Three Brief Reasons Why We Are Not in a Free Market

1.) The Federal Reserve. Karl Marx in his ‘Communist Manifesto’ said that the centralization of a nation’s credit and money supply is key in establishing socialism. As long as we have a central bank manipulating markets against the will of capitalism, we will never have it.

2.) The ability of private interests to influence politicians and thus legislation. This manifests itself in many ways. Anti monopoly laws are generally used to block entry to an industry to protect it’s profits. Tariffs, price controls, union legislation, “free trade” agreements, all these are examples of legislation that benefits one special group over another. Lobbying and campaign contributions are just the tip of the iceberg. How about Henry Paulson having led Goldman Sachs, one of the biggest beneficiaries of the bailout? Cut the political tie to business and watch capitalism thrive and competition force innovation.

3.) Fiat money. In a true free market, with competing currencies, fiat money would be available yes. But if it was devalued in the same way that our government does now via printing and inflation, it would quickly be phased out. This is due to it’s instability. While the value of a fiat money, like the dollar, is always decreasing, the value of a commodity, such as gold, remains very stable.

Does the Ban on Short Selling Create the Volatility it Was Meant to Ease?

The stock market is seeing some wild volatility. Up 200 one day, down 500 the next. Could this be due to the uncertain times we are in? Of Course. Could it be compounded by the ban on short selling by the Securities and Exchange Commission? Perhaps.

The SEC’s ban on ‘naked short selling’ is explained more thoroughly here and here, both excellent articles written by Robert Murphy for the Von Mises Institute. But essentially, short selling is vital and necessary part of the market. Speculation serves to push undervalued stocks up and overvalued stocks down closer to their fundamental value. When a price is undervalued, anybody can speculate and buy it thus driving the price up. However is the price is over-valued, the only ones capable of speculating in the opposite direction are those who already own it. This creates an imbalance in the trading, Thus we bring in short selling, the act of selling a stock that you didn’t own by borrowing it.

There is no evil inherent the process and because stock-brokers have to act as clearinghouses for both parties, they are on the line as much as the trader. It is their credit that is used in the transaction. It is in their best interest to make sure the deal is on the up and up. Because if it’s not, say a stock is borrowed and sold, ideally the price drops and the trader buys it back at less than what he sold it at. But if the price increases, his losses could theoretically be infinite. So both the trader and the brokerage firm have plenty of incentive to keep things from getting too crazy.

As far as ‘distort and short’ schemes, they will have little value in the long term, because other speculators and investors will recognize the difference between fundamentals and rumors and false information and act accordingly. This means they will see a company whose price was affected by false rumors and see it as undervalued and therefor buy it. This will at the very least keep the price stable and perhaps even drive the price above the original and creating a loss for those who would commit the fraud.

So what is the effect? To keep over-valued stocks from adequately having their prices forced down in a balanced way. Short selling does not create volatility, it smooths it out.

In the previously mentioned articles, it is argued that the ban served merely to introduce red tape and desensitize the public to the thought of public/privately owned companies. I do not know if i believe or truly understand that position. However from an economic standpoint the ban does no good but create more uncertainty in a market and compounding the problem later by creating a precedent for further regulation of trading.

A Take on the Community Reinvestment Act

While i’m not a fan of partisan politics (what’s the difference? they’re all over-taxing and over-spending), this article on the CRA does bring up some interesting points. Regardless of the administrations who wrote/passed the law and those who enforced it, the regulation it enables and the moral hazard in entails leads to some very serious economic consequences if the opponents of the act are correct in the scale of the issue. What i mean by that is yes the act is a terrible idea, but was it’s enforcement widespread enough to really cause the meltdown? Personally i think it was a contributing factor, if a small one. It certainly didn’t help.

The idea is that it allows community groups/organisations to coerce (via actual law) banks and lending institutions into lending money to whomever the community group wants, regardless of the financial ability of the recipient. The charge is that community groups used the law to make banks lend to ’sub-prime’ candidates based on their race or creed or even poor economic status… it’s irrelevant. The point is, once a group deemed necessary, a bank would be operating illegally if it did not lend to whom the organisations wanted.

As i said before, a law like this is terrible and unconstitutional. It should be immediately stricken from the books, however I myself am not completely convinced that the law was the sole cause of the mortgage crisis or even a major player. What are your thoughts?

When Will We Feel Inflation?

If the government is printing so much money, and the Federal Reserve is lending money to banks at near zero percent interest rates to bail them out increases the monetary base (the total amount of money), why aren’t we feeling the effects of inflation yet?

Because the banks are scared. They have tons of debt and securities that are unsecured and still subject to default. The mortgage mess is not over, there are still ARM’s (adjustable rate mortgages) to reset and foreclosures to come. There are still collateralized debt obligations (securities backed by the bad loans) that were built on those loans and there are still companies that insured those obligations against loss (like AIG). All this adds up to an economy and banking system where no one wants to get caught when the music stops. No bank wants to lend money in case things don’t turn around sooner rather than later.

Banks have built up enormous excess reserves to shield themselves from risk and in doing so have kept a large portion of newly printed money at bay and thus kept inflation low. Combined with global de-leveraging and a general deflation following the burst, the dollar has remained strong.

When will banks decide to let go of these reserves? What effect will that have on inflation? It’s hard to say, but increasing the money supply can only have one effect. Inflation.

As Interest Rates Get Lower, Fed’s Options Shrink

The Fed is planning to meet on Dec. 16th and is expected to reduce the target interest rate to 0.75%. But how far can it go? Personally, i’m worried that once the interest rates are at or close to zero the Fed will resort to simply buying assets. Not that it isn’t already, but that will be zero percent interest rates and fresh printing of money every day. Talk about inflationary pressure. Though to be fair, banks that have access to those rates are not forced to lend at them and indeed they most likely won’t. My guess is that once banks are able to borrow at such rates they will do so simply to pay off their existing debt at higher interest rates. It is impossible to completely predict whether banks will pass along interest rates to consumers and it is hard to predict whether consumers will be as willing as in the past to get into debt so quickly. These are simply observations.

3-5 Years Before Housing Markets Hit Bottom?

According to this article, that’s right… and he’s got some convincing evidence combined with some economic logic. He draws (literally, there’s graphs) parallels between Japan in the 90’s and the U.S. today and the coincidences are quite striking. I particularly like his refutation of the opinion that it is possible to spend our way out of a recession via public works projects.

Three to five years? That is a scary proposition for some who’s home value is dropping alarmingly close to their mortgage level.