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2021 | Buch

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Financial Markets and Economic Performance

A Model for Effective Decision Making

verfasst von: John E. Silvia

Verlag: Springer International Publishing

Enthalten in: Springer Professional "Wirtschaft+Technik" , Springer Professional "Wirtschaft"

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Über dieses Buch

Effective decision making requires understanding of the underlying principles of financial markets and economics. Intellectually, economics and financial markets are genetically intertwined although when it comes to popular commentary they are treated separately. In fact, academic economic thinking appears separate from financial market equity strategy in most financial market commentary. Historically, macroeconomics tended to assume away financial frictions and financial intermediation whereas financial economists did not necessarily consider the negative macroeconomic spill overs from financial market outcomes.

In more recent years, the economic discipline has gone through a serious self-reflection after the global crisis. This book explores the interplay between financial markets and macroeconomic outcomes with a conceptual framework that combines the actions of investors and individuals. Of interest to graduate students and those professionals working in the financial markets, it provides insight into why market prices move and credit markets interact and what factors participants and policy makers can monitor to anticipate market change and future price paths.

Inhaltsverzeichnis

Frontmatter

Chapter 1. Why Finance Matters for Economics: The Story of Financing the Railroad

Abstract

A dynamism in the economy surrounds the role of expectations and actual outcomes that prompts change. Price changes in one sector generate further price movements in other sectors. Recognizing change, however, is often difficult. Decision-making benchmarks/cognitive biases impact actual economic/finance decisions.

A four-sector framework illustrates the linkage between the real economy and financial markets. The framework examines the markets for goods, credit, equity, and foreign exchange and highlights the interrelationships between individual economic units. For each of these markets, leading indicators are essential to recognize change.

Markets are in a state of constant disequilibrium and are examined in the context of cycles, trends, and structural breaks as illustrated in several real-world economic series that move both the economy and financial markets. The story of the Transcontinental Railroad is particularly important.

John E. Silvia

Chapter 2. The Story of the Original Boom and Bust in Western Finance: The Mississippi Bubble

Abstract

Excess in one market motivates change in other markets since prices in each of the four markets (goods, credit, equity, and foreign exchange) are mutually dependent. The illustration of these excesses provides light on real-world events and the movement of market prices. Prices reflect forward-looking expectations. When actual events differ from those expectations, prices move. Often one expectation is that when markets are shocked, prices will return to prior values—positive static stability. Yet, that is seldom the case as commodity prices as well as other prices, drift, or migrate to new set of prices, neutral static stability, or crash—negative static stability. Public and private sector actions and, imbalances between markets, generate shocks. Intellectual biases, such as the confirmation bias, the framing of risk, and illusory correlation, often limit responses to those shocks. These biases influence the boom and bust of financial cycles.

John E. Silvia

Chapter 3. Price Determination in a Multi-Sector Global Economy

Abstract

Market prices during the 1970s illustrate how prices move from one perceived through a period of disequilibrium and then to a new equilibrium. Prices are seldom at equilibrium, partial equilibrium, and even more with the interactions of other markets, general equilibrium. In addition, price movements may exhibit a short-run cycle around a longer-run trend. In some cases, market price cannot move, or move too much, when we consider incomplete markets thereby generating price volatility. An administered price in one market (fixed exchange rates, central bank administered benchmark rates, or price-controls on commodity prices) may be inconsistent with the long-run equilibrium of that market or with other markets. Price “bubbles” reflect rational choices based upon currently perceived input information but maybe are inconsistent with future shocks and long-run fundamentals. These bubbles offer interesting cases for price discovery.

John E. Silvia

Chapter 4. Credit Allocation and the Role of Interest Rates as the Price of Credit

Abstract

Are low-interest rates an incentive to misprice capital? In the traditional view, low-interest rates prompt increased consumer spending, business investment, and economic growth. However, the case of the housing bubble/bust indicates that low-interest rates may lead to a misallocation of financial and real capital. Central bank policy is one example of administered rates and the purposeful change in the pricing of credit. However, there is no obvious truth that whatever the central bank policy rate is, that is the correct rate for long-term economic growth. The “Conundrum” cited by Chairman Greenspan hints at the limits of our expertise. The yield curve allocates credit over time but also reflects market expectations. After the U.S. presidential election in 2016, markets priced in higher inflation, on the expectation of incoming expansionary fiscal policy. Yet, the upward momentum in long-term yields was largely reversed.

John E. Silvia

Chapter 5. Short-Term Credit: Bridging the Next Few Years

Abstract

Barings Bank and the Louisiana Purchase illustrate the role of intermediary finance and liquidity in economic activity that characterizes the financing of economic growth. From the demand side for short-term credit, the link between the real sector and credit markets provides a cyclical character to both. On the supply side, the non-banking (shadow) sector has been a reality of short-term financing for over thirty years. Cyclical and structural change illustrate the evolution of consumer lending on both the demand and supply side. Evidence from the Senior Loan Officer Opinion Survey provides perspective. The impact of credit booms and busts is reflected in patterns of non-current loans, as well as charge-off rates. Asymmetric information and securitization influence the share of bank loans in credit market financing. The lower cost of long-term finance has encouraged firms to term out their financing while alternative nonbank financing options have grown.

John E. Silvia

Chapter 6. Capital Markets: Financing Business Over the Long Term

Abstract

New financial instruments emerge, are tested, appear dead, only to reappear in a more sustainable form. Both commercial paper and high yield bonds are examples as finance evolves with the economy.

The worst loans are made in the best of times. There is a procyclical pattern to both the supply and demand for bonds but when an economic shock happens, the viability of corporate debt and financial innovations is tested.

