Market Failure I - Global Warming

More bad news on the ice melting front, when an American Meteorological Society Panel disclosed that the Arctic and Greenland ice masses are melting faster than expected. Meanwhile oil hits $100 per barrel and the dirty energy economies of China and India boom forward. US production of greenhouse gases goes on unchecked.

Global warming and climate change are huge failures of the market. The market produces the fossil fuels and burns them in ever greater quantity in spite of the clear evidence that they are suffocating the planet. One can hardly say it is a failure of information.

In what ways has the market failed?

One. The market does not include the costs of human misery and planetary demise in the price of its products. This is a complete failure, because "the market" consists of nothing more than the incident of purchase and sale. Costs not captured in this moment are considered "externalities" and passed off to the public sector or to future generations or to those with too little power to resist.

For example, the price of a gallon of gasoline includes the costs of discovery, drilling, pumping, transporting, dispensing, and with the gas tax, building the roads upon which the gasoline is burned. Omitted are the costs of global warming as well as the not insignificant costs of geopolitical chaos, wars and sacrifice for "quote" national interests "unquote."

One could probably compute a total for the State and Defense Departments' efforts in this regard, and then triple it to account for the costs in human terms. But the costs of global warming cannot be accurately determined, because they will be extracted from those who cannot pay cash, and must pay with the pound of flesh or acre of innundated land or plot of parched and barren earth. Eventually "they" will include use all

Were global warming insurance required of gasoline purveyors, one could see the cost entering into the purchase-sale event. It might double. If an insurer could be found. At least one could say the market reflected the real world and the real world costs.

So, One, the market fails to account for all the costs. Or even half the costs. A modest market failure. But now, two.

The market does not produce because it cannot produce the public goods that are needed to address global warming. Its total product is in private goods, from candy bars to cars to houses to all the things our society produces in such abundance that are consumed by individuals or small groups. The market itself can only produce private goods because it, again, consists of the moment of purchase and sale and the product must have a purchaser who is identifiable, isolatable and who controls enough of the benefit to be willing to pay the price.

The market does not produce public goods at all unless the government collects its compulsory fees and contracts with private companies. The government thus creates the market for public goods.

Roads, schools, infrastructure of all types, national defense, courts and prisons. All necessary, but none created by the private market.

We can do this, as we've said in other posts, by regulation -- by strictly describing what can and cannot be sold, from toasters to tractors, in terms of carbon footprint.

Or government can create the market by directly contracting for, say, zero emission locomotives or buses or other government-purchased items. Private business can take a contract offer for a specific product, so long as it has a commitment to sale, and justify the R&D to innovate to the specifications. That is called making the market.

Will the private sector take it on itself, on spec, so to speak, to produce such a thing. No. A complete market failure to produce the innovation by itself. The government must create the market for the products and services that will get us off the carbon cross.

Notably, as far as I am aware, the efforts to massage the market with such things as carbon taxes and cap and trade efforts have had less success than they should be having. Leakage from the system seems to have devalued the carbon credits. It was a noble experiment, it should be refined and continued, but it has not produced the results we need, and there is no time for trusting the next version. Use it in addition to, but not instead of, direct government making of the market.

So two, the market will not spontaneously create the necessary technology. It needs the government to create the appropriate market or that market will never come into being.

Three. The market has completely failed to protect the Commons. The air, water, and ecosystems we all depend on are exploited mercilessly by market actors. Private property is sacrosanct, but the common property is without an entity or institution that will see its rights and the rights of the collective inhabitants of the planet are not trampled upon.

The examples are too numerous to mention. A system upon which the society depends to provide for its well-being must treat this common property with respect. That is not the so-called free market system.

How do you make sense of the markets, post housing crash?

ANOTHER Financial Sector binge covered up by the chief enabler -- the Fed.

Investors bidding up commodities, equities and currencies is the same thing -- dumping the dollar.

Look for a serious run on the dollar soon. By election time '08.

Why?

