“Yet another article related to the credit crisis? Noooooooooo… I can’t take it anymore! Have I not read, heard, seen, discussed, analysed, reanalysed the issue enough already? Then why do I need to go through another insanely long piece of shit discussing the same damn thing?”
If that was your first reaction upon reading the title of this post, then, well, I can understand your frustration. I too have begun to cringe at the sight of the words “crises” and “credit”, especially when they appear together. I have waded through seas of articles on the subject, which all seem to say the same thing, and at the same time, nothing at all. Most articles attempt at explaining the root cause of the problem. They don’t do a good job of it. Some try to propose solutions. They don’t do a good job of it either. With the exception of just a single article, by The Economist, none of the articles come even close to understanding the crux of the problem. But, unfortunately, the article by The Economist does not propose any solutions for the problem.
So, here’s my take on the REAL problem in today’s markets and the solution for the same. It’s kinda radical, so don’t hate me if you don’t agree with me. Nevertheless, I think you’ll at least have fun reading it. Well then, here it goes…
The price of something depends on 2 things, viz. demand and supply. (“Dude! What a radical proposal! I wonder if someone can get more radical than this!”) In a market where there are only 2 kinds of participants, viz. pure sellers and pure buyers (pure sellers are those sellers that are selling “something” that they themselves have “produced” and have not simply bought it from someone else, while pure buyers are those buyers that will use that “something” for their own consumption and not sell it further), change in the price of the product will reflect real supply-demand disparity, given that other conditions are near the conditions of perfect competition. For example, if we consider the entire supply chain as one “seller”, then a multiplex selling movie tickets is a pure seller and movie-goers buying them are pure buyers. For ease of understanding, if other factors show tendencies as in the state of perfect competition, the price of the movie tickets would rise if the demand rises relative to supply and would fall in the contrary case. So far so good.
But what if the sellers and buyers in a market are not of a pure nature? What if anybody and everybody, regardless of the consideration that whether he has produced the product or not or is the end consumer of the product or not, is allowed to buy and sell those products? What will be his motivation to participate in the market? To answer these questions, let’s bring back our example of multiplexes and movie tickets.
Let’s say that a movie is scheduled to be released on 1st January 2009. The producers decide to start selling its tickets from today itself. Nobody buys the tickets because the movie’s release date is far away. But, after a few days, suddenly the movie becomes extremely controversial. Almost everybody comes to know about the movie and gets really interested in watching it when it releases. They still don’t buy the tickets because the release date is far away. But a few smart people, realising that people will give anything to watch this movie when it releases, buy the tickets by the truckloads. Their calculation is that they’ll sell these tickets at the time of release at a higher price and earn fat margins out of it. A few days later, there are rumours that the movie might be shelved. So the guys who bought the tickets by the truckloads start selling them to other people who think that there are still chances that the movie may be released. As various positive and negative news keep coming out about the movie, such trading keeps happening and the price of the movie-tickets keeps going up and down.
Far fetched as the above example may seem, it summarises the way in which all “investment” markets function. The motivation of an individual or an entity, which is not a pure seller or a pure buyer, to participate in a market, is to simply profit by buying at a low price and selling at a higher price. He has no concern with the inherent value of the investment, only with its price movement. And herein lays the problem: speculation.
To be sure, in any investment market, the initial change in direction of prices, whether upwards or downwards, happens due to solid reasons. For example, when the Indian stock markets started rising in March 2003, it was because of real factors, such as the country’s growth potential in the near future. At this point of the cycle, people who understand the fundamentals of the market, and the companies, invest in them because they can see real corporate growth in the future. The question being asked at this stage is, “Will this company perform well in the future or not?” The change in prices at this stage is slow and steady. As the markets keep rising and start delivering good returns to its investors, they start attracting a lot of publicity. When others see that a few people are minting money by investing in a market, they naturally feel like getting their piece of the pie too. From this point on, most of the money that comes into the market is speculative. The question that is being asked at this stage changes to, “Will the price of this share/ commodity/ property go up or not?” The change in prices at this stage is extreme and volatile. (I have seen, with my very eyes, the share price of a company named Reliance Natural Resources Limited rise by 41% in a span of 5 and a half hours! And that too without any announcement by the company that could have greatly affected its future profitability.) This is the stage when newspaper headlines scream about new milestones reached and new peaks conquered. Insane predictions of future growth start flowing in (like an article published only a few months ago, proclaiming that the Sensex will reach 50,000 points by the end of 2008). But, at some point, the direction changes. First, the people who understand the fundamentals of the market, start selling their assets as they come to realise that the speculative boom will not last any longer. Prices fall as they make their selling. And then the entire cycle plays itself in the reverse, until the prices in the market have reached insanely low levels.
