One of the myths of capitalism is the "Efficient Market" Hypothesis. It confers upon The Market an all-knowing wisdom of the herd that divines at any point in time the best valuation of a security based on two fallacious assumptions:
- that a broadly based market assumes a broadly based correct assessment of value, based on...
- ...reliable information that is broadly available to all at the same time.
The past eight years have steadily demonstrated the bankruptcy of this hypothesis, and yet its acolytes cling to it.
Alan Greenspan's observation about "irrational exuberance" at the front-end of the dot.com bubble was confirmed at the back-end, but not before the Market reprimanded him for deviating from the Capitalist catechism. He recently strayed again in testimony before congress, acknowledging that the premise of self-discipline in the Markets has been seriously eroded by recent events.
The dot.com bubble revealed the duplicity of market savants and demigods who serve as opinion shapers in the dissemination of so-called information. The revelation of broker and market analyst betrayals of client trust were to be repeated immediately in the current mortgage meltdown by packagers of sub-prime mortgages and by the bond rating agencies.
Beyond the quality of the information shaping market perceptions is the size of the "market" itself. We have come to learn that the market may be broad-based in terms of exposed participants (workers and citizens who participate indirectly through their pension plans, 401(k)s and IRAs), but it is narrowly defined in terms of the institutional investors who are the financial intermediaries and true decision-makers that drive the market. We have come to learn that the decision-making mandarins are no better informed, for the most part, or responsible for prudent conduct and due diligence than Joe and Jane Six Pack.
Enron, Worldcom, and a couple of other notables led to Sarbanes Oxley in order to clean up the accounting abuses that threatened to undermine Assumption 2 of the Hypothesis. Those who did not like the rigor and cost of Sarbanes Oxley and other regulatory aspects of "transparency", opted for private equity. Think of it as the capitalist equivalent of off-shoring interrogation to Guantanamo in order to avoid other US laws.
Finally, the hedge funds, largely unregulated, ascended; assuming an ever greater proportion of market volume and value, further consolidating the market that was already consolidating in the hands of institutional investors. So a relatively few major investors, investing in complex instruments and arcane methodologies that not even they understood (as we now know), came to dominate the market, and trigger its decline.
We could dismiss this as an aberration of the moment. But most aberrations aren't. They often have a long series of events preceding them, and predicting them to the few perceptive enough to notice; which gives unique opportunity to the few with the knowledge and insight to benefit.
Here we stand at a plateau of the information age where, in spite of all of our technology, and all of our information, the market is paralyzed by distrust, Sarbanes Oxley notwithstanding.
* * *
If the stock market is more passion than prescience, it is not the only market suffering in an informational gulag. We have now come to understand that there are three parallel markets that define our economic existence, and all three are suffering from toxic data:
- the stock market (and bonds and commodities and futures, etc.)
- the credit market; and
- the Main Street market.
The Main Street market is where the rubber meets the road; the ultimate bazaar of consumable goods and services. But in our complex economy it lives or dies on the actions of intermediaries and an extenuated supply chain, often distant and increasingly unresponsive or indifferent to local needs or knowledge.
The Main Street Market depends on the credit market for the life-blood of economic sustenance: working capital. The credit market, in turn depends on Information about the viability of the life-forms receiving its benefit before it gives an injection. The credit market depends on historical relationships with debtors, and corroborating methodologies provided by credit rating agencies and auditors as trusted third parties. In our present circumstance, it is noteworthy that the banks not only do not trust the financial viability of their customers; they no longer trust each other. This is testament to the failure of the regulatory processes and the information base on which they depend.
* * *
Much has been made recently of the apparent failure of the TARP, which injected $350 billion into the banking system, to induce banks to resume extending credit. Congress is demanding to know what the banks are doing with the funds. Congress and the public are outraged that the banks decline to discuss what they are doing with the funds, and why.
One commentator recently noted that banks are caught in a bind. On the one hand, the Feds are warning the banks to increase their capital cushion. On the other the Feds and Congress are urging them to lend, to stimulate the very consumer-oriented economy that seduced us and led us over the cliff in the first place.
I suspect that there is a very practical explanation for why the banks are not lending more, and why they are close-mouthed about their rationale:
1. They know they need to increase their reserves because...
2. ...they know how much garbage they still have or potentially have on their balance sheets from the sins of the past, or ...
3. ...even they do not know how much garbage remains in their portfolio from sins of the past because it has not fully unraveled, but...
4. ...beyond the sins of the past, they have every reason to fear that the whirlwind they have unleashed will bring much more wreckage to their books, as growing unemployment and business failures make new loans to formally solid customers as toxic as the ill-advised loans of the past, and demanding yet more cushion for the banks' solvency.
If indeed this explains the rationale of the banks, where do we begin to build confidence?
* * *
Perhaps the most notable observation of the current financial crisis is that it is the most recent of a string of systemic failures in the larger society.
- dot.com market implosion
- 9-ll
- Afghanistan / Iraq
- Katrina
- energy policy paralysis
- Sub-prime, et al
- collapse of the auto industry
- health-care comatose and on the verge of collapse
- dis-investment in infrastructure
- technological decline
Each of these instances demonstrated not merely failure of reliable information, but failure of multiple institutions which generate the information, opine on the information and act on the information. Our failures as a society have reached a point that demands a serious self-examination. We cannot afford to continue the status quo. Our national self-esteem must surrender to self-awareness, and long overdue self-remediation.
Onward.
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