These days all too frequently we hear that billions of dollars have been lost in the latest financial downturn. While such frightening headlines lead to attentive viewers and readers, it is worthwhile thinking through their details.
Keep in mind that markets represent equilibrium situations, the balance between what sellers will accept for a commodity and what buyers are prepared to spend for that commodity.
In a normal market, if you try to instantaneously realize a substantial fraction of the value of the commodity traded in that market, you will disturb the equilibrium, which will affect prices and that effect will generally be dramatic.
For example, consider a quiet town and its property market. One percent of the houses in that town might be for sale on any given day, and let’s assume there is a balance between buyers and sellers. (We will ignore the fact that property prices are rather strongly influenced by interest rates, instead we’ll assume that the primary determinant of house prices is whether buyers and sellers can agree on a price). Happily, because house prices are stable in this town, it is possible to determine the approximate value of any home, by comparing with recent sales of similar properties.
It is even possible to put a value on the property of the entire town. You simply multiply the numbers of houses in the town by average home values, and obtain the town’s total property value.
If average property prices come down by 10 percent, for example, the local media will write headlines which read ‘Billions Lost in Property Slump’, using numbers which assume that the total property value can be obtained by valuing houses at the peak in comparison with current values. Such headlines will insure that home owners are worried enough to watch the ensuing set of commercials, or buy the evening paper, but do not imply that this amount of money has actually been lost.
This is because the ‘value’ of property in this market could never be deposited in a bank as a result of selling all the properties in the town simultaneously.
As soon as there were, say, twice as many houses in the town on the market at the same time, prices would drop. The same number of buyers would suddenly find twice as many properties to choose from, make lower offers, and realtors would start to encourage owners to price their houses ‘to move’, and banks would reduce the amounts that they were prepared to lend. Average prices would then fall, probably significantly, in response to the relatively small change from 1 to 2 percent in the number of houses on the market.
If the number of sellers were ever to get to 100 percent, the price of property in this town could go to zero.
So, the total value of a market is never going to be extractable and we should not think that if average prices move down that huge sums of money have been lost. Proclaiming that a reduction in home prices has led to a loss of billions is a vast over simplification. Despite the fluctuations in house prices, at no point in proceedings do houses disappear from the town. The people continue to have their homes and despite the unease created by the change in prices, most people are not materially affected, and most importantly no money actually vanishes from the system. All the money which moves from buyer to seller exists before and after the change in house prices. A small number of people may have assets which cannot be immediately completely liquidated by sales, and a small number of people have made profits on their sales of houses bought when the market was lower, but the vast majority of people in the town do not lose money.
This perspective can be applied to stock markets too. The favored headline will be ‘Billions Wiped Off Stocks’. However, just as for property in the small town, it is impossible for the value of the stock market to be liquidated and deposited in a bank, and we should not pretend that this is possible in order to create, or respond to, scary headlines.
What can remove money from the market are the fees associated with transactions. The commissions paid to realtors, stock brokers, and bankers are lost to the financial market, and impose a drag on the system. Hence, it is interesting to note that an enthusiasm to create transaction churn often precedes a crash. The packaging and repackaging of securities and large commissions associated with the sales of those securities, pulls large amounts of money from the market, and undermines market efficiency. The commissions become so large that they are simply added to the purchase prices but they are not returned to the markets when sales occurs. Indeed, such commissions lead to the transfer of substantial market value to realtors, stock brokers, and bankers. Headlines on these subjects tend to be relatively rare, although these are the real market losses. And, as the immense personal fortunes of Wall Street executives demonstrate, this aspect of capitalism can be remarkably efficient.
As much of the financial ‘get-well’ legislation is written from the perspective of commissioned market practitioners, rather than individual property owners and investors, it is quite likely that this weakness will continue to be built into the financial system.