Market
Efficiency Hokum
By Stephen Lendman
24 August, 2007
Countercurrents.org
You
know the story triumphantly heard in the West. Markets work best when
governments let them operate freely - unconstrained by rules, regulations
and taxes about which noted economist Milton Friedman once said in an
interview he was "in favor of cutting....under any circumstances
and for any excuse, for any reason, whenever it's possible (because)
the big problem is not taxes (but government) spending.
Friedman is no longer with
us, but by his reasoning, the solution to curbing it is "to hold
down the amount of income (government) has (and presto) the way to do
it is to cut taxes." He seemed to forget about borrowing and the
Federal Reserve's ability to print limitless amounts of ready cash the
way it's been doing for years and during the current credit squeeze.
Friedman further added in the same interchange "If the White House
were under (GW) Bush, and House and Senate....under the Democrats, I
do not believe there would be much spending."
Clearly, either the Nobel
laureate wasn't paying attention or age was taking its toll late in
his life. Since 2001, Democrats embraced tax cutting and overspending
policies as enthusiastically as Republicans with both parties directing
the benefits hugely to the right pockets. They're on Wall Street and
in corporate boardrooms where recipients know "free markets"
work great with a little creative resource directing from Washington.
Financial Market
Efficiency
In investment finance, Eugene
Fama is generally regarded as the father of efficient market theory,
also known as the "efficient market hypothesis (EMH)." He
wrote his 1964 doctoral dissertation on it titled "The Behavior
of Stock Market Prices" in which he concluded stock (and by implication
other financial market) price movements are unpredictable and follow
a "random walk" reflecting all available information known
at the time. Thus, no one, in theory, has an advantage over another
as everyone has equal access to everything publicly known (aside from
"insiders" with a huge advantage). That includes rumored and
actual financial, economic, political, social and all other information,
all of which is reflected in asset prices at any given time.
Those buying this theory
believe Milton Friedman knew best. He became the modern-day godfather
of "free market" capitalism and leading exponent that markets
work efficiently and best when unfettered by government intervention
that generally gets things wrong. In 1958, Friedman explained it in
his famous "I, Pencil" essay. In it, he illustrated the notion
of Adam Smith's invisible hand and conservative economist Friedrich
Hayek's teachings on the importance of "dispersed knowledge"
and how the price system communicates information to "make (people)
do desirable things without anyone having to tell them what to do."
Friedman's "pencil"
story explained "a complex combination of miracles: a tree, zinc,
copper, graphite, and so on." Added to these ingredients from nature
is "an even more extraordinary miracle: the configuration of creative
human energies - millions of tiny know-hows configuring naturally and
spontaneously (responding to) human necessity and desire and in the
absence of any human master-minding." None of them working independently
was trying to make a pencil. No one directed them from a central office.
They didn't know each other, lived in many countries, spoke different
languages, practiced different religions, and may have even hated each
other. Yet, their unrelated contributions produced a pencil.
By Friedman's reasoning,
this could never happen through central planning. It sounds good in
theory, but how does it jibe with reality. The Soviets split the atom,
were first in space ahead of the US with Sputnik 1, and developed many
advanced technologies even though they were outclassed and outspent
by the West overall with greater resources to do it.
In practical reality, governments,
like individuals operating freely in the marketplace, can succeed or
fail. It comes down to people skills and how well they do their jobs.
Top down or bottom up has little final effect on the end result, but
does direct what's undertaken and what isn't. Top down in Canada, Western
Europe and Venezuela delivers excellent state-funded health care to
everyone. Bottom up in America offers it to anyone who can pay, but
if not, you're out of luck if your employer won't provide it. Forty-seven
million and counting had their luck run out, and Friedman's pencil making
miracle won't treat them when they'll ill.
