A plan for 'Imperfect Competition'

For the last few days I have waited before wading into the conversation regarding the Volcker Rule.

The Volcker Rule was the plan President Barack Obama announced on 21 January 2010 in which he proposed to reform the banking and financial services sector in the United States.

As usual the Press have been trying to pull this press release into the wrong direction and flawed analysis is once again being applied to the debate on financial services regulation.

In my mind, having watched the 8 minute YouTube clip, see (Volcker Plan), what the President was referring to in his statement was to the economic theory of Imperfect Competition.

Imperfect competition refers to the fact that there are:

1)             Many participants in the market both buyers and sellers

2)             All sellers have diversified products and services they sell

3)             Monopolistic competition can be a resultant format of engagement in the market by sellers

4)             All participants participate equally and fairly on a level playing field, therefore the barriers to entry are low

Therefore the supply side concentration of power in the financial markets which currently rests with too few oligopolistic institutions (Oligopoly ), will be broken by a new framework being created, under which market participants will have to engage in the free market mechanism.

So there we have it in a nutshell, a democrat proposing a free market framework in which risk is shared over a wider continuum of participants and no one participant able to be a 'pure' price maker and thereby skewing the 'rules of the game' in their favour.

What better testimony to the theory of Imperfect Competition than to just ask the players to merely move away from the current uneven playing field on to a new more equitable playing field for us all to share.

As long as these players take one of the libertarian principals of personal responsibility to heart, we might actually end up with the “Socialist President” creating the (im)perfect free market mechanism for financial services competition for many a generation.

theMarketSoul ©2010, is open to one or two more pleasant surprises from beyond the pond.

Values and morals! Who's values and who's morals?

This post was inspired by another fellow “LinkeInner’s” question which read as follows:

Do you think that the core of the current economic crisis is a crisis of ethics and values?

Two-thirds of people believe the current economic crisis is also a crisis of ethics and values. But only 50% think universal values exist. These are among the findings of the World Economic Forum’s Faith and the Global Agenda: Values for the Post-Crisis Economy, an annual report on issues related to the role of faith in global affairs.

Global religious leaders identify the key values for a more just and sustainable post-crisis economy.

http://www.imf.org/external/np/pp/eng/2009/021909.pdf
http://www.universityworldnews.com/article.php?story=20091011105058536
http://www.weforum.org/en/media/Latest%20Press%20Releases/PR_Faithvalues

My answer is:

What do the other third think who DO NOT believe the economic crisis is a crisis of ethics and values? 

If we were to ‘layer’ the global economic landscape, we would discover that the playing field is never and never will be level.  As an example, in your part of the world, one man’s commission is potentially viewed as another man’s bribe...?  (See the Serious Fraud Office’s investigation into the BAE System’s contractual relations in Saudi Arabia).  I am not pointing any fingers or inferring wrongdoing on anyone’s part, but I am trying to highlight the problem of ‘relativity’.  Points of view on morality, ethics and values different depending on your position, relative to the other people involved in that exact same ‘transaction’.

But, to answer your question directly I would say NO, it isn’t a crisis of ethics and values.

My justification is this:

1.       There is a general misunderstanding of the Laws and forces of economics that are at play here:

The fundamental Laws and forces at play in economics have nothing to do with morality or values.  These are emotional characteristics and only ‘enter the field play’ and manage to distort the rules of the game.  Yes, don’t get me wrong there is hopefully a morally correct framework set up in the first place, in order to allow everyone access to an opportunity to participate in the market, however, as we know in practice, this is not necessarily the case.

Markets, on the whole, tend towards and actively seek states of ‘equilibrium’.  However, on the odd occasion there are factors at play (political, regulatory, information, access to resources, etc.) that distort and cause markets to deviate from this natural tendency to seek the ‘clearing price and volume’ in the market.  Equilibrium is defined as that point at which the demand and supply curve interacts in such a way that all parties are satisfied (achieved utility) and all products in the market is ‘cleared’ at a given price.  There is therefore no shortage or surplus available. 

Scarcity of resources leads to a continuous search and flow of innovation, capital, land, labour and resources into the economic landscape (the market) thereby combining to meet some economic need or want by the production, distribution and consumption process.

If we are lucky, we participate with like-minded ethical and value-based actors in this market-place, however, if we are not so fortunate, we have a choice as to whether we participate or not.  Regulation is supposed to assist us in defining the rules of engagement, however, sometimes these rules become so onerous that participants actively seek ways and means to avoid or circumvent them.  That is way libertarians in general favour principle based, rather that rule based systems of compliance and participation in free markets. 

Because of Information Asymmetry we do not necessarily know the intentions, wealth, capabilities, etc. of our fellow market participants.  This is why one of the fundamental principles of market participation is ‘Caveat Emptor’ or ‘buyer beware’.

