Sunday, October 5, 2008

On the Efficiency of Finance

From Michael Perelman:

Capitalism is the most efficient system known to mankind. Central to this efficiency is the ability of markets to channel capital where it is most effective. The current financial crisis might be expected to throw some doubts on this dogma, but I do not expect that to be the case.

For example, in 2001, in the wake of bubble, 2, the New York Times reported on one of the many excesses of the period:

"In the last two years, 100 million miles of optical fiber -- more than enough to reach the sun -- were laid around the world as companies spent $35 billion to build Internet-inspired communications networks. But after a string of corporate bankruptcies, fears are spreading that it will be many years before these grandiose systems are ever fully used."

The response was not to rethink the system, but to double down lowering interest rates to reignite the stock market. Investors, the government, and even ordinary people applauded the decision Federal Reserve Chairman Greenspan, who appeared to be the wisest man in the universe at the time.

Greenspan's manipulation of the interest rate appeared to be so beneficial, because it occurred without any direct effect on the proverbial taxpayer. Peripherally, why is it that this taxpayer ranks so much higher in our concern relative to the workers who make everything possible?

In retrospect, Greenspan's policy provided the fuel that helped to make the crisis possible, if for no other reason that falling interest rates reduce the payment on mortgages. So, for the same payments, people can afford to buy more expensive housing. Once housing prices begin to rise, housing becomes an investment as well as the source of shelter. In addition, people who suffered losses during the bust, saw housing is a safer investment than the stock market.

Just as the solution to the crisis produce the current crisis, the present bailout, if it works at all, will create the preconditions for the next one. The purpose of the bailout is to create confidence. Back in the 19th-century, the governor of Illinois gave an excellent analysis of the way confidence worked in financial markets. He said that confidence "could only exist when the bulk of the people were under a delusion. According to their views, if the banks owed five times as much as they were able to pay and yet if the whole people could be persuaded to believe this incredible falsehood that all were able to pay, this was 'confidence'."

His words may perhaps be the most succinct analysis of fictitious capital that I have read.

No comments: