What's happening?

Guest post by Professor Rabee Tourky, University of Queensland

These are interesting times for economists. I hardly know a serious economist whose attention in the past weeks has not been fixed on the changes in asset prices.

An emerging narrative is that for some years we have seen a bubble in US house prices, asset prices did not reflect the inevitability of this bubble bursting, this was made worse by the behaviour of brokers and bankers who through short-term thinking compounded the belief in the notion that there are never-ending arbitrage opportunities in the market, and that there was a failure in the market for credit default insurance and the prices of credit default swaps. All of this was exasperated by the behaviour of ratings agencies.

This emerging narrative with its various derivatives needs some tweaking before it becomes entirely convincing.

One variant of this narrative adds that all agents behaved rationally in this process, and another distinguishes itself by the thinking that bankers and agency analysts behaved rationally by duping, as it were, non-expert investors (Joe six pack house buyer). I think that it is reasonable to dismiss this second addendum to the narrative and to suppose that we are all adults.

A foundational conclusion in economics is that prices are the (exclusive) transmitters of information regarding relative scarcities. They are formed by equating demand and supply, which are influenced by peoples tastes and in the case of assets their beliefs about future events. There has been very little work about what we mean in an exact sense by prices transmitting information. This is particularly the case when models involve uncertainty. One can  fathom from thoughtful models of price formation under uncertainty that prices of assets reflect beliefs regarding future value.

Prices of derivatives therefore reflect beliefs about beliefs and this hierarchy of beliefs is consistent at equilibrium in an information theoretic sense as well as in a way that avoids the presence of arbitrage opportunities. Mind you I'm not aware of a theoretic work that addresses hierarchies of information involving prices.

Now it is rather difficult for me to imagine a convincing economic model whose conclusion is that assets prices do not reflect and aggregate beliefs regarding future prices and which at the same time does not involve arbitrage opportunities. Of course, there are no arbitrage opportunities in a competitive market. This brings us to the idea that there was an assets bubble in the US assets market.

So what is an assets bubble? Well that's not clear though there is a limited number of theoretical and experimental work on this topic. It appears that an assets bubble has the following characteristics:

1) A rapid increase in the price of an asset.
2) A catastrophic fall in the price of the asset.
3) Analysis showing that either:

The information available at the time of the price increase did not justify the increase in price.

There was some kind of fraud in terms of misrepresentation of the nature of the asset by people who could profit from the formation of the bubble.

There are of course assets bubbles involving fraud and misrepresentation, pyramid schemes come to mind. However, I have not seen models that convince me of the possibility of assets bubbles in which the available information is not reflected in prices. Prices can't tell you the future but they reflect a good guess at the time, and they can be wrong ex post simply because agents were not aware of future possibilities or that their best guess did not realize. Nevertheless, in such cases prices do reflect information available at the time that they are formed. The main thrust of arguments involving the possibility of endogenous bubbles not involving fraud is that the market does not work as expected. Well there is a desperate gap between such claims and the scientific models that we have at present.

So in regard to the assets price increases that we saw in the US, and which eventually collapsed, a main non-economic question to my mind is a legal one. Is there evidence of fraud? In the absence of serious fraud my own narrative regarding what is happing is somewhat different from the emerging narrative.

I do think that there was a market failure in the sense of market incompleteness. In a complete market one can ensure themselves against any economic risk. However, there are occasions in which certain markets are missing. I'll give two very extreme examples. Can one insure herself, using available assets, against the possibility of a world wide medical epidemic of unknown type? Can one insure themselves in regard to the collapse of government and its guarantee of private property?

Similarly, it seems that there was no available means to ensure against the collapse of the entire financial system. Credit default swaps provide a measure of insurance in regard to the default by a single (or multiple) agent(s) but cannot be used for the purpose of ensuring against endemic default.

In short, what we are seeing is the effects of the incompleteness of the kind of instruments available to the market and not the result of too many complicated assets. Derivatives are not weapons of mass destruction on the contrary the price changes are due in large to the incompleteness of the derivatives market.

In this narrative there is some sort of market failure but the nature of this failure probably means that governments and central banks should engage the market in ways that are different from the approach they would take should the emerging narrative prevail.

In the emerging narrative governments ought to reduce the kinds of financial instruments available in the market.

In the narrative I outline above the idea is for governments to intervene to help complete the market - one extreme idea is to provide its own derivatives that can help ensure against the kind of systemic collapses that we have seen. In the second narrative governments should disengage from the markets in all ways except for making explicit the kind of insurance it provides that guarantees the ongoing operation of the financial system. They should encourage financial innovation and even participate in that process.