Tuesday, March 24, 2009

Market Fundamentalists

Markets seem to incorporate prices reasonably well, and few people seem to beat the market.  Unfortunately, a few people seem to extrapolate from these facts that markets are perfectly efficient; that the market price is the only true barometer of value, and any public intervention is necessarily bad.  Worse, they still believe this today, after the excesses of the Dot-Com bubble and the Housing Bubble have shown that prices are volatile, and not the best indicators of future value.  This would be almost comical if they were not using this free market fundamentalism to block essential public measures needed to clear the financial markets.

Are these people Ivory-Tower Chicago academics?  Well, maybe them too, but I'm thinking Paul Krguman.  He's come out heavily against the Geither and earlier TARP plans for a number of reasons, but his basic objection is that toxic assets are correctly priced.  There are no liquidity problems, given the ability of investors and the Fed to invest, but only solvency issues related to the fact that toxic assets are fairly valued and are destroying trust in the banking system.  

If this is your view, then of course none of these repurchase plans make any sense--you have to 'overpay' for these assets to help out the banks, the government will necessarily lose money, and they block the passasge of necessary plans such as nationalization.  

I'm agnostic on which plan will actually work better, but what's odd here is the very, well, fundamental faith that Krugman has that current market prices for toxic assets reflect their future value.  If you really believe these prices, then you have to think that millions of people are going to foreclose on their houses.  Prevailing prices are extremely bleak, to say the least.

There's another possibility here, outlined by Brad DeLong, one that is consistent with a Cochrane-discount value view of the world.  Mortgage securities are cheap because they are right now essentially trading as options on the future state of the economy.  In the 'bad state,' investors really need cash (to pay for shotguns and canned goods), so they are extremely reluctant to invest.  But someone needs to hold these assets, so prices go down (and expected returns go up) until willing buyers show up.  

You can call this a psychological explanation, but I see it as about investors being rationally risk-averse today.  The government, however, can be virtually risk-neutral over the business cycle, so it is a natural buyer for these assets.  This is not a usual role for government, but in exceptional times, it can provide a public good by clearing out bank balance sheets--and make some money in the long-run as well.  

None of this is to say that creating 'good' and 'bad' bad banks, or nationalizing the banks, won't be a better solution.  But you can still do these things after trying this out.  In order to think that this is just completely wrong-headed, you need to be a Chicago-style market fundamentalist.  Which is a little ironic for Krugman.

There's also no reason that this incarnation couldn't have been the original plan proposed months ago by Paulson, or that Geither couldn't have proposed this plan back in January instead of wasting everybody's time with 'stress tests' that seem to have gone nowhere.  Sadly, it seems that fixing the problem seems to have taken second to--take your pick--passing a stimulus, preventing bank regulation, the war in Iraq, green energy, railing against bailouts, and so forth across two administrations.

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