Thursday, January 08, 2009

Of Course Markets Seek Equilibrium

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. George Soros

During a self-imposed hiatus from writing- I needed some time to fill the tank, if you will- I had ample time to allow a few thoughts to germinate and grow. Sometimes the rush to put something on the blog isn't conducive to following a thought in sufficient depth.

But, I digress.

As you can infer from the title of this post, I disagree with Mr. Soros' view that markets don't tend to equilibrium.

This view begs the question, what is equilibrium? Mr. Soros, I imagine, looks at the current financial chaos and sees disequilibrium. I take a longer view and see much of the past few decades as a period of disequilibrium obscured by easy credit. As credit conditions have tightened the hidden disequilibrium comes into view, or as Buffett would put, the outgoing tide exposes naked people.

The current chaos is, to me, part of the process of awakening people to need for change- an equilibrium seeking process. Chaos has its purpose.

A decade ago equity investors valued tech companies like the Dutch valued tulips during the early 17th Century- dearly. Today, after some chaotic price action, one can buy both items at much more reasonable, by which is meant, nearer to equilibrium, prices.

A few years ago US real estate investors valued properties at, in some cases, many multiples of replacement cost. This overvaluation has been and continues to be unwound.

Markets correct.

I'll repeat myself and argue that markets self-correct, to draw your attention to what I see as a distinction without difference- correction and self-correction.

To distinguish between correction and self-correction is to assume exogenous factors when, it seems to me, all market participants, be they private or public, are endogenous thereto. Had the Greenspan Fed decided to prick the numerous asset bubbles rather than let them expand, implode and clean up the mess left behind, this too would have been self-correction for the Fed is as much a market participant as you or I are.

I sometimes wonder if the distinction is, in part, a result of a desire to see government as Aristotle's (or Aquinas' if you prefer) "unmoved mover," adjusting a game board on which the rest of the world plays. The prevalence of this view might explain the rather curious distinction between public debt and private debt- a view which seems to assume that governments don't ultimately operate under the same financial constraints private sector corporations do.

The question of market regulation should not, it seems to me, be debated as if, in the absence thereof, markets wouldn't correct. They have and will. Rather, the question of market regulation should be debated in much the same way that education is debated, as a means of expediting and improving a process- in the case of education, general human awareness of the world- which occurs naturally, albeit sometimes slowly and even, at times, regressively.

Further, market regulation (and education) should not be seen as something imposed on others from outside but rather as a policy one would (and hopefully does) impose on one's self as Rawls argued in his Theory of Justice.

Some Austrian leaning readers may well be cringing at the thought of advocating market regulations as if a specie standard is not a form thereof. The classical Gold Standard was a severe regulation which allowed everyone to act as regulator, albeit with varying impact. Under that form of regulation one needn't turn to a public sector bank regulator, one merely forced the bank in question to return your deposits in gold at a fixed price.

Given the "success" of the alphabet soup of public sector financial regulators of late, a return to such a system might prove wise. In hindsight, it may be clear to many that such a system of regulation would have attenuated excesses. From the perspective of the self-regulator, those who thought of their money as real, i.e. those who self-imposed this regulation, have certainly outperformed those who thought that credit would always be easily found- an outcome which fits the Rawlsian perspective noted above.

When market regulation is considered from that perspective, the view proposed recently by Krugman, et. al. that FDR's regulatory system was some peak, relative to pre-Depression and current times seems a bit odd. Rather, market regulation has been in decline for decades. FDR did impose regulations on the financial sector but only after removing that regulatory power from the common man of means by outlawing private sector Gold holding. This substantial deregulation meant that financial firms need only convince the state that they were solvent.

Thus the Greenspan-era financial sector deregulation can be seen as just another step in a long process. As the Madoff (et. al.) scam demonstrates, convincing the state one is solvent is apparently quite easy, if you are considered to be an inside guy.

Coming full circle, recent steep market corrections in this environment of virtually no regulations seems to disprove Mr. Soros view.

Markets correct. It would just be better if they corrected sooner.

Up next: It's not the size of the stimulus, it's what's in it that counts.


STS said...

I marvel a bit at the confident use of the term equilibrium in a case where a system spends so much of its time out of equilibrium. It's almost a kind of magical thinking. But your point about the timescale of equilibration (or trend reversal, at any rate) is well taken. Markets have timescales which relate somewhat inversely to their depth and liquidity. I suspect a better way to think of market equilibrium would draw upon an analogy with the rather turbulent 'vacuum' in quantum field theory -- full of spontaneous creation and annihilation and anything but 'settled'.

A classic take on the paradoxes inherent in the classical economic view of equilibrium is Fischer Black's 1986 essay "Noise".

Dude said...

I'm a bit pressed for time these days but I will respond to your views this week.

STS said...

Here's an interesting clip from physics Nobelist Frank Wilczek which illustrates the fluctuations of topological charge density (gluon field) in "empty" space.

A big problem with economics as a discipline is that it tries to be scientific while limiting itself to the mathematical tools of 19th century science (with a few minor outliers to do with more recent extensions to those same 19th century ideas).