I have written in the past, mostly at Dissecting The Bull, about the problem with pretending markets are efficient pricers of goods when prices are set by auctions. The recent financial meltdown has given many real world examples of this, but they are difficult to explain to people who are not familiar with stock and bond pricing, much less derivative pricing. So I have made up an imaginary example that encapsulates, in a dramatic way, a particular type of auction malfunction (if by malfunction we mean pricing that veers from free market ideals). I'll walk you through the example, then relate that understanding to selected current economic and financial events.
You hear about an auction and it sounds like you might want some of items in it, if the prices are right. The auctioneers will take only cash, so you put together what you have, say $55. You get stuck in traffic, so you arrive late. Outside people are already boasting of what great bargains they won. You hurry in.
The auctioneer, "the next item is a bundle of $1 bills, 100 of them." You think it is a strange item to auction: it is clearly worth $100 [assume these are not bills of value to collectors, or counterfeits, just ordinary $1 bills]. No one makes an offer at first, because everyone says assumes that it will be bid up to just short of $100, so bidding is a waste of time. But the tension builds and you decide why not, and open at $10. At that point the bidding goes quickly up to $29, then stalls. You offer $30. No one else bids against you. You win the $100. You pay $30 for the $100 and have $70 at the end. Meanwhile the auction has ended.
How could that happen (aside from the fact no one would auction off actual money like that)? Everyone else had run out of money. The next richest bidder in the room only had $29. It is your lucky day.
Translating this imaginary excursion closer to reality, now suppose that the item you bid $30 on and won was a mortgage bond worth $100. It really is worth $100, because the mortgage backing the bond is sound and will pay $100 over time. You win the auction not because the bond is worth $30, but because there is not enough cash to efficiently price the auction. Free market ideals have broken down.
Lately, almost no one has wanted to participate in auctions of at least two types of securities, mortgage-related bonds derivative securities and auction-rate securities.
There are two basic reasons there has been little bidding for weeks now: fear and lack of cash to bid with. The kind of institutions that can play this sort of game were all suddenly short of cash, and wanting to auction off what they could for cash, rather than using their precious cash to buy more securities. But no one else knows how to price the securities. For instance, it is difficult to find out which particular houses correspond to which particular mortgage bonds; linking the houses to derivatives is even more complex. So it is not exactly like buying a bag of $1 bills, if you just start buying a bunch of bags without looking in them. It is like buying an unopened bag of $1 bills and moths. It might have $100 of usable bills in it, or it might be all moths, or anywhere in between.
This is a problem for the government bail-out program; is the government going to look in each bag before it uses taxpayer money to buy it, or is it going to guess about the value of huge groups of bags using sampling techniques.
In free market theory prices are supposed to emerge in an efficient manner and result in efficient allocations of resources. Putting aside that there may be (in fact, are) problems with free market economics even when pricing of commodities is efficient, in the real world the conditions necessary for efficient pricing often don't exist.
For an auction to price items efficiently, there need to be a reasonable number of bidders and a reasonable number of items to bid on. If anyone has the power to set prices, prices will be set by that person, not by the market.
Even when there are reasonable numbers of buyers and sellers, because of human nature, prices can get out of whack, as in both bubbles and Depressions. The housing market is an auction market. Two years ago there were relatively few houses compared to bidders, resulting in unrealistic, high pricing. Now the same houses are in abundance compared to bidders, so in many cases sales are either not made (because in effect the people auctioning off their houses have set a minimum bid that no one will meet) or made at well below the real value of the house. The actual cost of construction being a good surrogate for real value for new homes, and that cost adjusted for inflation and physical deterioration being a good surrogate for used homes.
The Federal Reserve has been tasked with making sure their are neither too many nor too few dollars in circulation. When there are too many dollars, they are used freely to create inflation and asset bubbles. When there are too few dollars, people are forced to sell assets at less than their real values. Free market theories pretend that the only real value is the selling price, and it a very real sense that is true. But when selling prices depend on the whim of the Federal Reserve, you might want to ask yourself: what really is true, and what is bull?