Finance and Econ 101 again

Over at Felix Salmon’s blog, the discussion of synthetic CDOs has included comments like “there was unlimited demand for the AAA tranches” and “the supply of underlying bonds was insufficient”.  This inspires the following Econ 101 exam question.

Econ 101 question:  There is a market that is a “black box” — that is, we have very little information about how it operates.  We do, however, have some information about this market:

(i) the supply of the good is universally viewed as insufficient
(ii) demand for the good is excessive, in fact, it’s sometimes described as unlimited

Explain what you think is going on in this market. [Hint: Draw a demand and supply diagram, and then find a situation that we have studied that would have the characteristics of this market.]

Answer:  A price ceiling.  Prices are so low that supply is “insufficient”, but at the same time demand is “excessive”.  These are the characteristics of a market where a price ceiling has been set by government policy.  If demand is actually being met it must come from outside the market — perhaps from abroad.

In a market with a price ceiling — for example, when government wants to keep staple items cheap for consumers — it is very clear that market forces are not operating to bring supply and demand into equilibrium.  On the contrary, the government must act so that consumer demand is actually satisfied — one method is to subsidize production of the good in question.

So when financiers claim that there was “insufficient supply” and “unlimited demand” for bonds, they are describing a classic case of an environment where the market price of these bonds is being held down below the equilibrium price.  This is only possible if some “identical” substitute is being sold to the buyers with “unlimited demand”.  The financiers are pretty clear about how demand was met:  “the synthetic was only useful because the supply of underlying bonds was insufficient”.  In other words, synthetic bonds (or credit default swaps) were used to manufacture a larger supply of mortgage bonds than the market could provide.

Basic Econ 101 analysis indicates that it was these synthetic bonds that made it possible for a disequilibrium environment that looks just like a price ceiling to be sustained in the mortgage market for a prolonged period of time.

On monetary policy and the Fed as a fiscal agent

Monetary policy is complicated, so maybe I’m missing something, but here’s my foray into the melee:

Following a link to an FT blog post titled “Asymmetry in monetary policy“, I was startled to find that the post was about the asymmetric risks of a double-dip recession and not about the asymmetry of monetary policy through the last decade.  It seems to me that we should admit that when the Fed reduces rates to a level below 2% for a prolonged period of time, monetary policy is being used where fiscal policy is more appropriate — the Fed is stimulating the economy because of a failure of government (update: or maybe that should be regulation).  Extremely low interest rates are dangerous because of the costs they impose on savers and their tendency to encourage, not healthy investment — which should be viable if financed near 2% — but the development of assets with hidden leverage (and decent nominal returns).

I agree with Thomas Hoenig.  The Fed should raise rates to 1% sooner rather than later.  The stock market will fall on the news, some mismanaged banks may need to be put through resolution and the economy will probably struggle.  To address the real consequences of the policy, Congress needs to pass a strong fiscal program of additional support.  But it’s time to acknowledge that supporting the real economy by destabilizing the financial sector is simply not good policy.

Finance and the perversion of the principles of economics

A recent exchange over at Felix Salmon’s blog made me realize that a large segment of the financial industry has no idea what economists mean when they say that a market is “efficient”.

So let me start with some Econ 101:  Trade improves welfare because both traders are made better off.  That is, when a farmer pays in wheat to the blacksmith who shoes his horse, both the blacksmith who needs wheat and the farmer who needs a healthy draft horse are better off.

In order for both traders to be better off the terms of the exchange must be completely understood by both parties to the transaction.  If the wheat is the rotten, or the blacksmith is putting the shoe on in a way that will fall off immediately, the trade does not contribute to social welfare because one party has given value without receiving value in exchange.

So economics claims that trade and markets and profit-seeking activity are all socially beneficial only when all participants have a full understanding of the nature of the market and given that understanding believe that prices were fair.  This is econ 101.  This principle is embodied in contract law as “the meeting of minds”.

The question raised on Felix’s blog was whether a transaction where an intelligent trader makes money off of the stupidity of an investor can be held to contribute positively to economic efficiency.  Given that the intelligent vs stupid framework is a strong indicator that the investor does not understand that he is not getting fair value for the asset, the answer to the question is obvious.  One party is being made worse off, so we know that social welfare did not improve — it may have stayed the same, or it may have fallen — but the trade cannot possibly have added to social welfare as long as the standard being used is economic (or Pareto) efficiency.

