Keeping It Real

 

Buy low, sell high. Supply and demand. Economics 101 explained those simple, but somehow still poorly understood concepts.  The recent (and in many ways still current) worldwide economic crisis is but another example.

Supply and demand.  It is often said that the value of something is whatever someone is willing to pay for it. Not true. That is only the value if it is an amount that the buyer is actually paying for it.  Credit mechanisms have changed “actually paying for it” to “stated willingness to pay for it.”  That distinction creates separation of price and value.  The bigger that gap, the more at risk the market or economy.

We don’t want a barter economy because it is inefficient.  We want an efficient market, so we have created financial instruments to reduce transactional friction.  Speed and acceleration we’re good at.  But we’ve not yet mastered the concepts of brakes, and certainly not of when and how hard to apply them.  Why?  Because individuals benefit from the reduced friction, but it is the public good that requires the brakes.

During the “dot-com” years of late 1990’s and early 2000’s, there was talk of a “new business model” that somehow held that profits weren’t necessary to substantiate value.  Value and price became separated, and boom/bust occurred.  The recent worldwide economic crisis is the same issue on a different scale fueled by a similar thoughts but different tools. 

Think SPC (statistical process control). An economy “in control” will keep the divergence of price and value within a “reasonable” band. The big question is:  how wide should that band be?  Individual self interest encourages a wide band, but public interest requires a tighter band.

A current WSJ article describes the insufficiencies of current economic theories in preventing a recurrance of the recent credit crisis and associated slide along the edge of economic doom. It argues that reliance on econometric models overruled critical thinking.  As they say in health care, treat the patient – not the test result, yet central bankers treated the test results instead of the obviously overheated economy. The difference between price and value was huge; we all knew it.  But when we’re each making money from that gap, it’s hard to create public will to narrow it.

Let’s keep it real. As funding institutions, be they banks, hedge funds, or those offering fancier financial instruments, loosened requirements for purchase (read “financing”), the resultant and intended increase in potential buyers increased demand and led to higher prices. As those same funding sources tighten requirements, they reduce the number of potential buyers, thereby reducing demand and prices.  Housing is just one obvious example of the boom/bust.  But it was price that skyrocketed and plummeted, not value.

The tallest fastest roller coaster is exciting, but don’t complain about the highs and the lows if you choose to ride it.  And don’t forget that you end up right where you started.

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