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February 04, 2008

The brave new world of finance-1

One topic that I have tended to avoid in my blog posts is the subject of economics. This is because the 'dismal science' is one of those subjects where I feel a little out of my depth. Whereas I can make sense of events in many other areas of everyday life, even to the extent of making modestly successful predictions about what should occur, behavior in the world of business and finance tends to defy my expectations. For a long time, I thought this was due to my weak understanding of the basics of economics. But now I am wondering if it is because the economic world is, frankly, crazy.

I am beginning to worry that the modern US and global economy has become untethered from reality or even basic common sense. French President Nicolas Sarkozy seems to share my alarm when he recently said that we now seem to have a global "financial system which is out of its mind and which has lost sight of its purpose."

Let me start out by admitting that I am old-fashioned when it comes to basic economics and finance. My understanding of those topics is similar to Benjamin Franklin's Poor Richard's Almanac proverbs, which extol the virtues of hard work, thrift, and prudence. The basic ideas that Franklin advocates – live within your means, don't waste time on too much frivolity, avoid spending money on things you don't need, save for the future – are things that I understand and basically try to follow. They still make sense to me as a means of ordering my personal finances.

Although I am not, and never have been, a businessman, the basic idea of business - investing money in producing some product or offering a service, and charging for those things at a price high enough to make a profit that is at least slightly above what one might earn from simply putting the money in a bank and earning interest on it – is again something I understand.

But those kinds of attitudes seem to be hopelessly out-of-place in the brave new world of modern high finance. My awareness that I don't understand modern finance is on display with the way that the stock market actually performs compared to the way that I expect it to perform. Again, I think I understand the basic idea of stocks. If a company needs to raise money to improve or expand its business, one option is to borrow it, another is to sell stock to the public. The public that risks its money this way gets rewarded if the company invests that money well and continues to make profits which gets returned to the stockholders as dividends. Also a company that is efficiently and well-run and produces goods and services that people desire is a company that becomes more valuable over time and that more people will want to own stock in, thus driving up the stock price and benefiting the stockholders even more.

Thus its stock price should be a gauge of the health of a company and the stock market should be a gauge of the overall health of the underlying economy and the companies that make it up. If a country has many companies that are producing goods and services of value that are sought, then the stock market indices should go up, and vice versa.

That is my admittedly naïve understanding of the world of business and personal finance. It is something I understand.

But as far as I can see, the world of business and finance is now topsy-turvy, with causes and effects becoming blurred or even interchangeable. The stock market seems to be acting independently of the underlying economy. Rather than its stock market being an effect, reflecting the basic health of a company, high stock prices are seen as good in themselves, even if that is obtained at the cost of driving a company into the ground. The actions of company management now seem to be increasingly driven by the desire to drive up the stock price, even if this might mean harming the long-term health of the company. And even government policies seem to be aimed at keeping stock market prices high rather than in ensuring that the underlying economy is sound.

Take for example the news released on Monday, January 28th that new housing starts had slumped dramatically. This was widely seen as yet another sign that the economy was slowing down and that activity was declining, perhaps the precursor to a recession. In other words, it was a sign of a seriously ailing economy. And yet the stock market shot up that day, as if this was the best news. Why? The ubiquitous financial analysts who can explain anything after the fact said that this was because investors felt that such bad economic news would cause the Federal Reserve to slash interest rates once again very soon, and stock market investors passionately love low interest rates above all else. This is because low interests supposedly make other forms of investments such as bonds and money market and certificate of deposits less competitive, and thus more people will divert their money from those areas into the stock market, driving up demand. Thus lower interests rates means that we can expect stock prices to rise in the future, making them a good buy now. This thinking is what raised the stock prices on such a bad news day. Furthermore, low interest rates make it cheaper for businesses to borrow money, enabling them to have more money to expand their operations, thus resulting in growth in the future. Since the stock market is supposed to reflect the future, not the present, bad economic news like the drop in housing starts was seen as a good thing.

Next: More signs that modern financial world is out of synch with the real world.

POST SCRIPT: Fame

The highly versatile Stephen Fry (actor, director, author) has his own blog with a nice essay on what fame is like for the famous.

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Comments

For my money, economists are like meteorologists in that they do a terrific job of telling you why something happened yesterday, but they don't have a clue as to what is going to happen tomorrow.

It's not their fault, it because the systems are just too darn complex.

Think of a market forcast just like the weather forcast. They might call for the dollar to finish up against the pound tomorrow but I wouldn't be surprised if it rained all day.

Posted by dave on February 4, 2008 01:49 PM

I too don't understand much of economics. It's such a confusing area of study, I can't even pretend to know why oil prices are affecting the price of my house, for example, or why house prices are so important to a country's economy.

Btw... tag

The 123 Rules:

1. Pick up the book nearest you with at least 123 pages. (No cheating!)
2. Turn to page 123.
3. Count the first five sentences.
4. Post the next three sentences.
5. Tag five other bloggers.

Posted by Mike on February 5, 2008 08:08 AM

I think you will enjoy the perspective of the writers on our contrarian news and opinion website. Here's a recent article about the manipulation of the US dollar and hence commodity prices: http://www.contrarianprofits.com/articles/goosing-up-commodity-prices/1934

The current financial woes are far from over, as the mainstream pundits would have you believe.

Posted by ContrarianProfits.com on May 13, 2008 08:02 PM

Hi there, :)

talking about finance, maybe you like to see my blog also and we can discuss something, if you like to.

regards,
Dyllan
http://www.coursefinance.blogspot.com

Posted by Dyllan on May 27, 2008 01:38 PM

I agree with you the economic world is out of control and we are in trouble.

Posted by G.Wadel on June 7, 2008 05:50 PM