Arbitraging markets and politics
October 3, 2010
Today I had a fascinating conversation with someone from the City. Not simply “someone” — but let’s leave it at that. Point is, our talk confirmed the potential of a sociological lens for understanding (and exploiting) the post-crisis financial context.
The chat centered on a key change in finance. Forget stocks. Forget bonds. The big bucks are now to be made in foreign exchange. The two-digit returns lie in predicting, say, the future appreciation of the dollar versus the euro.
From markets to politics
Far from being a technical twist, this change reflects an important sociological development in the post-crisis environment: the continuous blurring of markets and politics. That money and votes go together is almost a cliché. But exactly how – that is more complicated. And indeed, sociologists have fought over this again and again. At the 2009 “Politics of Markets” workshop, Neil Fligstein and a bunch of European sociologists (myself, and my co-organizers Marion Fourcade, Fabrizio Ferraro and Yuval Millo) debated the mechanism for an entire day. Is it through the design of market devices, as Michel Callon would have it? Or is it by influencing institutions, as Fligstein favors?
Current events speak to that. “Events,” my financial acquaintance said, “are unfolding exactly as expected – just like in the script of a film.” Ireland is spending more and more to bail out its banks, Portugal is in trouble. Spain and Greece are not better. The US and England — printing money like there is no tomorrow, their currencies are under stress. And all of it could have been predicted. Six months ago. By simply looking at the sum of their private and public debt.
Debt, as it turns out, has turned an economic crisis into a political one. The banks of all of these countries ran reckless strategies that landed them with tons of toxic assets. They should all have gone broke, but due to political constraints they did not. Private debt became national debt, and to the tune of more money than what many countries can handle. At a stroke, then, an economic problem became a political one. Thus, Act I of the crisis entailed private banks. And Act II — the predictable script that my friend referred to — entails public finances.
Although predictable, the response has been diverse across countries. Those with low debt levels – Switzerland, Australia, Canada– can simply take on some more. The US and the UK can print money. But the countries in the Euro-zone like Ireland, Portugal, Greece, Spain (yes, there’s an animal hidden in these initials) cannot fiddle with their rates. They are bound by the rules of macroeconomics.
This opens the door to arbitrage opportunities of the kind discussed by Stark and I in “How To Recognize Opportunities“. Grappling with them takes a sociological appreciation for the blurry space of markets and politics. This is difficult for traders, because they are used to the logic of the market, and to business as usual. The key here is to predict market outcomes based on expectations of what the political actors will do or not. And of crisis – change, inflection point, new rules of the game.
And indeed, this is the scenario where George Soros made his fortune, forcing the British pound outside the maligned European currency unit. As recounted by Soros himself, his private conversations with the German central bank at the time convinced him that Germany would not bail the UK out. And they did not. The equally famous trade by John Paulson against the credit bubble also straddled markets and politics.
A Soros trade in the post-crisis environment
How to pull a Soros/ Paulson trade in 2010? At some point, Mr. Someone explained, one of these countries will go bankrupt. What will the European Central Bank (read: “the Germans”) do then? Print money and hand it over to the suntanned southerners? Kick the spendthrift out of the Euro? Leave the Euro and sail away solo? Politics are intimately bound with the market in this context. And the tree has other branches. Say, the Chinese could worsen the global imbalances by escalating its export-led growth model. Or the US could admit that it’s debt is worth less than half its nominal value. In all cases, the key to these decision branches is that the choice entails a political logic in an economic context.
There’s another aspect. The doom scenario is so bleak, according to my contact, that investors are not even thinking about it. Too ugly. Fixed income pension funds are holding in cash all their new revenues. They’re supposed to hold bonds – that’s the point of being a “fixed income” fund. But they know they could lose their shirts. Yet they are not selling any of their vast existing bond holdings either. So they’re not acting as they normally would, but they’re not following their fears to their logical extreme, which would be to abandon their own social type, liquidate, and get the hell out. The decoupling, in other words, is there for any sociologist to read.
After a long and intense discussion, Mr. Someone and I looked at the clock. Eight pm. Time to move on. As I walked back to my home in Clerkenwell (East Central London), I was struck by how luck I am to be a sociologist of finance in a city like mine. Stuff happens. And sometimes, with a bit of luck, I get to see it coming.