Some things that should be obvious to anyone who has taken Econ 101 apparently need to be explained to members of the financial industry:

(i) The fact that trade takes place on a market does not make trade efficient.  Only if prices represent fundamental value (more or less) — or if some version of the efficient markets hypothesis holds — do we have reason to believe that market trade is socially beneficial.

(ii) The fact that somebody makes profits is not evidence that that individual contributed to society.  In fact, Adam Smith would probably laugh out loud if he heard that claim.  Only in circumstances where prices reflect fundamental values (approximately) are profits evidence of socially improving trade.

So if you ever hear some financier claim that when he gets rich off of some sucker’s stupidity the trade was efficient and the profits he made represent a positive gain to society, please tell him to enroll in Econ 101.

Could Goldman have survived financial collapse?

John Gapper parses Goldman Sachs’ view of the government’s role in saving both the financial system and Goldman, and tries to understand how government intervention could be “indispensable” for the financial system, but not indispensable for Goldman.

I think the answer to this conundrum lies in the system of collateral posting for OTC derivatives (that was put in place with heavy lobbying from Goldman as well other TBTF financial institutions).   As Lehman made clear, what happens when a financial firm is about to fail is that all of its counterparties swoop in and take ever increasing amounts of collateral — leaving shareholders and unsecured creditors with almost nothing.  Thus, in the event of a financial collapse, there will be one or two firms left with almost all the assets of the financial system (that existed prior to collapse).  I think it’s probably a pretty safe bet that the last firms standing will in fact be solvent.

The way I read Goldman’s statements:  We had every intention of managing our collateral demands in the event of a financial collapse so that Goldman would be one of the last firms standing.

Socializing costs: the ICI money market plan

Bloomberg reports on the mutual fund industry’s proposal for socializing its costs:

Under the ICI plan, fees collected from money-market funds would be used to capitalize a state-chartered bank or trust. The facility would purchase holdings at face value from funds during a crisis. That could prevent a fund fielding heavy redemption requests from taking losses because it is forced to sell healthy holdings at a discount.

As a bank, it would also have access to the U.S. Federal Reserve’s discount lending window, according to the ICI, making taxpayers the ultimate backer of money-market funds’ liquidity.

Why on earth should the federal reserve allow money market funds indirect access to the discount window?  So the banks continue to face undercapitalized competition for their deposits?

If the money market fund managers think they need access to the discount window, then they need to turn themselves into banks — and maintain the same capital positions that banks are required to maintain at every point in time.  Hopefully Larry Fink’s opposition to this proposal (per Bloomberg) means the Fed won’t be pressured to take it seriously.

A cautionary note for the CFPA

While I think that the CFPA should aggressively protect individual borrowers from unsuitable contracts (by for example defining ‘plain vanilla’ contracts etc.), I also think that  investor protection needs to be addressed with great care and balance — even when we’re talking about retail investors.  My concerns about investor protection derive from the fact that I think that one of the systemic problems that we faced in 2008 was a consequence of the over-regulation of money funds.

It’s very important to recognize that regulation that protects the public from investment losses may well have the consequence of making financial innovation more dangerous by creating the illusion that investment can be “safe”.  Thus, in my view the investor protection aspects of the CFPA should focus on the quality and ease of comprehension of disclosures as well as clarity and truth in advertising.  It should not dictate the content of investment products — especially with reference to ratings issued by rating agencies.

For example, in my view money market funds should be allowed to invest in any short-term assets — as long as the composition of the portfolio is fully disclosed.  Investors should be allowed to choose between low yield government money funds, mediocre yield AA money funds and high yield, high risk money funds.  Money fund failures are the discipline that will force investors to be careful.  Investors must face losses — even, rarely, on “safe” assets, because these losses train investors to be careful with their money.

While regulators should take aggressive measures to prevent fraud and deliberate misselling of investment products, care needs to be taken to avoid protecting investors from the risks of investing.  I think it is important to emphasize that it can not be considered the regulators’ job to make sure any investment product is “safe”.  When it comes to investor protection the regulators job is only to establish a strong framework for prosecuting those who engage in misleading marketing of investment products or who match investors with unsuitable products.

Were gambling laws designed as financial regulation?

Economics of Contempt claims “anti-gambling laws are anachronistic holdovers from a more paternalistic era”.   I have argued that gambling laws were designed in part as a form of financial regulation.  He’s the lawyer.  But I’ve started to wonder how well lawyers are trained in the history of law.