Posted by: Dirk | June 14, 2011

[Book review] The Volatility Machine

Michael Pettis, a professor at Peking University’s Guanghua School of Management, had written a book on emerging economies and the threat of financial collapse in 2001. As a former manager of Bear Stearns and professor at Columbia University’s Graduate School of Business he brings a lot of hands-on experience to the field and it shows. The main idea of the book is that there is something called financial structure and that this determines the financial activity. It can be used to safeguard balance sheets against trouble by designing a correlated (what I would name anti-cyclical) but it can also be used to increase risk through a converted structure (pro-cyclical). The latter structures increase volatility since in the upturn debt is lighter while in the downturn debt weighs heavier. Emerging economies have often used these structures, so says Pettis, and this has increased volatility and risk. Often this ended in financial crisis as the debt structures became impossible to support.

Pettis has written the book apparently as an afterthought on the Asian financial crisis of 1997. He also reviews some historical episodes of global financial flows in part II of the book, developing the argument that it is the increase in liquidity in financial centers that ultimately drives capital into the emerging markets, and not uncovered interest rate parity. Therefore, emerging economies which are small compared to developed economies should always be prepared that the liquidity contracts as soon as it appeared. In order to be prepared, the capital structure is important. Part III discusses the corporate finance of crises with a view to sovereigns. Exchange rate regimes and debt restructurings become relevant from the balance sheet perspective and these should be managed by the authorities – if the debt is sovereign – and at least examined and taken into account if the debt is private.

Pettis concludes that (p. 199):

[T]he recent financial crises were not a consequence of the malfunctioning of the international system. They had to do with poor liability management at the local level. The problem with the current architecture is not that global financial markets are too volatile or free capital flows to dangerous but that sovereign capital structures are not usually designed with this volatility in mind.

Some years down the road, it were sovereign capital structures in the US, Spain, Ireland, Greece, Portugal, etc. that caused a financial crisis. While the methodology in the book is historical, the main point of Pettis is right, I think. Balance sheets determine the way financial markets work. They are like functions and probably cause the “fractal behavior” that is so typical for markets. Also, balance sheets can be designed to increase shocks or absorb them, both in the positive and in the negative. When balance sheets are designed in the pro-cyclical way, like those of house owners in the US, everything looks excellent when the going is good. However, when things start to fall apart they really fall apart.

Of course, Michael Pettis should not be blamed to not see the financial crisis of 2007 in a book published in 2001. He should be congratulated upon his insights on the behavior of balance sheets and how markets structure does affect the macroeconomy – an insight, that still has not been understood by many economists.

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