Each and every boom and bust cycle in each and every investment market can be explained by this hypothesis. Speculation consecutively plays the hero’s role and then the villain’s role in each of the stories. One may pick up any boom and bust cycle from the past century and it will display the above characteristics. The Indian stock-market boom of the early 90s, the dotcom bubble at the turn of the millennium, and the recent US real estate boom, which is the real culprit behind the subprime mortgage crises and the ensuing credit crises, are some of the examples from recent decades.
Economic theory says that markets will be extremely efficient at price discovery when there are a large number of participants, among other things. Today’s investment markets definitely have a large number of participants, if nothing else. So why are they not efficient at their price discovery? Why do we CONSTANTLY see such anomalies as stock prices rising by 41% in a span of 5 and a half hour, without any apparent reason? That’s because there is a fundamental flaw in the economic theory and thus in the markets that have been designed on its basis.
The economic theory of efficient price discovery in a market holds true only when the participants of the market are pure sellers and pure buyers. This is because it assumes buyers and sellers to be 2 mutually exclusive sets and does not consider the possibility that buyers may themselves want to become sellers once they acquire the products. So, when non-pure sellers and buyers enter the market, the economic theory breaks down and efficient price discovery becomes a dream. This is the root cause of the problem plaguing the world’s investment markets. (The current unprecedented boom in the commodity markets of the world seems to be a result of the same phenomenon. Let’s wait and watch how it turns out to be.)
Thus, the solution to the problem is quite simple. Keep the non-pure sellers and buyers out of markets. This means that only those market participants that actually “produce” and “consume” the objects offered in a market, should be allowed to participate in it.
Implementing this solution is easier than it seems. We do not need to check the background of, and approve licenses to, each and every individual and entity that wants to participate in a particular market. That’ll be a bureaucratic nightmare. We simply need to introduce 3 conditions for participating in a given market:
1. Buying an item from a market, should always result in an ACTUAL delivery of that item to the buyer.
2. All the derivatives of a given market that do not result in an ACTUAL delivery of the underlying asset should be removed from the market.
3. A MINIMUM lock-in period should be imposed, before the buyer is allowed to sell his purchased item in the market.
The third condition is a crucial one. For example, if the lock-in period in the stock markets is 1 year then only those individuals and entities who think that a particular company will perform well over the next year will buy that company’s shares, thus removing speculation from stock markets. In the case of the property market, such a lock-in period will be longer, perhaps 10 years.
The above 3 rules will ensure that the only market participants are the ones that are pure sellers and buyers and not speculators. This will not only lead to efficient price discovery in markets, but it will also drastically reduce the occurrence of boom and bust cycles that are an inevitable part of a speculative market.
If that was your first reaction upon reading the title of this post, then, well, I can understand your frustration. I too have begun to cringe at the sight of the words “crises” and “credit”, especially when they appear together. I have waded through seas of articles on the subject, which all seem to say the same thing, and at the same time, nothing at all. Most articles attempt at explaining the root cause of the problem. They don’t do a good job of it. Some try to propose solutions. They don’t do a good job of it either. With the exception of just a single article, by The Economist, none of the articles come even close to understanding the crux of the problem. But, unfortunately, the article by The Economist does not propose any solutions for the problem.
