A Giant Ponzi Scheme

In business school, we learn that the price of equity in the market represents a measure of the long-term value that is available to the buyer of the equity, through the underlying companies' earnings. While investing and losing money in this same market, we gradually understand that that is not necessarily the case; often, in shallow markets such as India, it is quite possibly the exception. We realize that investors are not long-term buyers, and that they are usually more interested in making gains from capital appreciation (i.e. a rise in equity price) than from dividend payouts. In other words, the value no longer comes from a future growth in earnings, but rather, what price future investors can be coaxed into paying.

And this is where the similarities arise vis-à-vis Ponzi schemes. What such schemers do is that they publicize their fund, and collect cash from duped investors. The returns that these investors earn are primarily generated from the cash collected from subsequent investors. Publishing these great returns often leads to greater hoards of investors rushing to put their monies into the fund till, ultimately, a few investors are left holding the bill, as it were. By this time, the schemer has usually set sail on the high seas, with his ill-begotten earnings. I do not need to draw out the lines of correspondence; those of us who've participated in the equity markets over the past couple of years know them only too well.

Just like all Ponzi schemes always progress towards the same degenerative conclusion, the markets also go through periodic corrective cycles, such as the one we've just witnessed. While one would feel that the many market crises and sudden upswings and downswings would have sounded the death knell for the numerous efficient market hypotheses (the price is always right), one also realizes that people are not always ready to renounce whatever captures their imagination. Unfortunately for them, just like the amount of calamity insurance sold doesn't increase or decrease the probability of their occurrence, the market will remain irrational with scant acknowledgment of believers and atheists.

A number of studies have discussed this apparent disjoint between theory and empirical evidence. When Robert Shiller conducted a survey of investors who witnessed the 1987 market crash in the US, a large proportion of them said that their actions on that Black Monday were triggered by newspaper articles they'd read about price drops the previous week. Mind you, very few of them even mentioned a change in fundamentals as the problem, which is what proponents of the efficient market theory would suggest. Of course, people have pointed at many problems in hindsight, but one shouldn't always give credence to such artificial causality (retrospective bias is another interesting problem that warrants a discussion, but maybe at another time).

So where do efficient market hypotheses go wrong? In my opinion, in today's day and age, their assumption of a billion independent investors is the main stumbling block. With the incredibly ease of information transmission that one witnesses today, it becomes that much simpler for rumors / incorrect information to spread. It also becomes easier to capture market sentiment, which individual investors usually rush to emulate. So, investors are not necessarily independent; rather, they are inter-dependent. Such an increase in correlation between individual investors' sentiments and trades means that one can no longer assume that no single investor affects price abnormally.

The pervasive nature of market sentiment is what led to rises in equity prices with only cursory correspondence to underlying fundamentals. And all the investors who failed to exit while ahead were left with shares that had suddenly lost a non-negligible proportion of their value.

The market, every now and again, gives up its stubborn affection for unreal prices without warning. Unfortunately, not every rational one-step-ahead-of-the-rest investor can wait out this period, to obtain the profits that are surely his to be had – while guts may or may not be lacking, liquidity is limited. As I once heard a seasoned trader say (and no doubt he'd heard this somewhere else), "The markets can remain insane longer than you can remain solvent."

Market Failure

Economists have always been clamoring for a free market. Right from Adam Smith's Invisible Hand metaphor in The Wealth of Nations, government intervention has been tagged as 'unneeded'. Of course, there are a few practitioners (Cynics among us will scoff at this usage. For such, economics has always been a science for the idle mind) who say that a little intervention is needed for optimality. Most of these few use the argument of market failure.

So what really is market failure? Simply put, it means an exchange where the market-determined 'price' is not the best price for the buyers and sellers. This obviously doesn't happen all the time. In fact, it doesn't happen most of the time. The price that is set as a result of free trade between buyers and sellers usually maximizes satisfaction. But there are specific types of exchanges, goods with specific properties, which negate this assertion. I shall try to describe a few of them.

Public Goods: Public goods are not necessarily goods produced by the government. Rather, they mean goods that you cannot exclude anyone from using. For example, let's take a highway. Once it is built, anyone can use it. Suppose a supplier of roadways (a civic constructor) were to offer the road in a market. Whoever wants to use it would have to contribute for it. Naturally, this would give users an incentive to understate their need for the road, as others would be paying too. Ultimately, the price offered by the buyers would not be acceptable to the seller, and the road would not get built. This results in market failure. In economic and coffee-table conversations, this type of problem is called the free rider problem.

Externalities: Externalities mean effects of some action which are not taken into account in pricing that action. A couple of examples might help elucidate this particularly esoteric statement. Let's say that I try to build a house in a particular neighborhood. Let's also assume that the neighborhood is a little decrepit, and the house I am building is not. Then, it wouldn't be too far a leap of faith to say that my house increases the neighborhood's value. This is called a positive externality, i.e. one where there is a positive unintended effect. Now, because this effect is not taken into account in the market-driven price of the house, fewer houses will be constructed than is optimal. Similarly, consider the effect of pollution. Any task that creates pollution has a negative externality attached. The market price of such an activity only considers its immediate benefit to the buyer, and not the damage to society as a whole. Therefore, more of this activity will be done than is optimal for society. The government has to impose restrictions, or establish tariffs. The carbon-trading scheme that was created in the Kyoto Protocol is a very pertinent example of intervention to address market failure.

Non-Competitive Markets: This is a far easier example to understand, for most of us have come across terms like monopoly, oligopoly, etc. before. Briefly put, any market that does not have perfect competition allows either buyers or sellers to decide price, rather than a decision in tandem. The government might have to step in sometimes to prevent cartelization or monopolies, where sellers can extract supernormal rents.

Macroeconomic Stability: Sometimes, the market sells too much of a good. Macroeconomic instability can result from such behavior. For instance, let's say that the consumers in India want a particular good that is manufactured only in the USA. Therefore, the product is imported indiscriminately. But buying this product requires dollars, which would deplete the foreign exchange reserve of the country. In extreme cases, this will seriously affect the monetary security of a country, implying that governments need to regulate this flow.

Goods with no market: At a very basic level, a market trade takes place when two guys meet, and each one of them has an item that the other guy wants. In today's world, one of the two items is money. But in ancient times, barter was the system used with, obviously, limited success. Such a situation is called a double coincidence of wants by economist David Freidman. Now, unless such a coincidence takes place, trading is near impossible, and a lot of effort is spent in finding the opposite party to the transaction. A simple analogy is of marriage. A guy can't marry a girl unless she wants to marry him too, and I'm sure most of you will agree that finding the right match is very tough indeed (marriage is also a definitive example for the verity that the grass is always greener on the other side, but I digress). In economic terms, consider a situation where a railroad operator has to decide whether to build a railway line to an area in the countryside. Given that there is no economic activity there, no one will be ready to provide him capital without hefty payback. At the same time, a mining company is evaluating an option to set up a coal mine in the very same area. They won't receive capital on favorable terms either, given that there is no transport available from that area. Thus, unless someone pushes these guys into each other, some potential for economic profit is lost. This is something that intervention can do, and actually does every once in a while.

These are a few of the main motivations for market intervention. I do not intend to imply that the government is the best medium for such interventions, or indeed that it usually gets it right. But sometimes, reliance on the market to work things out perfectly has its price.