Saturday, November 29, 2008

Market signals and market failures (II)

Let assume that the value of the stock in a firm depends on observable signal (s),and unobserved random variable (e).Thus ,the value of the stock is given by v= s + e. Therefore the effective (expected) price is p = v .The better the signal the higher, the price. Besides, price itself must include all the information available.
Now consider a market with two types of investors: well informed and uniformed ones. Those uniformed investors , keep attention on prices to get the signal they need. In such a case, the market itself provide all the information about the value of the stock and its equilibrium range.(Varian ,1978).-
The problem arises because it is costly to get those signal, and the rating agencies have the task of reducing that cost .So, informed investor will pay the price (hiring financial advisers, consultants ,lawyers, accountants ), but , uniformed investor, who I assume do not have the same capability to get information on their own, depend upon the rating agency to make the proper decision. This heterogeneity ,will lead to information asymmetry with not market efficient equilibrium, as long rating agency on the other side has a profit seeking strategy which is a quite different goal , respect to the one most important for investors: to provide risk evaluation.-
Whether the rating agencies fool or mislead uninformed investors, the outcome will be inefficient allocation of resources ,because their portfolio will have riskier assets, than the investors consider representative of their preferences for assets risk . As a result, market might get into a risk bubble whose final outcome is not other than downward price adjustment once it burst, and both the investors and banks which support them with finance assistance , end up worse off. The raring agencies, might not be in such a trouble , given the fact that they manage a variety of portfolios none all of them equally risky.-
The insurance industry, is also a good example about the implication of information asymmetry .When a customer get an insurance for theft bikes ,the company has no way to make sure that the customer will behave properly to avoid his /her bike, to be stolen afterward the insurance has been signed up. As a result, the insurance company find itself losing money. In this case, to avoid such a loses ,insurance company offer deductible policies .Consumers pay a share of their insurance, which induce them to have a more cautious behaviour .However, what is it the optimal level of care on personal behaviour? .If consumer get too cautious, it is not worth to waste money with insurance programs , and on the contrary if it get too risky, there is no cost free insurance policy. Thus ,even with an average behaviour consumer end up worse off because they end up paying for higher risk than they effectively engage on.-
What all of this means ?. It is not impossible to prevent bubbles developing and its outcome , as long as there is information asymmetry among market players which is not corrected at the right time .Thus, to avoid such outcome, it is important to have the proper institutional setting to make sure that information asymmetry does not mean a systemic risk threat. This consciousness, will imply regular oversight about the risk level the system is undertaking. It follows, that full information about the quality of assets involved ,is key on this approach as much as it is necessary a review of Basel II accord.-

Saturday, November 15, 2008

Market signalling and market failure (I)

There is a discussion about the implications (the day after),for the future of capitalism , of the current financial crisis. There is the notion that whether it was a failure ,it was only a Government one. This way ,seems for some analyst specially in Latin America, the best one to protect the future of capitalism .
No matter the intentions ,the fact of the matter is that both markets and Government fail. Government has failed systematically in Latin America , with some exceptions, to provide better health care , education and environment protection and it does not seems to be a big deal for politicians, who are the main responsible in charge of Government. Markets have a risk propensity which is in the nature of profit maximization. For that purpose ,it is a necessary condition an institutional framework to clear the way for price signals ,basically in terms of the quality of information . Otherwise, those signals do not have the proper information for both the best decisions, and efficient allocation of resources. In such a case, welfare level fall. as a consequence of the wrong ,inefficient decisions. Ackerlof called the market for lemons. In the lemon market model ,economic agents have no way to get the information about the quality of the good ,except by observing the average quality available in the market. In the current financial crisis, that information did not came properly from the risk evaluation agencies .Besides, the market can not correct by itself such a problem, and the result turns out to be to acquire a lemon. The problem in this case, was that such huge amount of lemons exceeded the necessary to heal the cold.
Markets fails to overcome such a distortion ,and like a computer program with a virus into its software, it will a result but it will not be the best one. Fail also means that market are unable to solve, what it is other institution failure, in this case government. This the way capitalism has worked all the way since the eighteen century .The empirical evidence suggest that such a failure probability, can be reduced ,by optimal regulations based on efficient institutions.
Capitalism like democracy ,are not among the best alternatives ,but they both work among the whole available . They are the first best, compared to other combinations such as dictatorship and state controlled economy. So, capitalism does not need distortions about the nature of market behaviour , to get protected from those who do not believe in markets forces to create wealth.. It needs a clear understanding about the way it works and the role of information ,its quality and institutions design with a clear sense of what it is expected from them .
Markets also fails in a variety of situations, standard in the microeconomics books . Let just mention public goods, asymmetry of information(insurance industry), externalities, common property goods and the like. In all those failures ,markets can not solve by themselves ,what it is wrong about price signalling (given an institutional framework) , and that is the reason because they fail to get resources used in the best alternatives to improve welfare levels. Markets works on the assumption of perfect information , homogeneity ,zero transaction costs and values (institutions),on the side of producers and consumers. Most of these conditions are hard to find in real world, therefore on the aggregate, it means that only after trial and error , markets get a higher welfare level for society. Thus, after this mess melt down, it will become clear the relevance of better regulation ,not necessary more, and better global institutions , for global economy to get into the path of growth and prosperity.-