THE EMOTIONAL MARKETS HYPOTHESIS AND THE GREEK BONDS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

The emotional markets hypothesis and Greek bonds

By Gillian Tett

Published: April 9 2010 20:46

When Europe plunged into its last big markets crisis, almost two decades ago, George Soros, the hedge fund investor, reputedly made $1bn cannily betting against sterling. On Friday, as the eurozone writhed amid the Greek debt trauma, Mr Soros was fighting on another front: trying to redefine economics and markets to take account of human emotions.

In the genteel surroundings of the Great Hall of Kings College, Cambridge, dozens of the world’s leading economists conducted an earnest conference on the future for economics, partly funded by Soros’ $50m largesse. One of the central conclusions of the day was that economists and market traders alike need to devote far more time to human psychology, rather than just the raw economic numbers beloved of many policy wonks.

“We need to recognise that humans are partly rational and partly instinctive,” Adair Turner, head of Britain’s Financial Services Authority, solemnly declared. Or as Mr Soros echoed: “Economic phenomena have thinking participants, natural phenomena do not ... [but] participants’ thinking does not accurately represent reality.”

It is a timely lesson, given what is now happening in relation to Greece. In the past few days, the price of Greek government debt instruments has gyrated dramatically amid widespread concern about sovereign risk.

Last Monday, for example, the yield on two-year Greek bonds was just over 5 per cent. By the end of the week it had risen well above 7 per cent – an extraordinarily large jump by historical standards. Meanwhile, the cost of insuring one-year Greek debt against default, using derivatives, swung between 450 basis points and 650 basis points. That leaves Greece almost in the same category as Iraq.

Some of these price gyrations can be blamed on Greek finances. As my colleague Wolfgang Münchau noted earlier this week, the Hellenic republic’s debt is now so big that it is hard to see how it will restructure itself without a default, devaluation or international rescue – and the latest data appear to be getting worse, not better.

However, hard numbers do not explain all of these market swings. There is also a crucial problem of human psychology at work – albeit in a form that is perhaps more subtle than is usually recognised.

The events of the past two years have changed the way many market players assess risk. Until 2007, most professional western asset managers had built their careers in a world that seemed generally calm and predictable. To be sure, the average British, German or American fund investors might have seen some market shocks in their lives. Just think of the 2001 internet crash or 1997 Asian crisis.

But these prior shocks tended to be short-lived, relatively contained, and – crucially – did not threaten to bring down the entire system. Instead, in the decade before 2007 the macro-economic climate appeared to be so utterly benign and stable that economists dubbed it the “Great Moderation”. Investors were so confident – or complacent – that this “moderation” would last, that they kept borrowing more and more, and accepting lower returns for the same risk. “In the 1920s there was a similar pattern, [the] risk premium went down,” Jeremy Siegel, professor of finance at Wharton, observed on Friday, noting that this only makes sense if investors convince themselves that “the economy is stable”.

However, the events of the past two years have blown apart that cosy sense of complacency – and confidence. Suddenly investors have learnt, often for the first time in their lives, that the world is not always stable; scenarios that used to appear unimaginable have come to pass: the mighty Lehman Brothers failed; Iceland imploded; the entire capital markets system came to the brink of collapse.

And while some of this crisis may now have passed – at least, in the sense that the largest banks have been shored up – the sense of psychological shock remains. The markets are suffering from something akin to post-traumatic stress disorder. Or as George Akerlof, the behavioural economist, observed: “In good times, people trust. But in bad times, confidence disappears and that cannot be restored.”

One practical consequence of this is that many investors now find it hard to judge the “real” riskiness of sovereign debt. Three years ago, it seemed inconceivable that a country such as Greece would be allowed to default, or exit the eurozone. But back then it seemed equally hard to imagine that Lehman Brothers might fail.

Now that Lehman has gone, who knows what the worst-case scenario might be? Could the eurozone break up? Could Greece default? What might happen to other debt-laden nations, such as the US, if the worst case scenario occurred?

The one thing that is clear is that the answers to those questions now depend as much on culture and politics as on macro-economics. That in itself is apt to sow more fear, further undermining the complex computer models used by so many investors over the past decade in their efforts to divine the future. In this new world of sovereign risk, what really matters is a set of issues that cannot be plugged into a spreadsheet. The old compass no longer works.

For some investors, this brave new world is not quite such a shock; after all, as Markus Brunnermeier, a Princeton professor, pointed out on Friday, men such as Mr Soros did not make their fortunes by thinking that markets were rational. But for many ordinary investors, the extreme uncertainty is very unsettling. Stand by to see plenty more wild market swings in the weeks ahead as rational and emotional approaches collide.

The writer is an FT assistant editor

Copyright The Financial Times Limited 2010