Put another way, if "free
market" capitalism works best and America is its lead exponent,
why then:
-- is poverty high and rising
in the world's richest country;
-- incomes stagnating;
-- higher education becoming
unaffordable for the majority;
-- public education crumbling;
-- jobs at all levels disappearing
to low-wage countries;
-- the nation's vital infrastructure
in a deplorable state;
-- 3.5 million or more homeless
and heading higher in the wake of subprime defaults;
-- the standard of living
of most in the country declining; and,
-- the nation, in fact, bankrupt
according to a 2006 study for the St. Louis Fed.
Clearly, something is wrong
with the "pencil miracle" working for some but not for most.
Friedman no longer can respond and his acolytes won't.
The Myth that Markets
Get It Right and Operate Efficiently
Economist Hyman Minsky was
mostly ignored while he lived, but his star may be rising 11 years after
his death in 1996. Some described him as a radical Keynesian based on
the theories of economist John Maynard Keynes who taught economies operate
best when mixed. He believed state and private sectors both play important
roles with government stepping in to stimulate or constrain economic
activity whenever private sector forces aren't able to do it best alone.
It's the opposite of "supply-side"
Reaganomics and its illusory "trickle down" notion that economic
growth works best through stimulative tax cuts its proponents claim
promote investment that benefits everyone. It was Reagan-baloney then
and now, and so is the notion markets are efficient and work best when
left alone.
Minsky explained it, and
people are now taking note in the wake of current market turbulence.
His work showed financial market exuberance often becomes excessive,
especially if no regulatory constraints are in place to curb it. He
developed his theories in two books - "John Maynard Keynes"
and "Stabilizing an Unstable Economy" as well as in numerous
articles and essays.
In them, he constructed a
"financial instability hypothesis" building on the work of
Keynes' "General Theory of Employment, Interest and Money."
He provided a framework for distinguishing between stabilizing and destabilizing
free market debt structures he summarized as follows:
"Three distinct income-debt
relations for economic units....labeled as hedge, speculative and Ponzi
finance, can be identified."
-- "Hedge financing
units are those which can fulfill all of their contractual payment obligations
by their cash flows: the greater the weight of equity financing in the
liability structure, the greater the likelihood that the unit is a hedge
financing unit."
-- "Speculative finance
units are units that can meet their payment commitments on 'income account'
on their liabilities, even as they cannot repay the principle out of
income cash flows. Such units need to 'roll over' their liabilities
- issue new debt to meet commitments on maturing debt."
-- "For Ponzi units,
the cash flows from operations are (insufficient)....either (to repay)....principle
or interest on outstanding debts by their cash flows from operations.
Such units can sell assets or borrow. Borrowing to pay interest....lowers
the equity of a unit, even as it increases liabilities and the prior
commitment of future incomes."
"....if hedge financing
dominates....the economy may....be (in) equilibrium. In contrast, the
greater the weight of speculative (and/or) Ponzi finance, the greater
the likelihood that the economy is a deviation-amplifying system....(based
on) the financial instability hypothesis (and) over periods of prolonged
prosperity, the economy transits from financial relations (creating
stability) to financial relations (creating) an unstable system."
"....over a protracted
period of good times, capitalist economies (trend toward) a large weight
(of) units engaged in speculative and Ponzi finance. (If this happens
when) an economy is (experiencing inflation and the Federal Reserve
tries) to exorcise (it) by monetary constraint....speculative units
will become Ponzi (ones) and the net worth of previous Ponzi units will
quickly evaporate. Consequently, units with cash flow shortfalls will
be forced to (sell out). This is likely to lead to a collapse of asset
values."
Minsky developed a seven
stage framework showing how this works:
Stage One - Displacement
Disturbances of various kinds
change investor perceptions and disrupt markets. It may be a tightened
economic policy from higher interest rates or investors and lenders
retrenching in reaction to:
-- a housing bubble, credit
squeeze, and growing subprime mortgage delinquencies and defaults with
spreading contagion affecting:
-- other mortgages, and the
toxic waste derivative alchemy of:
-- collateralized debt obligation
(CDO) instruments (packages of mostly risky junk and other debt),
--commercial and residential
mortgage-backed securities (CMBS and RBMS - asset backed by mortgage
principle and interest payments), and even
-- commercial and AAA paper;
plus
-- home equity loans harder
to service after mortgage reset increases.