Think of the recent Fed bail-out as giving away money to the Financial Sector. Jim Cramer and the other hysterical old ladies of the high rolling investor class dropped their macho risk tolerance facade and started crying just long enough to get Papa Ben Bernanke to give them more money. Now they are busy converting that money into real wealth -- stocks and commodities, oil, gold, wheat -- and into secured financial wealth -- bonds.

The Fed's bailout follows the pattern of 1987 and 1998. Unregulated markets made fools of geniuses, upon which the Fed lent them the financial stability of the country so they could be geniuses again.

Now the market knows. Don't worry about risk. Papa Fed will bail you out. It's no accident that instead of vigorous industry, plant and equipment, we have instead the equivalent of a mammoth video game parlor called Wall Street. Fine for entertainment, but these games have real guns, and those are real people losing homes, families and hope. One of the things those real people don't understand is they are paying the freight

Certain inflation will follow the dollars fall and this bidding up of commodities. Pensions and endowments will lose their real value to that inflation. The financial system is gimmicked and rigged to such an extent the Fed has lost control.

It's not inflation OR recession. It's inflation AND recession.

If the Fed tries to stem the inflation or support the dollar with higher interest rates, it becomes a deep recession.

Why a run? This country's trade deficit over the past thirty years has put trillions of dollars in foreign hands. The money is in the form of securities, because those securities were a good deal with rising values. No longer the case. With the value of the securities fading and the value of the dollar falling, the foreign holders are seeing their investments eroded from two sides. Better get out sooner than later, hence a run.

Tomorrow:

5 Lessons from the financial meltdown in housing
and
7 Remedies for the Financial Sector

The housing debacle

What are the lessons from the housing debacle that is now unwinding?

First and most important, we were right. We predicted the housing collapse. We'll dig up the links and enter them on the web site treatment on Friday.

We predicted that the low interest policy of the Fed would produce the bubble. Others have talked about how the leverage and corruption of the mortgage brokers was key, but the cycle begins at the beginning -- turning housing into an investment. Speculation fever follows as prices rise. Then the leverage and the corruption.

Too much congratulations and not enough corporal punishment are being dealt the Fed. Under Greenspan and Bernanke, there was low interest at the beginning and bailing out at the end, with absolutely no oversight in the middle (or anywhere, really).

Second, others predicted it as well. Dean Baker is foremost among these. Baker of CEPR and now the American Prospect used a simple historical trend analysis comparing housing rents to home prices over time. It worked. He should be on every talk show in the nation.

Third, the people who didn't see it coming are still the "experts." (Much like in another key blunder, when Thomas Friedman and even the Neocons blew the Iraq analysis, yet are still showing up as experts. Compare this to others -- George McGovern, Joseph Stiglitz -- who offered accurate analysis and peaceful, productive resolutions. They are still on the outside.)

So, fourth, the people who say, "Nobody saw it coming" were and still are listening only to each other.

This debacle continues the ballooning of the financial sector. Henry Kaufman, formerly of Salomon Brothers and now of Henry Kaufman & Co. and hardly a communist, reported that the Finance Sector is now bigger than Health Care and Energy combined. Why not? Too bad some homeowners can't get hold of that "liquidity" and out from under their ARMS. Now is the time to buy stocks in the financial sector, before everybody realizes that -- just like in 1987 and 1998 -- the Fed is bailing them out. They get a hundreds of billions of "too big to fail" insurance for free.

Upcoming we'll look closely at tool the world class analysis at the Fed is linked too. It looks a lot like a catapult. The Fed's single blunt instrument is its control over short-term interest rates. It doesn't matter how smart you are, the interest rate is (1) ineffective against inflation, (2) operates with a lag in producing growth and is wildly inferior to fiscal policy for jobs, but (3) is great at bailing out a financial sector.

Outlook for the economy as housing deflates? Which economy?

• The financial sector will likely bounce back with great new investment opportunities.


• The wealthiest 20 percent will no doubt wonder what everybody is complaining about.


• The middle class will watch their home values receding in front of them as they approach retirement.


• The multiplier will bring down wages.


• The collapse of housing could create more hysteria in the immigration discussion, as migrants move out of their niche in relatively low-skill residential construction and residential support and compete for other jobs.


