I think there is an interesting disconnect between the impression of free market forces dominating the US economy and the extend of government influence. And I am not basing this observation on the huge government spending programs to bail out financial institutions, their shareholders and bond holders (thanks, tax payers). Nor am I referring to the huge stimulus package that interestingly enough has no clear signature initiative to revive the flailing economy.
Instead let’s look at the automobile industry, the initiative to curb Co2 emissions and the price of fuel. The problem with the fuel price is that it pays for the cost of extracting the oil, processing it into fuel and shipping it right next door to you ready to be filled into your car. However the cost of burning the fuel which has an adverse impact on the environment is not included in that price. The cost of that is burdened on society instead. This is called an External Effect. It leads to a wrong market equilibrium as the price of the good (here fuel) it too cheap, as the external cost of burning the fuel is not included in the price. Therefore this cost is not included in the decision making process on how much to consume, i.e. how to drive (MPG of your car, distance driven etc.).
Economists can agree that a way to improve the market allocation and thereby total welfare is to increase the price of fuel to reflect this external effect – basically tax it. That would lead people to demand less by either buying more fuel efficient cars or driving less.
But instead of using the price of fuel and thereby market mechanism to improve the market equilibrium and in our example reduce CO2 emissions and reliance on oil imports, the US government for years has used Miles-per-Gallon standards that the car industry had to meet by its average fleet. So instead of using price and market mechanisms, the government tries to ‘tell’ the car makers what cars to build and consumers what cars to buy. That does not make any sense. It is not an efficient way to influence behavior, it has huge time lags to be enforced and most importantly it is easy to circumvent – as is the case with all large, cumbersome government regulations. This is why Detroit has lobbied for these kind of regulations – they have in the end little or no effect.
We see a similar notion in todays debate around the banks bailout plan. Lawmakers want to ‘tell’ the banks to start lending. Banks do lend to make a profit, if they can make a profit. In the current market environment they cannot open the siphons and start excessive lending again – there are enough toxic, i.e. non performing loans for a while (wasn’t that the whole problem anyway?). Instead of forcing banks to do something that is not in their profit making interest, the government needs to set the right framework that will allow banks to do business which will inevitable leed to lending (one should not forget that banks still lend – but they are much more careful and have only limited liquidity).
But there are three reasons why government seems to prefer to try to directly influence the behavior of market actors (companies) instead of setting incentives and using market forces:
- It seems easy. Instead of understanding the complex framework of incentives that influences corporations and their customers, just draw up a bill that requires people to do stuff – no matter if it makes economic sense. Often it does not, otherwise you would not have to write a law.
- It is a quick fix. We live in fast times. Who remembers last years legislation. Who cares about next generation if re-election is around the corner. Roger Ehrenberg wrote a good post on short-termism that sums it up.
- It can be influenced by the industry that is to be regulated. We saw that during the last 20 years with the introduction of MPG standards. Detroit did a good job in making sure they were not adversely effected. Unfortunately they missed the whole point that at some point fuel might become scarce.
To me this kind of behavior legislation is not too far off what could be seen in former socialists countries and you would expect to see in many parts of Europe but not in the US. Influencing behavior by setting the right incentives seems to me far superior than guiding somebodies hand.
, which is based on a survey about the online and offline news preferences of 2,787 US news consumers.
I have repeatedly asked me this one question when it comes to the financial crisis: Was it a lack of intellectual capabilities that made people invest into structured subprime assets believing the AAA ratings? What about leveraging 40-1? Does that sound smart?
Mixed Thoughts on Markets – Part 1
February 25, 2009 at 11:10 am · Filed under Commenting the web
Capital markets have been swinging wildly and amongst all this chaos it is difficult to focus and spot trends. There is a lot of noise out there. Here are some thoughts that should help me to structure my thinking:
This post is about the Stock Market. Thoughts about inflation and commodities to follow later, even though all of these are connected, which makes my head spin. Let’s start with the stock market nevertheless.
The stock market is down 50% since its high. Or you could say, 50% of the gains of the bull market that started in ’82 have been eliminated. I see a lot of comparisons of this market decline to other bear markets, including the bear market during the Great Depression. Compared to the Great Depression we would have to go another 78% down from current levels to reach the low. It seems to be in the human nature to look for patterns and compare in order to understand. But are these comparisons valid or interesting? I do not think you can make a decision on the direction based on those past bear market charts.
I think more a long these lines:
1. Negative Feedback Loop
Is the economy getting worse than already expected or not? I think we will see more negative surprises. And those will come from outside the US. January exports in Japan fell by 45% (!) creating a trade deficit. That is pretty shocking. Similar numbers across Asia and Europe. It shows how hard consumers are clamping down on spending. And this hits those export orientated economies (China, Japan, Germany) that were a bit removed from the financial turmoils. This will lead to a further hit on domestic consumption in these markets as people will get laid off leading to shrinking consumption there as well. All markets are connected – no decoupling anywhere in sight. I think we have a negative feedback cycle right here. And no local stimulus package can address that easily. So without going into more details, I think that this has not been factored into corporate earnings.
2. D-Process
Here is a link to Ray Dalio from Bridgewater. I fully agree with him. While most recessions are triggered by either supply shocks or monetary policy to fight inflation, we are today in a process where we have to restructure nearly all economic sectors, because they are over-leveraged (and some are just bankrupt): Banks, Corporations, Consumers, Governments. This de-leveraging process takes some time and will bring us to lower stock market prices.
Conclusion
These two effects will bring us to lower stock market levels – slowly and steadily. I am short with an unlevered (!) ETF ($SH)for long-term holding (Never hold an leveraged ETF for more than 48h if you do not want to get bitten by compound performance effect). However, there are as well factors that will lead to higher stock market (at least nominal) such as inflation. The whole inflation topic is related to the policies implemented in regards to the D-Process but I feel this post has been too long already. Eventually the stock market will recover, when the negative feedback loop has been reversed, earnings expectations have been adapted and the D-Process has worked its course (but before it is finished).
By the way: Follow the stock market, and my inverse ETF $SH with Alerts4All – Real-time alerts. Real Simple.
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