The Warning Forecasts or Market Manipulations?

What are the warning forecast about? Who cautions who against what and how? Well, if we properly identify the underlying mechanisms of a given process, we conjecture that a continued existence of objectively occurring tendencies must lead to undesirable results. So we want to avoid them and we draw up a warning forecast whereby if relevant measures are not taken, the forecast will come true or the black scenario it presents, in the form of an undesirable phenomenon or process will become reality. We caution ourselves and others, stirring concerns, and sometimes even fears of a possible occurrence of something bad which we know is not unconditional but is possible. Warning forecasts are not about good news as nobody has to be cautioned against these, the other way round, they should be shared and celebrated.

Self-fulfilling forecasts

We also encounter self-fulfilling forecasts. No forecast, no problem; then a forecast comes up, and so does the phenomenon or process anticipated by it. The forecast comes true and something happens that would not have happened without it. A prophecy from Oscar Wilde’s story Lord Arthur Savile’s Crime is a great example of a self-fulfilling forecast. A clairvoyant foretells to the protagonist, who is about to marry a young woman, that he will murder somebody. The lord, unable to stand the anguish and to extract from the clairvoyant any detail of the imminent doom, kills him. He delays his own wedding over that but, in return, his soul is finally at peace as the awful forecast has already been (self) fulfilled.

In economy, we can also wake up the sleeping dogs or provoke something more pleasant to us, at least up to some point. The latter is a trick sometimes pulled off by financial analysts who comment on stock exchange trends in mass media or by big-time capital market profiteers. On many occasions, financial supervision organizations initiate explanatory proceedings or event investigations, when they notice that some shares go suspiciously up or down although the economic foundations of the companies involved provide no grounds for it. And yet somebody sells, somebody buys… It’s possible that in a certain set of circumstances, one can, by properly coordinating opinions to be published or by organizing rumor campaigns, successfully cause “forecasted” changes in interest or exchange rates on whose volatility we speculate.

Various experts not only dealt in illusions and expectations, speculating on greed and other human vices, but they also forecasted a permanent boom, which fueled the financial market even more, which had no relation to the processes taking place in real economy. In late 2007, the speculative bubble got stretched to its limits. “Assets” worth around USD 2 trillion were in circulation, in the form of CDOs (collateralized debt obligations), infected with the virus from the subprime mortgage loan market. They would soon be referred to as toxic assets, as the common term “securities” sounded almost sarcastic under the circumstances. What posed another threat was the unusual expansion of CDS derivatives (credit-default swaps), whose value was over four times as high as GDP of the United States, and the majority of which backed those “toxic” assets.

The power of interest rate

Although it’s not an example of a classic self-fulfilling forecast, some elements of it could be seen in the spectacular case of chicanery by a great UK bank, Barclays. It made impact on financial markets by manipulating, for several years, the basic interest rate, so called LIBOR (London Interbank Offered Rate). This rate determines the price of many loans, especially mortgage loans granted to buy apartments and houses.

The most important LIBOR rate is established as follows: on every business day until 11.00 GMT, a specific group of 16 large banks operating on the London financial market announce the interest rate they supposedly would be willing to pay for a loan, if they had to contract one on that day at the interbank market. To keep things simple, it’s about loans with maturity from one day to one year denominated in 10 major currencies, from British pound and euro to Japanese yen and Australian dollar, not to mention the American one.

The LIBOR-setting process doesn’t always involve 16 banks. Depending on the loan maturity and on the currency in which it is denominated, there may be from 6 to 18 of them, and a specific number of extreme quotes on both ends is always rejected (four if there are 15, 16, 17 or 18 banks, three if there are 11, 12, 13 or 14 of them, two if we have 8, 9 or 10 banks and one for a group of 6 or 7 banks). As a result of such a mechanism, where a smaller number of banks take part in LIBOR-setting, manipulations are even easier.

