The Hindu Business Line : Market prices vs fundamentals

The belief that markets tend towards equilibrium has given rise to policies which seek to give financial markets a free rein, observes George Soros in The New Paradigm for Financial Markets: The credit crisis of 2008 and what it means ( www.landmarkonthenet.com). He calls such policies ‘market fundamentalism’ — something that is ‘no better than Marxist dogma.’ Both ideologies cloak themselves in scientific guise in order to make themselves more acceptable, but the theories they invoke do not stand up to the test of reality, Soros notes. “They use scientific method to manipulate reality, not to understand it.”

His suggestion, therefore, is to renounce the ‘unity of method’ and adopt the ‘theory of reflexivity,’ which is about a two-way connection between the course of events and the participants’ thinking. He asserts that market prices can influence the fundamentals, as much as the converse can be true. “The illusion that markets manage to be always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process.”

After studying many boom-bust processes in the financial markets, the author finds a two-way, reflexive connection between market valuations and the so-called fundamentals that sets up some kind of a short circuit between them whereby valuations affect the fundamentals that they are supposed to reflect.

“The short circuit may take the form of equity leveraging, that is, the issue of additional shares at inflated prices, but more commonly it involves the leveraging of debt. Most but not all cases involve real estate, commercial or residential, where the willingness to lend influences the value of the collateral.”

Instructive read.

Optimal use of resources

Cost-benefit analysis may be an answer to know whether we are overusing, under-using, or optimally using resources, but the process can be full of moral and political dilemmas, cautions Michael Heller in The Gridlock Economy: How too much ownership wrecks markets, stops innovation, and costs lives ( www.basicbooks.com).

“To solve the equations, we have to put dollar values on human lives and on the costs of overuse and under-use behaviours… Should we assign different values to different people’s lives — based on, say, age, earning potential, gender, occupation, or criminal record?”

Take, for instance, driving faster, which gets you home sooner but increases your chance of crashing. Is the trade-off worthwhile, asks Heller. “To answer that question, you need to know how to value life. If life were beyond value, we would require perfect auto safety, cars would be infinitely expensive, and car use would drop to nothing. But if there is too little safety regulation, too many will die.”

With auto safety, society faces a Goldilock’s quest, notes Heller: “We strive to ensure that, all things considered, cars kill the optimal number of people. It sounds callous, but that’s what an optimum is all about.”

Prescribed study.

D. MURALI

BookPeek.blogspot.com

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