Dr Jerome Booth: ‘the days of an emerging market-wide crisis are over’ | Video

Transcript

Economic theories: just how reliable are they? That’s the question that a new book – Emerging Markets in an Upside Down World – aims to answer. World Finance talks to its author, economist and entrepreneur Dr Jerome Booth, about what impact economic theory has had on our understanding of risk and emerging markets

World Finance: Well Jerome, accepted economic theory: what’s the problem with it?

Jerome Booth: Well, there’s nothing wrong with a lot of finance theory as far as it goes, but there are severe limitations. And I think the problem is in the application of theories, where the assumptions are not correct. Milton Friedman once famously said that if a theory neither has realistic assumptions, nor any ability to predict the future, then it’s perfectly useless. And one could argue that a great deal of finance theory falls into that category. And worse, it’s then used by asset managers where it shouldn’t be used.

We have this phrase ‘risk-free’, which is an abuse of the English language

One example would be the way we think about risk. Risk is a very complex thing. It’s not as simple as volatility. For a lot of investors, large permanent loss is much more important than a bit of volatility. We don’t really understand a great deal about uncertainty as opposed to risk, where you don’t know the probability distribution of returns.

We have huge prejudices. I talk a lot in my book about what I call core-periphery disease, which is the idea that the core – the developed world – affects the periphery – the emerging world – but we ignore the affect vice versa. And we can’t do that anymore, because we live in a world where it’s the emerging market central banks that hold 80 percent of global reserves over 50 percent of economic activity.

World Finance: Well how is risk gauged in emerging economies compared to our own, for example?

Jerome Booth: Well it’s often ignored in our own! We have this phrase ‘risk-free’, which is an abuse of the English language. There is no such thing as a risk-free investment.

I’m not saying that emerging markets aren’t risky. What I am saying is that risk is different for different people; unlike volatility it’s not additive. I’m also saying that it’s the prejudice that people have which is often much more important than if we perceive something as risk-free, that is a problem.

World Finance: I have heard you suggest that as the world has become more globalised, certain frontier markets provide the best opportunity for returns, yet there’s a call for greater regulation. Well surely as demand increases to saturation point, the unknown unknowns become the known unknowns, and so returns decrease?

Jerome Booth: Yes, well that’s the difference between uncertainty and risk. I’m using Frank Knight’s 1921 definition here, he talks of uncertainty as being random events where you don’t know the probability distribution. He actually talks of one-off events, ie, there isn’t a probability distribution. And you know, the investor abhors uncertainty much more than risk, which you can ensure. And arguably this is one of the key bases of Keynes’ general theory, by the way.

As you learn more, you actually turn uncertainty into risk. But again, somebody’s ability to do that may be different from somebody else’s. If I have more information than you, I may actually be taking less risk. Whereas the simple way of analysing this, which is far too common, is to assume that risk is an absolute factor – in fact measured by volatility – and it’s the same for everybody.

[I]f 50 percent is in emerging markets, then one should look at doing something like 50 percent in emerging markets

World Finance: Well could this be seen as a self-serving prophecy? For example if investment goes to emerging economies, surely they’re going to become stronger?

Jerome Booth: What I am trying to say is not that the economic activity will follow where the money goes, because of course risk also follows the money. We’ve seen that with excess leverage and the huge blowups we’ve had, particularly 2008 and since then. There’s a triple cocktail which creates some systemic risks. One is a homogenous investor base. Another is a misperception of risk. And the other one is leverage.

So what I’m saying is actually something quite different. I’m saying that one should look at economic activity on the planet, and if 50 percent is in emerging markets, then one should look at doing something like 50 percent in emerging markets.

World Finance: Well creditors in a crisis hold the shots, and for the most part they’re in emerging economies. So is this where their strength lies?

Jerome Booth: Certainly for central banks. People often think of emerging markets – this is a la my core-periphery idea – as the recipients of what we do. And in fact you’re right: the emerging markets are now massive net creditors. The average debt to GDP of emerging markets is about 25 percent. Here in the UK public plus private debt is over 500 percent, and the average for the – what I call HIDCs – heavily indebted developed countries – is about 250 percent. That is 10 times the amount of debt in the emerging market.

So this brings up whole issues about things like the international monetary system, or the lack of a system! We know from history, most recently in 1971, when the system breaks down it’s the creditor central banks, the creditor nations, that actually call the shots. And we’re denying that, and not thinking of the US as volatile and risky, or Europe as risky, because of these high levels of debt. We know from history however that they’re not going to get rid of those debts overnight. They’re almost certainly not going to do it through fiscal adjustment, which means they’re going to rob people one way or the other. And the two traditional ways of that are financial oppression, and if that fails, inflation.

World Finance: So you forecast that emerging countries will shape the world’s economy, and obviously we’ve heard of the BRIC countries and the MINT countries, so what’s next?

Jerome Booth: When Jim O’Neil came up with BRICs all those years ago, I almost immediately came up with my own, which is CEMENT. Countries in Emerging Markets Excluded by New Terminology. The logic being that you need BRICs and CEMENT – in other words it’s just a marketing gimmick.

When Jim O’Neil came up with BRICs all those years ago, I almost immediately came up with my own, which is CEMENT

There are another 60 countries, it’s not just a question of four. There are nearly 70 countries just in the emerging debt index, and they’re all very very different. Much more heterogenous than the developed countries, by the way; not least because they don’t have this common factor of massive leverage.

So I think the answer is you do lots of different ones.

World Finance: So finally, surely there are parallels between emerging markets and western economies; so are they headed for a financial crisis?

Jerome Booth: Yes and no! There will always be crises, but I think there are two types of crisis. One, a crisis that is truly global. Well fine, that can affect emerging markets. And secondly you have country-specific crises. But I think the days of an emerging market -wide crisis are over. Because without that amount of leverage, and without that uniform investor base which is highly levered that you had in the 90s and before, you don’t have anything unifying these very very heterogenous countries.

The emerging markets as I said are not without risk. I’m not saying that! I’m saying that everything is risky, and there’s a price for that risk. You’re basically being overpaid by buying emerging markets, and you’re being underpaid by buying developed countries. So there has to be a balance.

World Finance: Jerome, thank you.

Jerome Booth: Thank you, my pleasure.