So, here’s my take on the REAL problem in today’s markets and the solution for the same. It’s kinda radical, so don’t hate me if you don’t agree with me. Nevertheless, I think you’ll at least have fun reading it. Well then, here it goes…
The price of something depends on 2 things, viz. demand and supply. (“Dude! What a radical proposal! I wonder if someone can get more radical than this!”) In a market where there are only 2 kinds of participants, viz. pure sellers and pure buyers (pure sellers are those sellers that are selling “something” that they themselves have “produced” and have not simply bought it from someone else, while pure buyers are those buyers that will use that “something” for their own consumption and not sell it further), change in the price of the product will reflect real supply-demand disparity, given that other conditions are near the conditions of perfect competition. For example, if we consider the entire supply chain as one “seller”, then a multiplex selling movie tickets is a pure seller and movie-goers buying them are pure buyers. For ease of understanding, if other factors show tendencies as in the state of perfect competition, the price of the movie tickets would rise if the demand rises relative to supply and would fall in the contrary case. So far so good.
But what if the sellers and buyers in a market are not of a pure nature? What if anybody and everybody, regardless of the consideration that whether he has produced the product or not or is the end consumer of the product or not, is allowed to buy and sell those products? What will be his motivation to participate in the market? To answer these questions, let’s bring back our example of multiplexes and movie tickets.
Let’s say that a movie is scheduled to be released on 1st January 2009. The producers decide to start selling its tickets from today itself. Nobody buys the tickets because the movie’s release date is far away. But, after a few days, suddenly the movie becomes extremely controversial. Almost everybody comes to know about the movie and gets really interested in watching it when it releases. They still don’t buy the tickets because the release date is far away. But a few smart people, realising that people will give anything to watch this movie when it releases, buy the tickets by the truckloads. Their calculation is that they’ll sell these tickets at the time of release at a higher price and earn fat margins out of it. A few days later, there are rumours that the movie might be shelved. So the guys who bought the tickets by the truckloads start selling them to other people who think that there are still chances that the movie may be released. As various positive and negative news keep coming out about the movie, such trading keeps happening and the price of the movie-tickets keeps going up and down.
Far fetched as the above example may seem, it summarises the way in which all “investment” markets function. The motivation of an individual or an entity, which is not a pure seller or a pure buyer, to participate in a market, is to simply profit by buying at a low price and selling at a higher price. He has no concern with the inherent value of the investment, only with its price movement. And herein lays the problem: speculation.
To be sure, in any investment market, the initial change in direction of prices, whether upwards or downwards, happens due to solid reasons. For example, when the Indian stock markets started rising in March 2003, it was because of real factors, such as the country’s growth potential in the near future. At this point of the cycle, people who understand the fundamentals of the market, and the companies, invest in them because they can see real corporate growth in the future. The question being asked at this stage is, “Will this company perform well in the future or not?” The change in prices at this stage is slow and steady. As the markets keep rising and start delivering good returns to its investors, they start attracting a lot of publicity. When others see that a few people are minting money by investing in a market, they naturally feel like getting their piece of the pie too. From this point on, most of the money that comes into the market is speculative. The question that is being asked at this stage changes to, “Will the price of this share/ commodity/ property go up or not?” The change in prices at this stage is extreme and volatile. (I have seen, with my very eyes, the share price of a company named Reliance Natural Resources Limited rise by 41% in a span of 5 and a half hours! And that too without any announcement by the company that could have greatly affected its future profitability.) This is the stage when newspaper headlines scream about new milestones reached and new peaks conquered. Insane predictions of future growth start flowing in (like an article published only a few months ago, proclaiming that the Sensex will reach 50,000 points by the end of 2008). But, at some point, the direction changes. First, the people who understand the fundamentals of the market, start selling their assets as they come to realise that the speculative boom will not last any longer. Prices fall as they make their selling. And then the entire cycle plays itself in the reverse, until the prices in the market have reached insanely low levels.
