What Price, Price?

By: Michael Ashton | Mon, Apr 19, 2010
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It was a relatively quiet day in the markets, despite the fact that stocks were weak overnight (partly because Greece's Prime Minister said the country was on an "inescapable path the IMF" but mostly because of the continuing reverberations from the SEC-Goldman tiff last week). Stocks shrugged off the impulse to do something important and closed +0.5%. Supposedly the rally was partly due to the news that the SEC's decision to sue Goldman was the result of a "secret" party-line vote of 3 (Democrats) to 2 (Republicans). Investors took comfort in knowing, I guess, that there was a difference of opinion based on raw partisanship. Yep, that surely is better news for Goldman, because one little contribution can make everything all better. But is it good news for the market? I think I saw the same approach on the Sopranos. There is lots of reasons these deliberations are supposed to be secret...that's one of them. The purpose of ballot secrecy is not just to protect you from negative consequences if I know your vote; it is also to protect the system from the consequences if you can prove your vote (and thereby sell it) to me. Which is, by the way, the reason that giving receipts at the voting booth is a very, very, very bad idea.

TYM0 fell 9/32nds; the 10y yield rose to 3.80%. The fact that Europe is still preoccupied with the question of how to ship out all of the folks who are stuck there due to the volcano (limited flights reportedly to begin tomorrow) probably doesn't help market liquidity. By the way, instead of calling the volcano by its proper name, Eyjafjallajökull, which I am pretty sure involves glottal clicks and other strange sounds I am incapable of making, can we non-Icelanders just call it E*, pronounced E-star? In exchange, we will allow Icelanders to call Obama "the big O." Either the letter or the number, your call.

Since the markets are relatively quiet, yields have retreated from any immediate sign that I need to reconsider my near-term bearishness on fixed-income, and therefore my working hypotheses need little adjustment at the moment, I want to touch on two other topics that are broadly relevant to the market these days but not necessarily breaking news. I'll tackle one today and perhaps one tomorrow.

Price Serves A Rationing Function (Normally)

I think that when we teach economics in school, especially at the high school level when economics isn't generally being taught by economists, we tend to do a decent job of indoctrinating students with positive economics verities (positive in an economic sense, as opposed to normative) but a relatively poor job of teaching why those verities are in fact verities.

[This is one reason that I like to read books and articles by Thomas Sowell (I do not recommend that you read him if you are not conservative, or open-minded to cogent argument, or both). I think he does a terrific job at demonstrating just why economists believe certain things, and doing it in a way that doesn't involve graphs. Personally, I love graphs and I 'get' them, but it doesn't work for some people.]

Ironically, I think one of the things that most people forget about is one of the first things that is taught in microeconomics: the function of price. Why is it that the demand curve slopes downward? That is, why is it that the market wants more gold if the price is lower?

The answer is that we have more uses for gold at a lower price. We can make coins with it; at a lower price we can hammer it into fillings; at a lower price still we can use it in lieu of toothpicks. So if you ask me how much gold I need at $1,000,000/oz, the answer is zero; at a price of $0.01/oz, the answer is "I'd love to have a desk made of solid gold."

The price that a consumer is willing to pay is related to the marginal utility of the good to that consumer. So how is the actual price set? Well, in a one-period model where the quantity supplied is given - which allows us to consider just the demand side - we can think of price being set in a big auction with all of these consumers bidding against one another. There is a limited quantity of gold for sale, and I am just not going to be able to get any of it with my 1 penny bid (drat! No gold desk). In short, the gold ends up in the hands of the people who have the highest-valued use for it. Price, in short, serves a rationing function that routes goods and services efficiently to their highest-valued uses, if the market is free.

I like this explanation, which comes from the Wikipedia entry for the Paradox of Value:

The reasoning goes like this. If someone possesses a good, he will use it to satisfy some need or want. Which one? Naturally, the one that takes highest-priority. Eugen von Böhm-Bawerk illustrated this with the example of a farmer having five sacks of grain. With the first, he will make bread to survive. With the second, he will make more bread, in order to be strong enough to work. With the next, he will feed his farm animals. The next is used to make whisky, and the last one he feeds to the pigeons. If one of those bags is stolen, he will not reduce each of those activities by one-fifth; instead he will stop feeding the pigeons. So the value of the fifth bag of grain is equal to the satisfaction he gets from feeding the pigeons. If he sells that bag and neglects the pigeons, his least productive use of the remaining grain is to make whisky, so the value of a fourth bag of grain is the value of his whisky. Only if he loses four bags of grain will he start eating less; that is the most productive use of his grain. The last bag of grain is worth his life.

So why do I mention this? I think it is useful to think about this in order to understand why Western civilization doesn't collapse with $100 or $200 oil. Life changes, to be sure, and the economy bears large costs as a result of that change. But it isn't as calamitous as it might seem because the highest-valued uses tend to be filled first. The first thing to go are the joy rides; more commuters car-pool; sooner or later the Vespa becomes a popular mode of transportation in the U.S. as it is in many cities in Europe.

Moreover, price serves a signaling function. At $200, many other forms of energy become economical. Most "alternative energy" is not economical because fossil fuels have a much higher energy content than switchgrass (for example), so you need a whole lot of switchgrass to replace one barrel of oil and that simply costs too much. But if oil costs three times as much, voila! Other forms of energy come online.

The pain from spikes in energy prices are because of just that - they're spikes, and supply takes time to adjust (at least one season in grains and livestock but lots longer than that when we're talking about mines or wells or nuclear or alternatives). We are experiencing a long-term bull market in many commodities because the low prices of the 1990s led to decaying infrastructure. Leathernecks who made gobs of money on drilling rigs in the Gulf of Mexico in the early 1980s have retired, and no one replaced them because in the late 1980s and 1990s there was no money in oil drilling. So now we want to drill new wells, and we're out of leathernecks, tankers, etcetera. New nuclear plants take ages. Storing wind energy is woefully inefficient. And the list goes on. That is why an oil spike is a problem.

There will be a big economic shock, to be sure, if oil spikes to $200 especially if we haven't developed the capacity in those alternative sources and the price adjustment happens suddenly. This will be a big problem in a levered economy that has as many imbalances as this one does. I'm quite concerned about that. But price will to some degree help solve the problem - rapidly in the demand (rationing) case, and somewhat more slowly in the supply (building) case. Civilization won't collapse. We'll just wear out more shoes.

There is no meaningful economic data due out tomorrow, so I suspect I will tackle my second topic: what if our access to our money was cut off suddenly, for example in a financial collapse? I will respond to William Poole's argument in recent Financial Analysts Journal writings (his sentiment shared by many in government) that the economy would utterly collapse and there would be mass starvation if we couldn't use our credit cards for a week or a month. This argument is at the heart of the question of what "too big to fail" and "systemic risk" means.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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