Wednesday, March 05, 2008

Why markets are not always better

Well, it was a longer break than I had intended! Still, a lot has been happening while I was off-line. I have been jotting down notes in my spare time to provide a base for future stories.

I had to laugh today.

Eldest is doing economics at the University of New South Wales. Her latest assignment was to prepare one side in a debate. There were meant to be two of them in the team, but her partner dropped out of the course so she had to go alone.

Why did I laugh? The topic they were given read "the market always gives better results than Government action." Helen had to argue the negative.

How could she not win? Because of the use of the word always, she had only to provide one example to prove her case. The results of the sub-prime collapse are all around us. Of itself, that was sufficient for her to win.

However, while I laughed I was left with a feeling of unease. Irrational exuberance has always been with us. To illustrate her point, Helen gave tulip mania as an example. She could equally as well have taken the south sea bubble.

There have been many crashes. Today, or so it seems to me, we are especially vulnerable because of the sheer size of financial markets relative to physical markets.

Leverage is central to financial markets. If you are making widgets or mining iron ore, then what you do is subject to physical as well as financial constraints. In the financial world, you can leverage transactions far beyond the real value of the underlying assets.

We call this financial engineering. This is a misleading term because it implies a degree of precision, of safety, that is simply not there.

When a small number of institutions operating in a relatively small market by global standards can leverage to the point that they threaten the whole global financial system, then we have a problem.

In Australia where our major financial institutions are generally secure, we still have something of a funding drought because of the flow on effects. This hurts everyone.

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