The Quality of Price Signals

March 24, 2009

by Mario Rizzo

In an under-appreciated book, The Foundations of Morality (1964), the Wall Street Journal and New York Times economic journalist, Henry Hazlitt, wrote that the price system does not send accurate signals in the absence of private property rights.

“It is important to insist that private property and free markets are not separable institutions… If I am a government commissar selling something I don’t really own, and you are another commissar buying it with money that really isn’t yours, then neither of us really cares what the price is” (p. 304).

The so-called Geithner (U.S. Treasury) plan to purchase toxic assets from banks disregards the relationship between an adequately functioning price system and property rights. The purchasers will not be playing with money that is really theirs. In the first place, up to 85% of the value of a portfolio of assets can be borrowed from the Federal Deposit Insurance Corporation (FDIC). These loans will be “nonrecourse loans,” that is, they are secured only by the value of the assets being bought. So if the assets turn out to be worthless (an extreme case) the FDIC is out the 85% and not the purchaser. In the second place, the Treasury itself will put up the money for as much as 80% of the remaining 15%.

Under these circumstances, when the private investors bid for these assets, what price will they pay? The provisions of the Treasury’s plan largely insure them against downside risk so they are not risking their own money. Therefore, their bids will not reflect an unbiased estimate of the value of these assets. The bids will be biased upward since the potential owners’ private payoffs will differ systematically from the social payoff. The quality of the prices that come out of this process will be poor.

There is a general lesson here. The market is a complex system in which both property rights (responsibilities) and the price system play inextricably linked parts. The failure to recognize this is responsible for much mischief. This is only the latest.

When the prerequisites for a well-functioning market are not in place, it is wrong to say that there is (or will be) market failure.

UPDATE: Jeffrey Sachs has an excellent article presenting an arithmetic illustration of my point. He also tells us why the government would advocate such a flawed bidding scheme — and it is not because they don’t know better!

15 Responses to “The Quality of Price Signals”

  1. goldtracker Says:

    Great read on the current plan, Mario.

    And now China is calling for a new reserve currency. In other words, our biggest debt holder is saying they want out.

    I’m thinking the best investment right now is going cash and hedging in gold and silver. I’ve been tracking them with the widget http://www.learcapital.com/exactprice and it looks to me that a lot of people are feeling the same way as those two metals continue an upward trend in light of all this printing of paper money.

  2. Kurt Bouwhuis Says:

    “When the prerequisites for a well-functioning market are not in place, it is wrong to say that there is (or will be) market failure.”

    It’s too bad more people do not understand this concept.

  3. RickC Says:

    Even as a non-economist, when I read this part of the Geithner plan, I was in complete disbelief. Talk about moral hazard on steroids.


  4. “So if the assets turn out to be worthless (an extreme case) the FDIC is out the 85% and not the purchaser.”

    No big deal, they’ll just retroactively tax it back.

  5. Peter Boettke Says:

    Mario,

    Fantastic post. I made this point in less elegant form in my post on the Geithner plan yesterday and pointed to my earlier work on the “valuation” trap in post-communism as analogous to our current situation.

    I wonder why economists in the wake of the intellectual defeat of market socialism and the practical defeat of real-existing socialism, do not get this basic point that was made by Mises, Hayek, and G. Warren Nutter, among others.

    Keep up the great work.

    Pete


  6. […] In a related discussion, Mario Rizzo reminds everyone that valid asset pricing is dependent on a coherent regime of property right assignments. […]


  7. I wonder what the folks at this conference will be saying:

    http://www.marxismfestival.org.uk/

  8. Mario Rizzo Says:

    Pete,

    Of course, you have been explaining for years why the market must be embedded in a set of appropriate institutions.

    I am not so sure that Geithner doesn’t understand this. It is perhaps likely that the system is being intentionally rigged to get high bids so as not to reveal the dire condition of some banks. I think that the Administration thinks that the fundamental problem is just confidence. Thus, if people can be persuaded that things are all right then they *are* all right.

  9. goldtracker Says:

    Good point, Mario. I think the perception slant is one of the key things going on this administration. I guess others would call it propaganda and frankly every political figure engages in it no matter what side of the aisle one is one. But it does seem this administration is real big on this idea of using the euphemism to steer perception.

    I don’t think that will work long term for them. Simply because reality will hit. And because the perception will have been believed the hit will be a hard one.

    Of course I continue to see evidence that Wall Street is teetering on the tight rope when it comes to the Treasury and Geithner’s statements. Today I was watching gold with http://www.learcapital.com/exactprice and while he was doing a news conference he stumbled over questions about the dollar and China and gold’s price rocketed up. Has since come back down a bit after he tried to clarify his comments but it proves to me how much uncertainty and fear there is in the minds of people.


  10. […] for Geithner’s other plan, the one for betting toxic assets off the banks’ book, see this great post by Mario Rizzo. No one has been so clear in explaining what is wrong with the Bush-Obama approach […]

  11. Bob D Says:

    I just want to know how to get in on the action! The Government is determined to keep the “Zombie” Cos. afloat no matter how much currency debasement it takes. I guess you could look at Bernanke as Dr. Frankenstein and Giethner as Egore pumping Money/Electricity into a corpse until they see some signs of movement. As the Austrian and Neo Classical Economists have reminded us many times, the cos. who are first in line for the “newly printed money” are main beneficiaries. Last in liners are the ones who get little or no benefits but pay the bill plus interests. The can’t beat them, so might as well join in on the money grab strategy!

  12. dg lesvic Says:

    Well, what do you know, it looks like I slipped one past Prof Horwitz.

  13. Andrew Says:

    I just picked a book called ‘The Failure of the New Subjectivist Revolution: A Critical Essay on the Economic Theory of Ludwig von Mises’.
    Starting page 96, there is a section named; ‘Why the Absence of Property Rights in Some Goods and Factors Should be Part of Economic Theory’.
    I have not read it yet but here is a quote from the said section:

    Enforcement Costs
    We can bolster the case against assuming that there are property rights in all goods by considering enforcement. One could assume that government agents are omnipotent and omniscient (so that there are no costs of enforcing property rights). However, it is contrary to common sense to believe that they would be successful in completely defining and enforcing private property rights in all prospective goods and factors. Nor should they be. The benefit of enforcing some property rights is presumably lower than the cost.

  14. dg lesvic Says:

    I didn’t really understand what that public/private “partnership” was all about. I do now, thanks to you, Prof. Rizzo


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