Stage Two - Prices
start to rise
Following displacement, markets
bottom and prices begin rising as fundamentals improve. Investors start
noticing as it becomes evident and gains momentum.
Stage Three - Easy
credit
Recovery needs help and plentiful
easy credit provides it. As conditions improve, it fuels speculation
enticing more investors to jump in for financial opportunities or to
borrow for a new home or other consumer spending. The easier and more
plentiful credit gets, the more willing lenders are to give it including
to borrowers with questionable credit ratings. Yale Economist Robert
Shiller shares the view that "booms....generate laxity in standards
for loans because there a general sense of optimism (like) what we saw
in the late 80s" preceding the 1987 crash that doesn't necessarily
signal an imminent one now.
New type financial instruments
and arrangements also arise as lenders find creative and risky ways
to make more money. In recent years, sharply rising housing prices enticed
more buyers, and lenders got sloppy and greedy by providing interest-only
mortgages to marginal buyers unable to make a down payment.
Stage Four - Overtrading
The cheaper and easier credit
is, the greater the incentive to overtrade to cash in. Trading volume
rises and shortages emerge. Prices begin accelerating and easy profits
are made creating more greed and foolish behavior.
Stage Five - Euphoria
This is the most dangerous
phase. Cooler heads are worried but fraudsters prevail claiming this
time is different, and markets have a long way to go before topping
out. Greed trumps good sense and investors foolishly think they're safe
and can get out in time. Stories of easy riches abound, so why miss
out. Into the fire they go, often after the easy money was made, and
the outcome is predictable. The fraudsters sell at the top to small
investors mistakenly buying at the wrong time and getting burned.
Stage Six - Insider
profit taking
The pros have seen it before,
understand things have gone too far, and quietly sell to the greater
fools buying all they can. It's the beginning of the end.
Stage Seven - Revulsion
When cheap credit ends, enough
insiders sell, or an unexpected piece of bad news roils markets, it
becomes infectious. It can happen quickly turning euphoria into revulsion
panicking investors to sell. They begin outnumbering buyers and prices
tumble. Downward momentum is far greater and faster than when heading
up.
Sound familiar? It's a "Minsky
Moment," and the irony is most investors know easy credit, overtrading
and euphoria create bubbles that always burst. The internet and tech
one did in March, 2000, and since mid-July, reality caught up with excess
speculation in equity prices, the housing bubble, growing mortgage delinquencies
and subprime defaults. Goldilocks awoke and sought shelter as lenders
remembered how to say "no." This time, central banks rode
to the rescue (they hope) with huge cash infusions, the Fed cut its
discount rate a half point August 17, and it signaled lower "fed
funds" rates ahead if markets remain tight.
Intervention may reignite
"animal spirits" and work short-term but won't easily band-aid
over what noted investor Jeremy Grantham calls "the broadest overpricing
of financial assets - equities, real estate, and fixed income - ever
recorded" with the financial system dangerously "overstretched
(and) overleveraged." His view is that current conditions have
"almost never been this dire," and we're "watching a
(too late to stop) very slow motion train wreck." Minsky would
have noticed, too.
Grantham's exhaustive research
shows all markets revert to their mean values, and all bubbles burst
as the greatest Fed-engineered equity one ever in US history did in
2000 but didn't complete its corrective work. In Grantham's view, lots
more pain is coming and before it's over, it will be mean, nasty and
long, affecting everyone. Minsky saw it earlier, studied it, and wrote
about it exhaustively when no one noticed. If he were living today,
he'd say "I told you so."
Federal Reserve Engineered
Housing Bubble and Resultant Financial Market Turmoil
Astute observers continue
to speculate and comment that the housing bubble and resultant current
financial market turmoil came from deliberate widespread malfeasance
aided by considerable cash infusion help from the Federal Reserve in
the lead on the scheme.
