Cassandra’s Principle (part 3)

In the mind as well as writings of its historical fathers, free market economy was never supposed to mean wild and unregulated economy. Left to itself, any free market inevitably generates distortions, e.g. monopolies behaving like tumours which may very well kill it if left unchecked. It is therefore the duty of market authorities to constantly protect markets from self-generated diseases.

A well-known condition for a healthy open economy is for instance the speed and quality of the information circulating within markets. This principle is today often understood as meaning that prices will automatically incorporate all available information about underlying assets. This interpretation is wrong. Market information does not come as a fixed quantity and its quality is a goal to be proactively achieved, not a given or spontaneous feature. Sources of distortions are varied and many: for instance, some agents are too weak to leverage the good information they possess, while others draw their strength from distorting information.

It is indeed difficult to overstate the importance of protecting economic agents in complex markets against bad information. This is particularly true in an age of extended securitization. Series of complex operations can transform any financial product bearing on real assets into an unrecognizable object composed of intricate layers of derivatives. When the distance between the final buyer of a security and the underlying assets is very large, there is simply no way for the final buyer to verify the nature of assets actually purchased. At each step of the transformation process, waivers are signed making it impractical or impossible to exercise guarantees from operators who may have corrupted the product or its components.

The subprime mortgage tragedy is nothing but the most massive example ever seen of this problem. Market authorities and regulators were unwilling to prevent manufacturers and brokers of such trash securities to create and sell on the largest scale nominal obligations having the highest probability of default. A chain of intermediaries was able to multiply their poisonous effect by mixing them up with otherwise healthy securities, spreading both the disease and its opacity into what was precisely supposed to be the safest and most liquid part of portfolios.

The magnitude of the crisis can only be guessed based on unheard of injections of liquidity made by central banks visibly attempting to avoid a market meltdown, without any further consideration for what used to be their primary concern, i.e. inflation. The best informed institutions all simultaneously trying to get rid of their plagued assets, are calling all possible margins, also creating the conditions for a domino effect and credit crunch.

 At this stage the probable willingness of governments to bail out irresponsible lenders is the least of many systemic problems induced by a major lack of market regulation and surveillance. Good wealth (made from real contributions to the global economy, e.g. long term investments in emerging countries) is likely to be destroyed together with artificially made wealth (from junk assets), when stock markets eventually adjust to the situation. Stagflation, the cancer of economy, will then show its hideous figure.