When examining the evidence of corporate balance sheets, there are distinct cyclical and structural patterns in financial benchmarks such as the corporate short-term to long-term debt ratio and the ratio of corporate debt to equity.

The distinction between ex ante and ex post returns brings in the all-important role of expectations and cognitive biases. This emphasizes the linkage between interest rates, exchange rates, and sovereign risk in the U.S. context.

John E. Silvia

Chapter 7. Dynamics of Corporate Finance: What Motivates Change?

Abstract

The ratio of corporate debt and to GDP provides little insight into the reality of corporate finance. In contrast, patterns in net interest expense relative to operating surplus, current assets to current liabilities, and the financing gap provide cyclical patterns that serve as reliable guidelines—but not rules. Corporate financial leverage varies over the business cycle and therefore provides a cyclical character corporate credit quality in response to changes in interest rates, inflation, and the pace of economic growth. These three factors influence corporate choices of bank, bond, or equity finance, which themselves are the result of evolving cyclical activity. Tobin’s Q provides a gauge of the balance between the replacement costs of real assets and the market value of equities. Implementation of this benchmark as a tool illustrates the principle that many economic series are often more of a guideline rather than a rule.

John E. Silvia

Chapter 8. Evolution of Household Finances

Abstract

Both the supply and demand for household credit associated with the housing crisis reflect cognitive biases, such as the recency bias, that drives borrower and lender expectations. Well-intended, but poorly proscribed, financial deregulation offered a field of experimentation that reinforced the housing crisis. Increases in household debt alone, tells us little about the true financial state of the household. A better approach is the comparison of assets/liabilities—the concept of household net worth. Income statement ratios, such as the interest expense to disposable personal income ratio, provide a view of household finance. This introduces the influence of changes in interest rates, credit availability, and the pace of employment/income growth. Since the financial crisis of 2007–2009, the household debt service ratio remains below the level of early 1980s—a structural break in the series intimates a new model of household supply and demand for credit.

John E. Silvia

Chapter 9. Capital Flows: The Dollar and Global Capital Allocation

Abstract

Good due diligence in foreign investment reflects a careful balance of risk and reward. Yet in so many cases, the South Seas Bubble being one of the earliest examples, investors place financial capital without a proper perspective of the expected returns and the risk involved. The U.S. dollar, expressed as an exchange rate for any other currency, is a price, in fact a relative price. Any exchange rate today reflects investor expectations for growth, interest rates, and equity returns. Numerous historical attempts to set a fixed exchange rate (Bretton Woods) are honorable but the economic forces in the global economy are unbending. These fixed exchange rates set up a disequilibrium problem that can only be resolved by significant moves in inflation, interest rates, or economic growth—or a breakdown of the exchange rate peg. Moreover, any attempt to target an exchange rate opens the markets to spillover and repercussion effects that once again will alter equilibrium values in other markets.

John E. Silvia

Chapter 10. Profits: Rewards and Incentives in an Economic System to Allocate Capital

Abstract

Profit-seeking, not just religious freedom, was a motivation for the English colonists in America. In fact, the search for profit prompted many a voyage (Portuguese, British, and Dutch) of exploration. The pursuit of profits provides both the incentive and reward for economic activity. Profits provide the funds for capital investment and employment. Profits of the enterprise are the income to owners and shareholders. However, profits do not run in sync with economic growth and so a dynamic is set up where profit growth is sometimes strongest as the economy recovers from recession and slows as the economic recovery matures. Yet, there is often a disconnect between the ability of companies to deliver profits and the expectations of investors to reap these same profits. One interesting twist in recent years has been the willingness of investors to invest in capital gains rather than income.

John E. Silvia

Chapter 11. Equity Finance: Financing Innovation and Long-Term Household Wealth

Abstract

Equity markets function to raise capital, allocate capital, and distribute the gains to investors and households. Yet few economic courses cover these markets even while many students are fascinated by the workings of these equity markets. The positive capital allocation function is sometimes overshadowed by speculation. The speculation aspect is certainly there but the existence of cognitive biases, such as the recency bias, help define the behavioral problems in equity pricing. As is true of pricing and credit cycles, expectations may not match real outcomes thereby providing a dynamic impulse to equity investing. The earnings/price ratio is not mean reverting and yet investors often benchmark their sense of value against an average earnings/price ratio measured over an arbitrary period. Instead, equity valuations, relative to nominal GDP, have a more volatile pattern that reflects the influence of other economic price, such as interest rates.

John E. Silvia

Chapter 12. Sovereign Finance: When Economic Growth and Sovereign Debt Are a Mismatch

Abstract

The imbalance between the federal debt burden and economic growth was evident in the experience of Germany in the early post-WWI period.

Private sector demand for sovereign debt is a function of expectations of income, expected real returns exchange rates, and the availability of alternative financial returns. On the supply side, the supply of sovereign debt as a function of perceived policy desires and any limits that may arise from the cost of finance.

Today, the three biggest holders of U.S. Treasury debt are the Fed and the central banks of China and Japan. These institutions are not motivated by maximizing profit nor do they mark to market their sovereign debt portfolios.

The grand assumption that federal spending is costless has failed to hold. The ability of the sovereign to issue debt has faced limits. Two failures were for France and John Law and the United Kingdom after WWI.

John E. Silvia

Backmatter

Titel: Financial Markets and Economic Performance
verfasst von: John E. Silvia
Verlag: Springer International Publishing
Electronic ISBN: 978-3-030-76295-7
Print ISBN: 978-3-030-76294-0
DOI: https://doi.org/10.1007/978-3-030-76295-7