the global investment environment is so unsustainable.