2.       Compliance and regulation are well intentioned in order to help define the rules of engagement, but as I stated above, they can become onerous, leading to dysfunctional behaviours in the market place and can contribute to the Law of Unintended Consequences.

Competition and the way in which ‘free markets’ operate invariably lead to ‘cutting of corners’ and finding ways and means of gaining some form of an advantage, be it lower costs, more features, better built quality, etc.  The problem is when sub-standard materials, labour and skills get involved and is then presented and ‘superior’ products and the purchaser does not derive the ‘intended utility’ he expected from that product.

The question really is whether this is a moral, ethical and values based issue?  No-one wants to be cheated o feel cheated and taken advantage of and therefore be disappointed in the market place; but as realists we all know that utopia is a very distant aspiration...

This is but the beginning of the debate and I would like to continue this theme in future posting

All the best.

theMarketSoul © 2010

I lost my glove tonight...

Well, it was borne out of anger, causing stupid behaviour and the next minute my glove was gone, fallen between the platform edge and the almost departing train. Next followed frustration, with a few expletives thrown in for good measure.

However, I look to this episode and try to draw a lesson from it. An economic lesson and this is what I came up with:

Gloves come as pairs. To the two handed individual, one glove is not really fit for purpose, except if you decide to permanently put the other non-gloved hand in your pocket, thereby proverbially 'tying one hand behind your back'.

This is what happened, figuratively speaking, during the lead up to the financial crisis.

Accounting regulatory standards meant that Financial Asset valuations had lost one of its gloves. The intentions were good, but as financial instruments increasingly became impaired the 'Mark to Market' ruling of IAS39 meant it forced banks to write-down instruments to market values.

Effectively the Profit & Loss account (Income Statement) became the dumping ground for the now 'toxic' assets. In the past any revaluation was done via the balance sheet.

The intentions of IAS39 were good, with a stated aim of increasing transparency and better valuations of banks and financial institutions, however, this was drafted and conceived during the go-go boom years, not anticipating a catastrophic downturn such as the one we just experienced.

Another factor I am paying a bit more attention to these days is the pricing of risk into financial products. As previously commented, if risk is priced in properly and this resulting premium capitalised as a reserve, then we should have a buffer for the rainy day.

The one problem or challenge we face is competition. Competition generally should encourage innovation, efficiency and cost reductions, via scale, however, it also encourages risk taking at the expense of risk pricing. This is one of the areas whereby our 'free-market mechanism' fails the test and does not 'balance the books' effectively.

How and what we do to address this deficiency is the stuff future blogs will explore in more detail.

But for now, the one-gloved 'soul' has had to wave goodbye to a matching pair.

theMarketSoul (c) 2010
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Asset bubbles: Not just valuations, but what and how we value

Where is the next Asset bubble likely to emerge? And what class of assets will drive and become the next bubble?

This is a question that is addressed in The Economist of 9^th-15th January 2010, p.65 "The danger of the bounce". Link: [The danger of the bounce]

The arguments are clear and concise enough; however a further factor to consider as part of the general historical trend and valuations analysis expounded in the article is the accounting distortions recently caused and driven by IAS 39 – Financial Instruments: Recognition  & Measurement.  The problems with IAS 39 are being addressed by the IASB, however, in a nutshell the challenges we face at the moment is thus:

Having changed the historical cost accounting valuations of corporate balance sheets to ‘the dumping ground of the "mark to market" tyranny’ on the Profit & Loss (Income Statement), we are not currently comparing apples with historical apples.  Having switched to "mark to market" accounting and utilised the Profit & Loss account as the dumping ground and not the Balance Sheet, we are currently looking at corporate balance sheet asset and liability valuations that are not what they were or have been over the last 100+ years of the historical comparison cycle referred to in the article.

Now I hope and trust that this issue is so blatantly obvious and has already been corrected and factored into the analysts calculations, that I am wrong about this; however, my experience of the analysis in the past, does not fill me with enough confidence to ensure that this is not the case.

Further to this, the fact that the debate is already starting about Asset bubbles, is good and an encouraging sign, however, there is also the little matter of risk (outside of pure compliance risk) and the pricing and factoring of this into the asset valuation equation, which needs to be highlighted and debated further.

Part of the debate this column attempts to stimulate is a ‘true and fair’ economic factor cost model and approach to understanding economic discourse in general.

So, let’s continue adding value and centring our arguments around this important issue.

theMarketSoul ©2010

An unfinished Poem...

Don’t Hurry

The world will still be turning

And time will run your emotions

And we will still be living.

The struggle is in knowing

And wisdom still eludes us,

Like the sands of time

Its flowing

Should we catch it now or just keep it going?

theMarketSoul ©2010