Tuesday, March 11, 2008

Eliot Spitzer and the forgotten "if"

An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts Journal, September/October 1965

What a surprise we New Yorkers got yesterday afternoon. It wasn't the news that a high ranking public official had enjoyed (we assume) the services of practitioners of the "oldest profession," but rather that a totally unregulated market, at least here in the US, could be so inefficient.

$5,500 an hour! C'mon Mr. Spitzer, haven't you heard about the virtues of globalization, specifically outsourcing (perhaps in-sourcing is a better fit), i.e. labor market arbitrage? With that kind of cash he could have flown to Asia or Eastern Europe, enjoyed the services of multiple women for days, and may well have avoided the prying ears of the FBI to boot. I guess some high ranking public officials aren't rational, profit maximizers.

Sadly, it seems to me, given the massive and continuing shift in control of global wealth from private sector hands into the official sector, the irrational, non-profit maximizing habits of public officials (and even private sector officials of big firms) is becoming a real drag on the global economy. Sadder still, this deterioration in market efficiency is, in a sense, invisible because of a forgotten "if."

To what forgotten "if" do I refer? The implied "if" in Eugene Fama's definition of an efficient market- for he did not argue that all markets ARE efficient, but rather that markets are efficient IF participants exhibit certain qualities. It then follows that the fruits therefrom, notably that market prices will be good estimates of intrinsic value, are not guaranteed but instead conditional.

Nietzsche argued, As long as a man knows very well the strength and weaknesses of his teaching, his art, his religion, its power is still slight. The pupil and apostle who, blinded by the authority of the master and by the piety he feels toward him, pays no attention to the weaknesses of a teaching, a religion, and soon usually has for that reason more power than the master. The influence of a man has never yet grown great without his blind pupils. To help a perception to achieve victory often means merely to unite it with stupidity so intimately that the weight of the latter also enforces the victory of the former.

The true masters, it seems to me, are aware of the necessary conditions to achieve the desired benefits while their more powerful apostles promote the simpler views- man IS rational (not that he can be) and markets ARE efficient (not that they can be).

Thus the conundrum we seem to be facing.

Having assumed that markets are efficient, the idea that, for instance, market interest rates, in the US at least, are far from their "intrinsic" value makes no sense. Thus the sense that officials can "tinker around the edges" and fix things still seems credible.

Trillions of $s are managed in "trust" by the few, who, as the example of Mr. Spitzer makes (facetiously) clear, are irrational non profit maximizers, for the many, who will pay and are paying the price of market inefficiency in the form of a credit crunch, et. alia. Stupid people with lots of money not their own can distort any market, even the oldest one there is.

The cause of the crunch, it seems to me, is not, as Central Bankers, who also rarely exhibit profit maximizing behavior (think BoE gold sales under $300) a lack of credit, but a mis-pricing thereof. The supply of true (as opposed to the Central Bank variety) credit will rise, as with every other market, when its price rises, or so elementary supply-demand curve analysis argues.

As an example, I have a house to sell (yes, I know, this isn't a good time) and I'd love the write the mortgage. Yet, the rate I want would seem usurious to anyone who thinks that the current 6.07% 30 year mortgage rate is the result of an efficient market, i.e. an good estimate of "intrinsic" value. So both my house and my credit will stay off the market for a while.

On the plus side, market inefficiencies have a way of working themselves out spontaneously, recalling my last post on entropic processes. The greater the inefficiency, the worse the outcomes. The worse the outcomes, the easier it becomes to accept radical solutions and the more likely that radical change will simply erupt.

Or so I believe.

Until then I'll just sit back and enjoy sun rises like these from my new office window.