• A huge burden of private debt has been created, for the purpose of building an immense stock of passive housing vs. productive assets. And very little of this building was green. Both the debt and the character of the housing stock will weigh us down.

What a mess.

Why listen to the Market when it is talking gibberish?

Steve Conover at the Skeptical Optimist displays the vagaries of jobs numbers today and wonders what the Market will make of it.

Any Market response to jobs numbers is unintelligible over the sound of investors trampling each other at the exit door of real estate and "alternative" investment vehicles.

As Michael Metz, chief investment strategist at Oppenheimer Holdings said yesterday, the Market has stopped sending rational or intelligible signals.

Rational investors and students ought to see current strength in the stock market as money with no other place to go.

Chaos reigns in currency markets as well.

Strength in stocks in the face of an impending downturn in the domestic economy is, at best, Pig Latin.

see previous Demand Side take: Strong Stock Market, Weak Economy

Prediction: Strong Stock Market, Weak Economy

The economy slips toward recession and stocks ignore it. Why? Courage from the average investor perhaps? Confidence in the underlying strength of the economy? Hardly.

Investors are in full flight, trampling each other to get out from under the collapse of the housing industry, just as they rushed out of stocks and into housing after the so-called dot.com bust. Now they are fleeing housing after creating a similar fiasco in that market. But the money has nowhere to go.

The Fed’s solution to every crisis since 1987 has been to pump low-cost money into the financial markets. That’s one reason Wall Street thinks strength over the past four decades while Main Street has turned into a row of double-wides.

The money pump rattled into action again on September 18, when Bernanke and the Fed cut rates by half a point. There was only one excuse: To give the financial markets "confidence" so they can “run smoothly.” Bailing out financial institutions is a central bank theme.

So we have plenty of money sloshing around at the top. But where to put it? Housing is deflating. (Pity the poor homeowner who was counting on that to finance his retirement.) Stocks? It IS rumored some companies have foreign presence. Bonds? Sure, but you’re going to lose real value if inflation kicks up.
The smart money is buying foreign securities. Even if they don’t appreciate in value, you can ride up with the underlying currency. Or at least avoid sliding down with the dollar.

End of the Year Market Dis

(The stock picks and plays are at the end.) 2005 was a flat year for stocks. Why? The Right Wing spin machine tells us the economy is booming. The president has done all he can to promote Wall Street. Beginning tomorrow, January 1, for example, a couple of new tax breaks cut in for the rich, and as we learned here before the top ten percent owns nine-tenths of all stocks.

Before we get to our answer to why stocks are flat and where they may be going, context is necessary. This corner is Demand Side economics. We do not believe stocks are priced exclusively according to their "fundamentals," nor that the true value is computed by the magic mind of the market in response to each new mote of information. This latter contention is promoted by some of the most prominent academic departments in the country, under the rubric Efficient Market Hypothesis, in spite of all evidence to the contrary.

The joke was, "How many economists does it take to screw in a light bulb?" Answer: None. If the light bulb had needed screwing in, the market would have already done it. All information was supposedly factored in immediately. It was impossible to outguess the market.

It is a theory that belongs on the scrap heap of history, along with Monetarism and next to the predictions of Dow 36,000 and the Great Depression of 1990. Unfortunately, once a theory gets into the halls of academia, it is impossible to dislodge it with facts, such as the dramatic boom and bust we have witnessed over the past decade.

Make no mistake, the market does factor in information, with alarming efficiency, but that information is often:

Wrong, as with the scandals of WorldCom and Enron, where the books were cooked with creative accounting to gin the stock price.

Irrelevant, as with parts of the dot.com bubble, where for example, market share was translated into high stock values, even when it was bought by untenable business models. Amazon, for example, basically gave away ten dollar bills with every order and dominated its niche. The market rewarded it with stock prices over the top. Now that it is profitable, its stock price is 4 percent of what it once was.

Serves only to price things relatively, as putting GE above Global Crossings, for example. The absolute value, for the sake of our discussion here, is determined by demand for the stock.

