Customer Reviews

The Volatility Machine: Emerging Economics and the Threat of Financial Collapse

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There are some books that were important to forming the way I think about economic problems, but if I write about it, I feel that I can't do justice to the quality of the book. The Volatility Machine, by Michael Pettis, is one of those books. Michael Pettis was a managing director at Bear Stearns, and an adjunct professor at Columbia University when he wrote it.

The book was written in 1999-2000, and published in 2001. It explains how economic activity in the developed world travels into the smaller markets of the developing world, amplifying booms and busts. Coming off the Asian/Russian crises of 1997-1998, it was a timely book. During boom periods, capital flows from the developed countries to the developing countries; during bust periods, capital gets withdrawn. There is a kind of "crack the whip" effect, where the tail feels the change in direction the most.

Borrowing short is a weak position to be in, as the Mexican crisis in 1994 showed us, as the Fed raised rates and the tightening spilled into Mexico, which was financing with short-term debt, cetes. The same is true of corporations that finance with short debt; they are ordinarily less stable than firms that finance long. The Volatility Machine explains why the same forces apply to both situations.

Buffett has said, "It's only when the tide goes out that you learn who's been swimming naked." Rising volatility is that tide going out, and it reveals weak funding structures and bad business/government plans. Booms set up the overconfidence that leads some economic parties to presume on future prosperity, and choose financing terms that are less than secure if the market turns.

Countries that are small and reliant on continued capital inflows are vulnerable to volatility. In the 1970s-1990s, that was the developing countries. Today, the developing countries vary considerably. Some have funded themselves conservatively, some have not, and a number are net capital providers. The US is the one reliant on capital inflows. So what would Michael Pettis have to say in this situation?

You don't have to look far. Today, Michael Pettis is a professor at Peking University's Guanghua School of Management. He is studying China from the inside, and writes about it at his blog (I read it every day, and will add it to my blogroll the next time I update it), China financial markets. Among his most interesting recent posts:

China's latest batch of numbers aren't good

Chinese pro-cyclicality makes predictions so difficult

More on why high share prices don't mean Chinese banks are in good shape

The new China-Europe-US world order

Things have gotten grimmer in China

His views are complex and nuanced, and reflect the sometimes asymmetric incentives that politicians and policymakers face. When I read his writings on China, I am simultaneously impressed with the rapid growth, and with the potential fragility of the situation.

So, enjoy his blog if that is your cup of tea. If you want to learn how international finance affects developing economies, buy his book.

I am over halfway through the book right now, but having read Pettis' work before, I know where it is heading, but I still cannot put it down.

I have an econ/finance background, so much of this comes naturally. But his explanations are so clear that almost no background would be required. I have flown through the book, rarely re-reading anything, which says a lot about the author's writing ability. Most economics is dull, boring, and a difficult slog. This book is crisp, on point, and I always just want to finish one more page.

Having experience trading options, his thesis rings remarkably true. This is really an eye-opening book as he does a great job explaining the theoretical underpinnings of his thesis. This book was far ahead of its time. Pettis saw the gaping holes in the financial system a decade ago. It really was only a matter of time before the shaky facade came crashing down.

This is a MUST READ for institutional investors worldwide! For the first time I have a confident sense of what is at the core of emerging market instability. Now if only some government policy makers would read this (even they would understand it!), the causal conditions might start to improve.

This is one of the very best books on macroeconomic finance and the relationship between liquidity and volatility. I am absolutely using this book for my thesis and was inspired enough to contact the author to try to learn more about his work.

The volatility machine goes into great detail about financial crisis of multiple periods. Unlike other authors who skate through the details, only looking at a few of their favorite crises, Petis incorporates work as far back as financial data has existed. As a result, his conclusions are more fleshed out than many of the more recent books that have been written on the topic. He also - unlike so many other economic writers - has solid financial experience; a big plus for practitioners. His ideas of volatility and it's relationship to liquidity and financial crisis are really unique in a nuanced way. They are practical and theoretical all at once.

This should be read by anyone who is interested in financial crisis or happens to work in any area of financial products that are impacted by liquidity (basically every financial product). It clearly links macroeconomics, volatility, and financial asset pricing/risk together.

If I could give it 6 stars if I would.

Michael Pettis has succeeded in mystifying the collapse of EM economies. His approach is new and indeed very methodical. I found the book intellectually challenging and have learned quite a lot reading it. I highly recommend it for those who want to understand how LDC economies rise and fall. Having a background in corpporate finance is crucial to enjoying the book though.

This book completely transformed the way I think about sovereign financial crises. Michael Pettis creates a simple yet elegant framework by which to think of sovereign crises, the fundametal problems which precede them and potential solutions. This book should be every finance minister's primary reference tool for the development of sovereign capital structure.

This book completely transformed the way I think about sovereign financial crises. Michael Pettis creates a simple yet elegant framework by which to think of sovereign crises, the fundametal problems which precede them and potential solutions. This book should be every finance minister's primary reference tool for the development of sovereign capital structure.

Apart from the main idea of this book, which is using the capital structure to reduce wrong-way risk, Pettis also includes an original and unique perspective on how engineering liquidity leads to an initial booms followed by a bust. If nothing else, the appendix which includes a model for treating bonds as vertical put spread is worth the price of this book alone.

One of the most common (mis)interpretations of the east Asian currency crises of the late 1990s is that they were caused by George Soros and other speculators, hedge fund principals for the most part, who shorted those currencies and the respective bonds in order to create a self-fulfilling prophecy.

I was happy to se that Mr. Pettis knows better. He writes that he was in regular contact with three large macro hedge funds in 1997, in his capacity as an emerging markets specialist for Bear Stearns, "including the most famous of these, and our discussions about Asia generally centered on ways to gain protected access to LONG rupiah positions. There was very little interest in shorting the currency."

Indonesia and its rupiah provides a particularly vivid example of the capital structure trap that Pettis adumbrates so admirably in this book.

I needed to have background knowledge of the Emerging Markets and this book was recommended by a colleague.