Friday, April 10, 2009

Financial Markets Closed Today

in the United States, but here is the question--are they working, even when they are open?

I guess that leads to two more questions--how do you judge, and which markets? For instance, the market for residential real estate isn't really a financial market, but I'd argue that the market for commercial real estate is. Clearly the equity markets are financial markets, as are the commodities markets, and as are the various markets (formal and informal) in which debt securities, credit swaps and the like a created, placed, layered and, sometimes, traded. That final collection of markets, with so many tailored instruments and so little liquidity is the one about which the biggest questions have to be asked.

Self-professed proponents of the free markets who know argue that we are facing a liquidity, not a solvency crisis don't generally distinguish between the equity markets valuing a financial institution's publicly traded securities, and the swaps markets in which that same institution surveys the landscape in vain for a credible pricing benchmark. But there is a real distinction.

Most commodities, real estate, equities, forex markets, etc., appear to be working just fine. You may not like the action, but they are functional if you judge them by three factors--does the market in question provide adequate liquidity for most purposes, is the price signalling generated by trading activity generally accurate for most purposes, and are the transaction costs reasonable (not optimal, and not frictionless, mind you, just reasonable).

The markets for debt instruments and their derivatives are another kettle of fish. Those markets are the sources of the anomolous price signalling that The Financial Times reports every few weeks--interest rates going negative, corporate default projections in excess of 100% of principle, and so on. In a functioning market, arbitrage would eliminate those before Lex could highlight them in a mocking squib.

Perhaps the best argument for unwinding the casino, and banning further financial innovation for a generation or so, is that it would allow time through custom, practice, trial and error and a generation of practical experience, to develop the norms, procedures and institutions necessary to a sophisticated financial market. That may not be the conclusion a true believer in the free market would promote, but I'm not a true believer in the free markets anymore.

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