October 01, 2008
Market to Marks
Hidden amongst this current financial crisis is a nasty little truth about neoclassical economics the hits to the core. This is the idea that economic objects should have one "market price" or equilibrium. The truth that lies in plain site is that this just isn't true. A bottle of orange juice might be a dollar in one shop, a buck fifty down the road and seventy five cents across town. There is a whole bullshit loads of talking around the clear fact of how this undercuts the very basics of economic theory. And there are also massive systems in place at stock and commodities exchanges, explicitly design to produce something as close to equilibrium prices as can be generated. But under this age's crisis all that cover falls clearly apart.
The issue is what is known as "mark to market", a system by which firms need to value their investments for accounting purposes based on the present market value of each financial object. And it needs to be done daily. In stable yet liquid market conditions this is generally a good thing, it promotes transparency and prevents firms from hiding bad investments behind dubious accounting practices.
However the system has fallen clean apart over the course of 2008. As firms get more and more risk adverse the liquidity for many investment vehicles has evaporated. The market value has plunged to zero, no one is out there that is willing to risk buying these things. Standard economic theory would have it that these things with zero market value are then financially worthless. But the fact is that they actually stand to return quite a bit of money over their lifespan. They have no market value in a risk adverse environment but have plenty of value to the firms holding them.
The mark to market rules have played at least some role in worsening the current financial crisis by exaggerating the losses in many firms. They are forced to report huge losses as the market value hits zero for their illiquid assets, yet these same assets will return at least some income over their lifespan. The SEC is currently "loosen" these rules, but just how so remains a bit unclear. Ultimately I can be almost sure they won't address the core issue though.
What really needs to happen is for economics to give up it's insistence on the idea of equilibrium pricing and acknowledge that markets can happily support a multitude of prices for any given object at any given time. It's no easy task because it essentially means scrapping a mass of economic theory and starting over from close to scratch. No easy task there, to say the least. But for a discipline that still can't answer Thorstein Veblen's 110 year old question of "Why is Economics Not an Evolutionary Science?" it's a completely essential step.Posted by Abe at October 1, 2008 12:28 AM