Prices, Politicians, and Common Sense

I’ve watched the stock market go up and down lately like a giant yo-yo. I’ve followed the details of how and why the so-called bailout failed in the House early this week, and will probably pass the Senate on Wednesday, and possibly the House a day later. In revised form, of course.

But there’s an aspect of this situation which applies to the bad mortgages, whose failures led to the collapse of Fannie Mae and Freddie Mac. And applies to the failures of Lehman Brothers, Washington Mutual, AIG, Wachovia, the House of Representatives, the Senate, the White House, and both presidential campaigns.

What is the common denominator of all these failures? It is rapid decline in prices of mortgages, bundled mortgages, and businesses which trade on bundled mortgages, and finally, politicians who are rented by such businesses. The part of these related disasters which no one in the press has bothered to discuss, is basic.

Basic fact one: A price for any product or service is the dollar value at which a willing seller will transfer it to a willing buyer.

Basic fact two: Whenever government interferes in the free market by forcing any product or service to become either cheaper or more expensive than it normally would be, the price of the forced change will be paid by other people, somewhere else in the economy.

Basic fact three: Some prices depend heavily on future expectations about the value of the product. No one buys a pencil hoping its value to go up in the future. However, everyone who buys a share of stock expects its price to go up (or dividend increase) or otherwise he/she wouldn’t buy it in the first place.

Mind you, I am not advocating laissez faire economics at the Darwinian level. Telling a manufacturing firm that it cannot dump the toxic byproducts of its factories into the nearest stream obviously raises the price of the widgets that are produced in that plant. And, the cost of controlling, rather than dumping those byproducts will be passed onto the rest of society when people buy and use widgets. The point is that such “social costs” should be honestly recognized, and openly imposed.

Let’s apply these ideas that are taught in the first week of Economics 101, in all colleges where such courses are taught by professors who impart knowledge, not politics, to their students.

As Ben Franklin observed, centuries ago, and Abe Lincoln reaffirmed a century ago, time is money. When Congress passed a law in the Carter Administration to force lending institutions to make home loans to people who wouldn’t otherwise get them, it forced the prices down for certain people. A 5% down payment, or even less, is easier to accumulate and takes less time, than the standard 10% to 20%. Likewise, a shoddy credit record is easier to acquire than a clean one.

Then, in the Clinton Administration, Fannie Mae and Freddie Mac were ordered to increase their purchase of such loans. And, they bundled them and sold them in the open market to assorted private investment banks and brokerages. At the time, the price of these bundled securities were high. After all, they had higher yields than normal loan packages, and they seemed to be guaranteed by the federal government.

Put it in your own terms. If there are two banks on the same street, both with federal deposit insurance, and one pays a 4% interest rate and the other an 8% rate, where would you deposit your money? You should put your money where you receive the highest price.

Ah, but what happens if the higher rate bank turns out to be uninsured? So, your whole deposit could be lost? Then, you should grab your money and run. That is exactly what both individuals and institutions have been doing for the last two weeks.

But, remember that the whole disaster began with the government – both Congress and Presidents – artificially lowering the price of houses for certain people (including as it turns out, people who are not even American citizens). Efforts to place controls on the excesses of Fannie Mae and Freddie Mac sponsored by President Bush and Senator McCain, among others, were defeated on a party-line vote in the US Senate, by Democrats who had received substantial contributions from Fannie and Freddie.

There are no goods and services, and only a fraction of individuals, who do not have a price. And when that price is met, the exchange takes place.

I hope this discussion of prices is helpful to you in considering what is happening, and not happening, both in the economy and in the halls of Congress.

About the Author: John Armor practiced law in the US Supreme Court for 33 years. He now lives in Highlands, NC, and is working on a book on Thomas Paine. John_Armor@aya.yale.edu

But, remember that the whole disaster began with the government – both Congress and Presidents – artificially lowering the price of houses for certain people

I agree with you that loosening eligibility standards for mortgages was a bad idea and contributed to the current mess. I'm not quite sure though why it's a pricing issue. Were houses sold at lower prices?

Price is relative, and is much more than the dollar value of a good or service; it is not necessarily a fixed quantum. Pre-existing conditions, externalities, convenience, and substitution availability are all factors in ''price''.

It is also much more than ''willing seller meets willing buyer'', because the ability of the buyer to come up with the dollar price comes into play.

For example, if someone has crappy credit and wants to buy a $200,000 house with 5% down, in a normal banking environment he would be refused a mortgage loan. This is an example of a pre-existing condition affecting (adversely, here) a transaction.

If someone wants to buy the same house, and has the $200,000 (or can borrow it), but discovers pre-purchase that the house is down the street from a catfish-processing plant, this might be an example of an externality affecting relative price...unless the purchasor REALLY likes the smell of catfish offal.

If someone wants to buy the same house, but also wants to buy a piece of lakefront property on his favourite fishing lake, the transaction is likely to be affected by the substitutability of one property for the other. Which purchase -- he can't afford both -- will he go for?

And on, and on, and on. John's written quite a decent essay on price here. WTG, John!

Well I just heard Sarah Palin on Hannity and she still is Blaming Wall St. And the public for buying houses that they could not afford .There was no Blame placed on the CONGRESS ,no offers of accountability for anyone aka Enron . So the Taxpayer takes it in the shorts from both of these frauds . Obama and the SO CALLED Maverick Who loves to trot out the Sharpie pen and tell us how he is going to Veto Earmarks which are chump change compared to this and NAME NAMES ! What a Fraud , Why doesnt he name names now ?

One point that is very important to note is that prices are only relevant for the particular goods or assets being bought or sold. They are often used to judge the worth of assets which are similar to those being bought and sold, but which are not actually involved in any transactions. Such usage often contributes to the creation of imaginary wealth, and an irrational desire to preserve it.

As a simple example, suppose some particular asset has an easily quantifiable liquidation value of $100 and no other worth, but for whatever reason people get involved in a mad bidding war. Someone buys the asset for $250 from someone who had in turn bought it for $240. Suddenly all interest in the item vanishes, leaving the item worth the same $100 liquidation value as it's always had.

No matter what the market did, the item was never worth $250, nor even $101. It was always worth $100. Anyone who spent over $100 for the item lost money on the deal; although someone who overpaid for the item might be lucky enough to find someone else who would overpay even more, that person would end up losing money equal to the seller's original loss, plus the seller's profit.

Such usage often contributes to the creation of imaginary wealth, and an irrational desire to preserve it.
>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

Some years back I was talking to someone about Bill Gates. Gates was supposedly worth about 80 billion dollars at the time. I remarked that he really wasn’t worth that much and was challenged on it. My reply was to the effect that most of Gates’ wealth was in Microsoft stock (as was being reported at the time) and if he were to cash in even ten percent the price of the stock would falter and his supposed net worth would drop sharply. I considered some large portion of Gates’ fortune to have been “imaginary wealth”. On his level it would have made no difference in his living standard but for folks at the bottom of the stack it is different.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.