Wednesday, April 30, 2008


Will you recognize me?
Call my name or walk on by
Rain keeps falling, rain keeps falling
Down, down, down, down
--Simple Minds

For anyone seeking background on moral hazard and how it has been enacted in financial markets, Jeremy Grantham's April 2008 Quarterly Letter, "Immoral Hazard," is a brilliant read (you can find it at

My only criticism is that Mr Grantham continually cites actions that the Fed 'should have' taken to reduce moral hazard and deflate asset bubbles. As if perhaps a different bunch of bureaucrats could have done any better.

Poor decisions are inherent to central planning. When decisions are taken away from markets and put into the hands of bureaucrats, the inevitable result is distortion that impairs societal growth and prosperity. There is no secret sauce that will make central planning work.

Market controls are destined to fail by their design.

Tuesday, April 22, 2008

Voices Carry

I try so hard not to get upset
Because I know all the trouble I'll get
--'Til Tuesday

Have long regarded market journalist Caroline Baum as a sharp cookie. Her recent commentary on "John Galt Plan Might Save U.S. Financial System" reaffirms the vibe. Quoting from near the end:

"We want laissez-faire capitalism in good times and a government backstop against losses in bad times."

True dat, CB, and worth pondering as we watch bankers from Citi (C), Merrill (MER), Lehman (LEH), et al queue up in the Fed Bread Line.

no positions

Saturday, April 19, 2008

Special Purpose Entities

Too many shadows, whispering voices
Faces on posters, too many choices
If, when, why, what?
How much have you got?
--Pet Shop Boys

Conventional wisdom holds that specialization encourages progress via the magic of comparative advantage. Viewed through this lens, we're collectively better off when producers focus on a narrow set of tasks and output. The specialization notion influences prominent socio-economic concepts such as work organization (Taylor, 1911), trade theory (Smith, 1776), and strategic competence development (Prahalad & Hamel, 1990).

Increasingly, I find myself questioning the merits of specialization in the context of free market systems. Free markets rely on the decisions of individuals who assess risk and reward in their own best interest.

In economies where specialization dominates, individuals necessarily outsource capacity for production and decision-making to others. Problematically, agents who make decisions on behalf of their principals may possess motivations and objectives that stray from the individuals they represent (Jensen & Meckling, 1976).

Essentially, specialists are more dependent on others. Agency problems that arise may distort the independent, individiualistic decision-making process necessary for effective free market functioning.

Problems related to specialization may be exacerbated in dynamic environments. For example, innovation may obsolete some individuals' specialized crafts. Unwinding the specialized commitment may require considerable resources, such as time and money for retraining. As such, specialized individuals are more rigid and less adaptable than their generalist counterparts.
Service economies may also be more susceptable to problems of specialization. Agency problems can be reduced by monitoring agent behavior (Jensen & Meckling, 1976). However, service processes that rely heavily on tacit decision-making processes may be difficult to monitor. As such, when a specialist outsources, say, investment decisions to an advisor at Merrill Lynch (MER) or tax decisions to an accountant at H&R Block (HRB), a mismatch between principal and agent goals may lead to decisions that differ from those that would be made by the individual alone.

Plausibly, to the extent that it increases dependence on others, specialization impairs the individualistic decision-making mechanism that drives free markets.

no positions


Jensen, M.C. & Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 304-360.

Prahalad, C.K. & Hamel, G. 1990. The core competence of the corporation. Harvard Business Review, 68(3): 79-87.

Smith, A. 1776. An inquiry into the nature and causes of the wealth of nations. London: Strahan & Cadell.

Taylor, F.W. 1911. The principles of scientific management. New York: Harper & Brothers Publishers.

Friday, April 11, 2008

Fortune Teller Troubles

Nothing's so cold
As closing the heart when all we need
Is to free the soul
But we wouldn't be that brave I know
--Toad the Wet Sprocket

It has long been held that the stock market is an effective forecasting mechanism. Because investors are motivated to process information in a forward-looking mindset, the aggregate result has often been an eerily accurate discounting of the future. Stock prices have commonly anticipated salient news 6-12 month ahead of time. Like magic.

Mr Practical argues pursuasively that the market's capacity for accurately discounting information is no longer what it was. I think he's correct. To me, it boils down to the extent to which markets operate freely. Market decision making requires probabilistic assessment of risk versus reward. When policy makers intervene in market activity to bail out losing decisions, such as the Bear Stearns (BSC) situation, the perceived need to assess risk decreases. Over time, complacency blunts the edge of effective risk assimilation.

As such, market intevention should serve to distort collective market decision-making processes. If, for example, interventions that are presumed to prop up prices actually don't work, then the aggregate discounting mechanism may be way off.

Given the degree of intevention we are currently witnessing, the market's crystal ball has likely clouded considerably.

no positions

Tuesday, April 1, 2008

Tick Tac Toe

I was halfway home - I was half insane,
And every shop window I looked in just looked the same
--Style Council

Many lament that elimination of the 'uptick rule', which permitted selling a stock short only if the previous trade price was lower, has exacerbated downside volatility in the markets.

This bids an obvious question. If it is not ok to short stocks on a downtick, then why is it ok to buy stocks on an uptick?