Thursday, March 20, 2008

Markets work – even in downturns

They are messy, inelegant and brutal, but they work.

by StFerdIII



Utopians and fantasists usually use the turmoil of 'bourgeois' living and market upheavels to propose 'brave new world' solutions. These 'new' solutions are of course, the very old and tired ideas of conformity, equality, security and risk-less living. Even in turmoil, more dynamic and open markets are far better, than state-controlled, regulated and fettered systems. The facts, as John Adams once said, are stubborn things supporting this truism.

There are periods of rising markets and falling markets. Some sectors of the economy will expand, others will contract. Sometimes there will be excessive and speculative enthusiasm to buy tulip bulbs, South Sea company shares, real estate in Florida, gold and oil commodities; leading to inevitable and quite mad declines. Markets and the price mechansim are complex – far too complex for any government, bureaucrat or philosophical seer to understand or manage.

Markets in their delirious and uncaring way do work. The problems with markets – all markets – is that they require study, comprehension and effort. For many people due to time, skill or interest this is the issue. For many, the 'markets' in any product – consumer goods, equities, bonds, real estate or what have you – seem to be an opaque and quite unfathomable magic show. This line of thinking leads directly to concepts about managing or controlling markets in such a way, that risk is significantly reduced and security established. While tempting it is wrong.

Current conditions highlight the reasonable speed and efficiency of well functioning price-based markets. Even in an economic slow down the intersection of supply and demand in competitive markets makes a mockery of government and state control. Prices need to adjust and the more interfernce from the state the less opportunity there is for corrections and catharsis.

Consider the current environment:

-Gold prices have a record 7 year run to over $1000 per ounce. A lot of this is based on a weaker US dollar and inflation. This speculative excess is now being purged as gold is falling towards $800 quite rapidly. The signal is clear – the US dollar has probably reached its bottom.

-Commodity prices have set records in oil, silver, wheat, sugar, copper and other 'things'. Some of this is due to a huge increase in demand [the BRIC] and some is due to investor speculation [buy more oil as the US$ falls]. With a slowing US and global economy, demand must fall off, putting downward pressure on all commodities. The excessive speculation in 'things' which accounted for perhaps 30% or more of the increase in prices is now being squeezed out.

-Stock markets are now correcting for many factors. After a great 2007, a slowing economy, a financial crisis, a weak dollar, too high commodity prices; and a fear of increased taxation and reduced trade is weighing on stocks. Rationally one would expect a pull back of at least 15-25% and that is what we are experiencing.

-Credit markets are now adjusting to the reality that bad loans on real estate, transformed through complex instruments into credit facilities for firms were irrational and speculative. Markets run on financial liquidity and capital availability. This in turns rests on land collateral. When the base of the financial pedestal – land value – comes under attack, then capital liquidity must by definition retract. When capital flows are diminished the markets will fall.

Markets however painful and brutal they may be, do work. There is only so much that government can do in the current situation for example. Central banks at the behest of the government, can lower interest rates; improve money supply; guarantee bad bank loans; or provide credit facilities. But the money under central bank and government control is paltry compared to the $50 Trillion of investment capital sloshing around the world's financial system. Simply put, while having an impact, governments have little real control over liquidity and market corrections. Governments and central banks can't by themselves, stop downward corrections, nor limit speculation upwards.

For many people this is appalling. Why should charming and hard working citizens watch their stock values evaoporate due to falling markets or a repricing in real estate, gold or oil? Why shouldn't government guarantee all investments, offer a certain return, or ensure that all banks, finance houses, and even corporations never go bankrupt? Wouldn't that help the 'little guy'?

Of course not. Markets work best when the good win over the bad. If a big bank needs to go bankrupt – let it. Most deposits are insured and the market will come in, pick up the repriced assets, and use them in a productive way so that in the long term society will be better off. It will be painful for some [those who lose their equity value] but beneficial to others [the firm and its stockholders who benefit from the asset repricing and use them to generate more wealth].

In the current financial mess governments have a role to play but it should be rather limited. They can via their central bank proxies, make money more available and support or guarantee the private buying of troublesome debt. They can also lower interest rates stimulating more loan activity.

But the largest and most important role of government is rarely discussed – that of lowering taxes on capital; lowering marginal tax rates and reducing payroll taxes. Along with spending cuts these measures would increase economic growth; restore confidence and improve incomes. With inflation galloping along at 4-5% thanks to a devalued hegemonic currency and speculative commodity pricing, average real incomes are now falling. Real asset wealth is also declining.

From the bottoms come new hope. Falling markets and asset repricing are in fact opportunities. From the lows one has the chance to buy and sell higher. Thus are good profits made. The trick is to recognise trends, capital flows and understand how markets work. That takes effort, knowledge and vigilance and unfortunately many will lose money, just as many will make money.

Nothing is secure in life and nothing is sacred. Markets are not perfect. Goverments do have a role in building laws, regulations and ensuring honest and contractually based exchanges. But there is no point in having massive state distortions in the setting of prices. That would just simply make us all a lot poorer and less free.