Economist Paul Krugman is
one of the latest with his views expressed in an August 16 New York
Times op ed piece titled "Workouts, Not Bailouts." He began
by debunking Wall Streeter Treasury Secretary Henry Paulson's ludicrous
April claim that the housing market was "at or near the bottom"
followed by his equally absurd August view that subprime mortgages were
"largely contained." Krugman's response: "the time for
denial is past....housing starts and applications for building permits
have fallen to their lowest levels in a decade, showing that home construction
is still in free fall....home prices are still way too high (at 70%
above their long-term trend values according to the Center for Economic
and Policy Research, and) the housing slump (will be around) for years,
not months" with all those empty unbought homes needing hard to
find buyers to fill them.
In addition, mortgage problems
are "anything but contained" and aren't confined to the subprime
category. Krugman believes current real estate troubles and mortgage
fallout bear similarity to the late 1990s stock bubble. Like today,
they were accompanied by market manipulation and scandalous fraud at
companies like Enron and WorldCom. In his view, "it is becoming
increasingly clear that the real-estate bubble of recent years (like
the 1990s stock bubble)....caused and was fed by widespread malfeasance."
He left out the Fed but named co-conspiratorial players like Moody's
Investors Service and other rating agencies getting paid lots of money
to claim "dubious mortgage-backed securities to be highest-quality,
AAA assets." In this role, they're no different than were "complaisant
accountants" like Arthur Andersen that lost its license to practice
from its role in the Enron fallout.
In the end, this scandal
may be more far-reaching than earlier ones because so many underwriters
and other firms are part of the fraud or are seeking to profit from
it. At this point, it's hard separating villains from victims as, in
some cases, they may be one in the same. They're all involved in dispersing
up to trillions of dollars of risks through the derivative alchemy of
highly complex, hard to value, packages of mostly subprime CDO and various
other type debt instruments that may even end up in so-called safe money
market funds unbeknownst to their unsuspecting owners.
Before this scandal ends,
they'll be plenty of pain to go around, but as always, small investors
and low income subprime and other mortgage homeowners will be hurt most.
Krugman says this is "a clear case for government intervention,"
but it won't be the kind he wants. He cites a "serious market failure
(needing fixing to) help (as many as) hundreds of thousands" of
Americans who otherwise may lose their homes and/or financial nest eggs.
Faced with this problem, "The federal government shouldn't be providing
bailouts, (it should) arrange workouts....we've done (it) before (and
it worked) - for third-world countries, not for US citizens." It
helped both debtors escape default and creditors get back most of their
money.
By providing huge cash infusions
to ease credit and reignite "animal spirits," the Fed and
other central banks showed they aren't listening. It proves what Ralph
Nader said in his August 19 Countercurrents article called "Corporate
Capitalists: Government Comes To The Rescue" that's also on CounterPunch
titled "Greed and Folly on Wall Street." With "corporate
capitalists' knees" a bit shaky, Nader recalled what his father
once explained years ago when he asked and then told his children: "Why
will capitalism always survive? Because socialism will always be used
to save it." Put another way, the American business ethic has always
been socialism for the rich, and, sink or swim, free market capitalism
for the rest of us.
As the housing slump deepens
and many tens of thousands of subprime and other mortgage holders default,
vulture investors will profit hugely buying troubled assets at a fraction
of their value as they always do in troubled economic times. Writer
Danny Schechter calls the current subprime credit squeeze debacle a
"sub-crime ponzi scheme (in a) highly rigged casino-like market
system" targeting unsuspecting victims. Schechter wants a "jailout"
for "criminal....financial institutions (posing) as respectable
players." Krugman, on the other hand, wants a "workout"
for the victims. Neither will get what he wants. In the end, as ordinary
people lose out, big government will again rescue "corporate capitalism"
(at least in the short-term) the way it always does when it gets in
trouble. It's the "American way." It'll be no different this
time.
Stephen Lendman
lives in Chicago and can be reached in Chicago at [email protected].
Also visit his blog site
at sjlendman.blogspot.com and listen to The Steve Lendman
News and Information Hour on TheMicroEffect.com Saturdays at noon US
central time.
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