Excerpted from The Fearful Rise of Markets by John Authers. Published with permission of FT Press, an imprint of Pearson.

The Fearful Rise of Markets

By John Authers

"A rising market can still bring the reality of riches. This, in turn, can draw more and more people to participate.... The government preventatives and controls are ready. In the hands of a determined government, their efficacy cannot be doubted. There are, however, a hundred reasons why a government will determine not to use them."
J.K. Galbraith, 1954

World markets are synchronized, and far more prone to bubbles and meltdowns than they used to be. Why?

It was in March 2007 that I realized that the world's markets had each other in a tight and deadly embrace. A week earlier, global stock markets had suffered the "Shanghai Surprise," when a 9% fall on the Shanghai stock exchange led to a day of turmoil across the world. By that afternoon on Wall Street, the Dow Jones Industrial Average suddenly dropped by 2% in a matter of seconds. A long era of unnatural calm for markets was over.

Watching from the Financial Times' New York newsroom, I was trying to make sense of it. Stocks were rising again after the shock, but people were jittery. Currency markets were in upheaval.

I anxiously checked the Bloomberg terminal. One screen showed minute-by-minute action that day in the S&P 500, the main index of the U.S. stock market. Then I called up a minute-by-minute chart of the exchange rate of the Japanese yen against the U.S. dollar. At first I thought I had mistyped. The chart was identical to the S&P.

If it were not so sinister, it might have been funny. As the day wore on and turned into the next, we in the newsroom watched the two charts snaking identical courses across the screen. Every time the S&P rose, the dollar rose against the yen and vice versa. What on earth was going on?

Correlations like this were unnatural. In the years leading up to the Shanghai Surprise, the yen and the S&P had moved completely independently. They are two of the most liquid markets on earth, traded historically by completely different people, and there are many unconnected reasons why people would exchange in and out of the yen (for trade or tourism), or buy or sell a U.S. stock (thanks to the latest news from companies in Corporate America). But since the Shanghai Surprise, statisticians show that any move in the S&P is sufficient to explain 40% of moves in the yen, and vice versa. As they should have nothing in common, this implies that neither market is being priced efficiently. Instead, these entangled markets are driven by the same investors, using the same flood of speculative money.

The issue is vital because as I write (in early 2010), markets are even more tightly linked than they were in early 2007. It is once again impossible to tell the difference between charts of the dollar and of the U.S. stock market. Links with the prices of commodities and credit remain perversely tight.

The Shanghai Surprise, we now know, marked the start of the worst global financial crisis for at least 80 years, and plunged the global economy into freefall in 2009--the most truly global economic crash on record.

Inefficiently priced markets drove this dreadful process. If currencies are buoyed or depressed by speculation, they skew the terms of global trade. Governments' control over their own economies is compromised if exchange rates make their goods too cheap or too expensive. An excessive oil price can drive the world into recession. Extreme food prices mean starvation for billions. Money pouring into emerging markets stokes inflation and destabilizes the economies on which the world now relies for its growth. If credit becomes too cheap and then too expensive for borrowers, then an unsustainable boom is followed by a bust. And for investors, risk management becomes impossible when all markets move in unison. With nowhere to hide, everyone's pension plan takes a hit if markets crash together. In one week of October 2008, the value of global retirement assets took a hit of about 20%.

Such a cataclysm should have shaken out the speculation from the system for a generation, but evidently it has not--and this implies that the risk of another synchronized collapse is very much alive.

What I hope to do in this short book is to explain how the world's markets became synchronized, how they formed a bubble, how they all managed to crash together and then rebound together, and what can be done to prevent another synchronized bust in the future. In the process, I also hope to provide some guidelines for investors trying to deal with this situation.

Investment bubbles inevitably recur from time to time because they are rooted in human psychology. Markets are driven by the interplay of greed and fear. When greed swamps fear, as it tends to do at least once in every generation, an irrational bubble will result. When the pendulum snaps back to fear, the bubble bursts, causing a crash.

History provides examples at least as far back as the seventeenth century "Tulip Mania," in which wealthy Dutch merchants paid their life savings for one tulip bulb. Then came the South Sea Bubble in England and the related Mississippi Bubble in France, as investors fell over themselves to finance prospecting in the New World. Later there were bubbles in canals. The Victorian era saw a bubble in U.S. railroad stocks; the 1920s saw a bubble in U.S. stocks, led by the exciting new technology of the motor car.

But the last few decades have seen an increase in bubble production. Gold formed a bubble that burst in 1980; Mexican and other Latin American debt suffered the same fate in 1982 and again in 1994; Japanese stocks peaked and collapsed in 1990, followed soon after by Scandinavian banking stocks; stocks of the Asian "Tiger" economies came back to earth in 1997; and the Internet bubble burst with the dot-com meltdown of 2000.2

Some said good news for the world economy had understandably created overenthusiasm. From 1950 to 2000, the world saw the renaissance of Germany and Japan, the peaceful end of the Cold War, and the rise of the emerging markets--all events that had seemed almost impossible in 1950--while young and growing populations poured money into stocks. Maybe the bubbles at the end of the century were nothing more than froth after an unrepeatable Golden Age.