There are two crude and inexact dynamics at work in the judging of stocks and the prospects for the future. Regarding prospects, the dominant prognostication is that the trend of the past three years or so will continue into the dim future, barring any explicit information to the contrary. Regarding the judging of stocks, beating the market is similar to winning a certain type of beauty judging contest. Both were proposed by the great economist John Maynard Keynes (pron. KANES, get it right).

The first is relatively self-explanatory. We assume that, for example, we can continue to run $500 billion deficits as we have at the same interest rates and underfund education and infrastructure and so on.

The second involves a metaphor familiar to Keynes that needs some explanation. In the 1920s and 30s, newspapers ran contests involving the photographs of 100 or so pretty girls. The winner of the contest was the one who could pick out the five or six prettiest girls -- as judged by all contest entrants. That is, it was not the individual's perception of who was prettiest, but the ability to tap the perception of the herd. Fundamentals were and are beside the point, because speculators are primarily concerned with liquidity, the current market value. This is no place for patience. (One of the interesting implications is that the most unanimous market is also the most unstable.)

So, I am not going to bore you with which sector is sexiest, or which company has the best prospects, I am going to bore you with Demand Side keys to stock prices.

* More people buy stocks when the prices go up consistently. Prices go up consistently when more people buy stocks.

* People who are getting older buy stocks. During the 1990s, the baby boomers, the so-called demographic pig in the python, bid up the price of stocks in anticipation of retiring.

* People who have dollars buy stocks. Who is this? The rich! you say, remembering the beginning of this post and the billions of dollars in tax cuts. Wrong. Well, not wrong, but the net amount of tax cuts in the Bush economic blunder scheme needs to be borrowed back to finance the government. Conceptually, it is the same money, we're just paying interest on it under Bush.

The people who have the dollars I'm talking about are the Asians who are financing our trade deficits. We are giving them dollars in trade for their goods. In normal times we would be trading our goods for their goods through the medium of currency. Now we are running massive trade deficits and trading dollars for goods. Dollars don't spend so good there. Not like they do here, anyway, so they are buying American stocks and government bonds, liquid assets priced in dollars.

Which brings us to the last category.

* Outsiders who like the dollar buy stocks. This is the George Soros play. When you buy a stock, you are also buying the currency that underlies it. If you hold it a year or two and it does nothing, but the underlying currency appreciates, then when you sell you have still made a profit. (The strong and stable dollar was another reason people put money in American stocks in the 1990s. It seemed like a continent of sanity in an ocean of currency chaos.

So during 2005 the stock market was flat. It was dull. What does that mean? One thing, obviously, people have moved from stocks to bonds and real estate. Notice the relatively low return on bonds in spite of the immense federal deficits, indicating demand. Notice the high prices of homes, the housing bubble which I have posted so much about.

Another thing, it means stocks are not getting bid up by baby boomers, foreign investors, or people who like the dollar. This is weakness. It means other things, but the 14 people who actually reached this point on a New Year's Eve need to be rewarded, not punished, so I'll save the rest.

Beware! Republicans are no good for stocks, because they are no good for business. But, you say, Republicans provide all those tax breaks and roll over for Corporate America at every opportunity. The corporatization of the government is reaching the level of Benito's Italy.

It is because the business of "business" is demand. "How's business?" means "How much are you selling?" Democrats supply only one thing for business. Customers. Democrats mean jobs. Jobs means customers. Always remember, the budget has never been balanced except at full employment, and the economy has always grown best at full employment. That is the definition of "a healthy economy." Everybody is contributing. People have money and purpose.

Now, the sexy market plays

Buy Boeing on the weakness of the dollar against the euro. Boeing's competition is Airbus. The people with dollars above like airplanes. When the euro appreciated against the dollar, Boeing made advances against Airbus. The euro ran up to $1.30 and higher a year ago at this time, but has stalled and is down in the $1.17 neighborhood. (If they ever start making planes in Asia, sell, sell, sell.)

Buy natural gas futures based on the price of oil. Oil leads all energy prices by 3-12 months. When oil goes up, natural gas is sure to follow, and the reverse. It's true for electrical energy, coal and alternative energy as well. This play is tired right now, but watch in the future.