Where 16 banks take part in setting the most important interest rate, four extreme quotes among those received are excluded from both ends and a simple arithmetic average of the remaining hypothetical interest rates is calculated. The index calculated this way is LIBOR, whose level also affects the interest rate on our bank deposits (we want it to be as high as possible, banks wish it was as low as possible) and that of loans granted to us (we want them to be as cheap as possible, banks do their best, not always honestly, as it turns out, to make them as expensive as possible).

Manipulating the LIBOR

Although an extreme quote is eliminated from the average calculation in the daily LIBOR-setting process, you can still co-determine, by overstating or understating your quote, depending on what you’re aiming for, which items remain in the pool and are taken into account when making the estimate. This way, providing a quasi-objective forecast in the form of your own expectations of how the money market will behave, you can influence its actual behavior. Naturally, having in mind your own benefits from huge financial operations rather than somebody else’s (overstated) costs or (understated) revenue. When a higher LIBOR was profitable for Barclays group, this bank would give a quote high enough to be eliminated from the account, and, consequently, the average of those considered got higher than it would have been if the bank had really quoted an interest rate it would accept when borrowing on that day. It could be lower than the highest quote in the pool under consideration, and, consequently, the average or LIBOR, would be lower. Or the other way round if, under given business circumstances, lower interest rates were more profitable.

This game, however, is more complicated than that. Barclays is a huge bank and an important market player. So important that a large number of other large banks and lesser financial intermediaries watch carefully the opinions coming from such a source. If, throughout some period, high interest rates are offered, let’s say for one-year loans in USD, this is treated by others as a kind of a forecast by the entity that sends this message, a suggestion of its allegedly genuine expectations. Other financial market players may adjust, at least partly, to such a forecast. Consequently, a quasi-forecast becomes a self-fulfilling forecast. And in this case, as it turned out, also an instrument for furthering particularistic interests of an otherwise respectable bank.

This only seemingly applies to temporary and short-term issues. In the particular case of LIBOR, there are far-reaching long-term outcomes involved because where this index stood at a given point determines not only the price of many long-term loans but also exchange rates. This, in turn, affects a number of behaviors, decisions and economic processes, including long-term investments and the competitive trends for enterprises, industries and national economies. Furthermore, it has an impact on the possible future exports and imports growth rate and thus on the balance of payments, as well, and, last but not least, on the dynamics of industrial production and on the employment level. The interest rate is a powerful instrument of shaping financial and real economic processes.

Better to be careful

If we take a look at forecasts of changes in the basic interest rate, the market predictions are strikingly accurate. The interest rate is, apart from the exchange rate, to which it is indirectly linked, a basic price in a national economy as it determines the price of money now and in the future. Is it possible that bank analysts, who are the authors of those forecasts later averaged out by a small circle of pundits, and then promoted to the general public, have such great skills and maybe also a bit of good luck, to boot? Then maybe they deserve to be praised rather than reprimanded? It is sometimes the case; forecasts are accurate because they were based on correct theoretical reasoning and predicted wise, substantially justified decision. However, there are also cases where we witness symptoms of a self-fulfilling forecast, as well as attempts to manipulate the council (an independent one, of course) which formally determines the central bank’s interest rate. Not to mention the fact that analysts, after all, consult one another and sometimes work out a common view; their announcements are so aggressively pushed by certain mass media (independent ones, obviously), that monetary policy council members not only couldn’t possibly not know them, but also it’s hard for them to go against the so called market consensus, or the averaged predictions by those analysts. Psychological pressure is enormous, and none of the council’s experts wishes to be portrayed in those media as an ignorant who tilts at the windmills and fails to understand what’s clear to all bank analysts, namely what interest rates should be like! So, usually they are “the way they should be”.

Professor Kolodko runs a special portal and blog, www.volatileworld.net, devoted to his bestselling book “Truth, Errors, and Lies: Politics and Economics in a Volatile World” http://cup.columbia.edu/book/978-0-231-15068-2/truth-errors-and-lies