But since then, the process has gone into overdrive. Bubbles in U.S. house prices and in U.S. mortgage-backed bonds, which started to burst in 2006, gave way to a bubble in Chinese stocks that burst in 2007. 2008 saw the bursting of bubbles in oil; industrial metals; foodstuffs; Latin American stocks; Russian stocks; Indian stocks; and even in currencies as varied as the Brazilian real, the pound sterling, and the Australian dollar. Then, 2009 brought one of the fastest rallies in history. News from the "real world" cannot possibly explain this.

Why have markets grown so much more prone to new bubbles? Overenthusiasm and herding behavior are part of human nature and it is fashionable to blame greed. But this makes little sense; it implies that people across the world have suddenly become greedier than they used to be. It is more accurate to say that in the last half century, fear has been stripped from investors' decisions. With greed no longer moderated by fear, investors are left with overconfidence.

This, I suggest, is thanks to what might be called the fearful rise of markets. The institutionalization of investment and the spread of markets to cover more of the global economy have inflated and synchronized bubbles. The rise of markets has brought the following trends in its wake.

Principal/Agent Splits

In the 1950s, investment was a game for amateurs, with less than 10% of the stocks on the New York Stock Exchange held by institutions; now institutions drive each day's trading. Lending was for professionals, with banks controlling virtually all decisions. Now that role has been taken by the capital markets. As economists put it, in both investing and lending, the "principals" have been split from the "agents." When people make decisions about someone else's money, they lose their fear and tend to take riskier decisions than they would with their own money.

Herding

The pressures on investors from the investment industry, and from their own clients, are new to this generation, and they magnify the already strong human propensity to crowd together in herds. Professional investors have strong incentives to crowd into investments that others have already made. When the weight of institutions' money goes to the same place at the same time, bubbles inflate.

Safety in Numbers

Not long ago, indexes were compiled weekly by teams of actuaries using slide rules. Stocks, without guaranteed dividends, were regarded as riskier than bonds. Now, mathematical models measure risk with precision, and show how to trade risk for return. Computers can perform the necessary calculations in milliseconds. The original theories were nuanced with many caveats, but their psychological impact on investors was cruder. They created the impression that markets could be understood and even controlled, and that led to overconfidence. They also promoted the idea that there was safety in investing in different assets, or diversification--an idea that encouraged taking risks and led investors into new markets they did not understand. This in turn tightened the links between markets.

Moral Hazard

As memories of the bank failures of the 1930s grew fainter, banks found ways around the limits imposed on them in that era, and governments eventually dismantled them altogether. Banks grew much bigger. Government bank rescues made money cheaper while fostering the impression among bankers that there would always be a rescue if they got into trouble. That created moral hazard--the belief that there would be no penalty for taking undue risks. Similarly, big bonuses for short-term performance, with no penalty or clawback for longer term losses, encouraged hedge fund managers and investment bankers to take big short-term risks and further boosted overconfidence.

The Rise of Markets and the Fall of Banks

Financial breakthroughs turned assets that were once available only to specialists into tradable assets that investors anywhere in the world could buy or sell at a second's notice with the click of a mouse. Emerging market stocks, currencies, credit, and commodities once operated in their separate walled gardens and followed their own rules. Now they are all interchangeable financial assets, and when their markets expanded with the influx of money, many risky assets shot upward simultaneously, forming synchronized bubbles. Mean¬ while, banks, which had specialized in many of these areas, saw their roles usurped by markets. Rather than disappear, they sought new things to do--and were increasingly lured into speculative excesses.

These toxic ingredients combined to create the conditions for the now notorious mess in the U.S. subprime mortgage market, as financiers extended loans to people with no chance of repaying them, and then repackaged and dispersed those loans in such a way that nobody knew who was sitting on losses when the loans started to default. That led to a breakdown of trust in the U.S. financial system and--thanks to interconnected markets--global finance. Bad lending practices in Florida created a synchronized global crash.

This is not the place to dwell in detail on the subprime mess. Nobody now seriously questions that the absurdly complex financial engineering that undergirded it must not be repeated. It is much tougher, however, to deal with the conditions that made such a disaster possible. They are still in place and involve many worthwhile investment products we take for granted. Dealing with the problem at this level will involve very difficult choices.

As a start, I suggest we need rules to contain the most extreme behavior. Simply put, we must put fear back into the hearts of traders and investors, and force them to treat the money they are investing as if it were their own. The structure of the investment industry, which has evolved to reward and encourage herd-like behavior, must be rebuilt.

How markets rose to lead the world into such a synchronized mess is a fascinating but long story. As many of these themes overlap, I will cover them chronologically. But remember that bubbles are rooted in human psychology. It is inevitable that they will recur, but not inevitable that they need recur so swiftly or burst together, as they did in 2007 and 2008.