Each and every boom and bust cycle in each and every investment market can be explained by this hypothesis. Speculation consecutively plays the hero’s role and then the villain’s role in each of the stories. One may pick up any boom and bust cycle from the past century and it will display the above characteristics. The Indian stock-market boom of the early 90s, the dotcom bubble at the turn of the millennium, and the recent US real estate boom, which is the real culprit behind the subprime mortgage crises and the ensuing credit crises, are some of the examples from recent decades.
Economic theory says that markets will be extremely efficient at price discovery when there are a large number of participants, among other things. Today’s investment markets definitely have a large number of participants, if nothing else. So why are they not efficient at their price discovery? Why do we CONSTANTLY see such anomalies as stock prices rising by 41% in a span of 5 and a half hour, without any apparent reason? That’s because there is a fundamental flaw in the economic theory and thus in the markets that have been designed on its basis.
The economic theory of efficient price discovery in a market holds true only when the participants of the market are pure sellers and pure buyers. This is because it assumes buyers and sellers to be 2 mutually exclusive sets and does not consider the possibility that buyers may themselves want to become sellers once they acquire the products. So, when non-pure sellers and buyers enter the market, the economic theory breaks down and efficient price discovery becomes a dream. This is the root cause of the problem plaguing the world’s investment markets. (The current unprecedented boom in the commodity markets of the world seems to be a result of the same phenomenon. Let’s wait and watch how it turns out to be.)
Thus, the solution to the problem is quite simple. Keep the non-pure sellers and buyers out of markets. This means that only those market participants that actually “produce” and “consume” the objects offered in a market, should be allowed to participate in it.
Implementing this solution is easier than it seems. We do not need to check the background of, and approve licenses to, each and every individual and entity that wants to participate in a particular market. That’ll be a bureaucratic nightmare. We simply need to introduce 3 conditions for participating in a given market:
1. Buying an item from a market, should always result in an ACTUAL delivery of that item to the buyer.
2. All the derivatives of a given market that do not result in an ACTUAL delivery of the underlying asset should be removed from the market.
3. A MINIMUM lock-in period should be imposed, before the buyer is allowed to sell his purchased item in the market.
The third condition is a crucial one. For example, if the lock-in period in the stock markets is 1 year then only those individuals and entities who think that a particular company will perform well over the next year will buy that company’s shares, thus removing speculation from stock markets. In the case of the property market, such a lock-in period will be longer, perhaps 10 years.
The above 3 rules will ensure that the only market participants are the ones that are pure sellers and buyers and not speculators. This will not only lead to efficient price discovery in markets, but it will also drastically reduce the occurrence of boom and bust cycles that are an inevitable part of a speculative market.
4 comments:
Hey Rishit,
Nice post man! I really liked the explanation and analysis
I have few questions:
When you talk about pure buyers and sellers in markets (stock and property), does a lock in period of 1 year make the buyer a pure buyer?. The buyer who purchases stocks with a lock in of 1 year will sell the shares after 1 year. So, how is this buyer consuming the share? Can we assume that taking dividend is like consuming?
nice read lateral thinker.. :) cant put any other comment here though.. last i studied economics was in 12th standard.. :P
@ Vijay
Thanks :)
I have used the words "production" and "consumption" in a broader sense, as in: a person who is selling shares is "producing an investment opportunity" and a person who is buying shares is "consuming that investment opportunity". The same goes for property.
@ Pratik
Thanks :)
Hope you can comment on this by the time we reach convocation :P
I like your theory. But you know this kind of theories won't work in reality. Just like communism didn't work.
Well, one particular flaw in this theory is this. Let us say that I bought a house for 10L today. After two years, I want to sell that house and use the money let us say to marry my daughter. There is no another way for me to get money. You can say that we can get loans on that house. But I don't want pay any extra amount of money unnecessarily. I have an assert and I just want to sell it off whether it is house or shares or whatever and get money back.
Just for these type of cases, if you relax your rules then there will always be people to take advantage of such things and again everything gets complicated. When a lot of people are involved then things will always get complicated no matter how much you try to make it simple.
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