28 December 2010

Virtuous and Vicious Circles

At least in short run, there is no such thing as tendency towards equilibrium in finance and in economy. Instead, there are at the beginning virtuous circles that tend to transform into vicious circles. According to Wikipedia, a virtuous circle or a vicious circle is a complex of events that reinforces itself through a feedback loop; a virtuous circle has favourable results, and a vicious circle has detrimental results.

Each financial player has to:
a) understand the circles and feedback effects,
b) figure out where we are in a given circle,
c) identify the external factor that intervenes and breaks the circle (if applicable – the trick is that it is not always applicable), and
d) take the eventual negative feedback of a virtuous circle and the eventual positive feedback of a vicious circle seriously / react appropriately.
By all that, timing is more than important.

Below there are outlined some of the virtuous and eventually vicious circles. Of course, there are frictions and other nuances to be accounted with, but these do not change the overall tendencies. Furthermore, in reality one cannot draw a clear distinction line between one and another circle; instead, feedback effects are very much interrelated as a result of which one can identify very different (yet incomplete) loops. Some simplified examples could still be helpful.

Perceived credit risk and credit availability
Virtuous circle: lower perceived credit risk means improved risk ratings and lower CDS spreads; improved risk ratings and lower CDS spreads lead to increased availability of credit and lower credit prices; more and cheaper credit (and hence more money) in the economy supports the performance of credit customers as well as collateral market values; in result, the perceived credit risk declines further and the circle starts all over again.
Vicious circle: higher perceived credit risk means lower risk ratings and higher CDS spreads; deteriorated risk ratings and higher CDS spreads lead to decreased availability of credit and higher credit prices; less credit and higher credit prices mean less money in the economy, and hence weakening performance of credit customers as well as declining collateral market values; in result, the perceived credit risk increases and the circle starts all over again.
Intrinsic turning points (respectively): credit customers with high ratings default or nearly default; loans in overdue start to decline considerably.

House prices
Virtuous circle: house prices go up and people perceive themselves richer; home is seen as a good investment and demand for mortgage loans increases; as collateral market values are going up, banks are willing to lend more; easier credit means increased demand for houses, which in turn drives up house prices; the circle starts all over again.
Vicious circle: house prices go down, people perceive themselves poorer and loan collaterals are being eroded; there is less demand for mortgage loans and credit supply is lower too; this means declining demand for new homes; in result, house prices decline further and the circle starts over again.
Intrinsic turning points (respectively): home buyers are not able to serve their credits despite of all the refinancing possibilities, flexible repayment options and restructuring efforts; compared to the amount of money in circulation, house prices are cheap enough to attract new buyers.

Stock prices
Virtuous circle: increasing stock prices attract more investors to the stock market, demand for stocks increases and this pushes stock prices further up; in parallel, increasing stock prices also mean higher profits for companies (especially when we are talking about companies in financial sector, but not only) and thus, P/E ratios may even improve despite of higher stock prices; the latter helps to reinforce the virtuous circle.
Vicious circle: declining stock prices scare investors away from the stock market, sale of existing stocks and declining demand pushes stock prices further down; in parallel, declining stock prices also mean lower profits for companies and thus, P/E ratios may even deteriorate despite of cheaper stocks; the latter contributes to reinforcing the vicious circle.
Intrinsic turning points (respectively): ultimately stock prices are so high that smart money starts leaving the stock market as Buffet’s type of investors are no more able to find reasonable investment opportunities; ultimately stock prices are so much underestimated that liquidation values of several companies are higher than their market values, and this attracts smart money.

Confidence
Virtuous circle: rising confidence in an institution or government means easier access to money; easier access to money in turn means improved ability of the institution or government to honour its obligations in due (incl. via refinancing); the later further improves confidence and the circle starts all over again.
Vicious circle: falling confidence in an institution or government means limited access to money; limited access to money in turn means deteriorated ability of the institution or government to honour its obligations in due; the later leads to further fall in confidence and the circle starts all over again.
Intrinsic turning points (respectively): the institution or government is by far too over-indebted and despite of easy money no more able to serve its obligations; default or forgiving of at least a part of the obligations may be the only way out of the vicious circle if the process has gone far enough.

Mark Twain once famously said: “History doesn’t repeat itself, but it does rhyme.” This quote very well describes the nature of virtuous and eventually vicious circles. Booms and busts come and go, but they are never exactly the same: the underlying conditions (products, technologies etc.) are different, there may be different external factors causing breaks of the circles, responses to the problems may vary. This is what makes forecasting work highly uncertain.

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