What is Liquidity?

Investopedia defines Liquidity as "the degree to which an asset or security can be bought or sold in the market without affecting the asset's price."  In other words, if offering to buy or sell a thing doesn't have any effect on the price of that thing, the market for that thing is perfectly liquid.

In daily life, it would appear that almost everything is perfectly liquid.  Prices are set, and they don't change when make purchasing decisions.  In reality, though, aggregate purchasing decisions of the entire market do move prices, and illiquidity is everywhere.

Most everyone is familiar with an auction.  The market we all use every day is very much like an auction, but with many sellers along with the many buyers.  The price of gasoline fluctuates as buyers and sellers negotiate prices.  You negotiate with your local gas stations by buying from the stations with lower prices.  Your choice to buy from the cheaper stations will cause the more expensive stations to lower their prices.  That shows that the gasoline market is not perfectly liquid.  In fact, no market is.

Gas is still fairly liquid, though.  Other goods are extremely illiquid.  Consider a fine art auction, where every time a person raises their hand, the price of the good being auctioned could go up $5000.  Picasso's paintings are extremely illiquid.

Credit Rating Agencies "Look Like Idiots"

The Financial Times published "Emails Detail Role of Ratings Firms in Crisis" today.  It appears that employees of the two big credit rating agencies (Standard & Poor's and Moody's) thought that their firms' own ratings of some mortgage backed securities were faulty.

A big problem in the way the ratings market does its job is who pays for the work.  When S&P or Moody's are hired to rate a fixed income security about to go to market, they are paid by the people trying to sell the security.  This incentivizes the rating agency to rate in favor of the security seller, to encourage future business.

This is akin to you trusting a used car dealer's mechanic regarding the quality of a car you are considering to buy.  A savvy used car buyer has the car checked out by their own mechanic before buying.  Of course, this means you likely pay your mechanic for their trouble, but that fee is worth the information you gain before making the commitment to buy the car.

Investors should be doing the same thing with their fixed income securities.  Go hire your own credit rating agency.

Fixing Environmental Externalities

I had a comment on my Externalities post asking about the Cap and Trade program being considered as a way to combat carbon emissions.  The cap and trade idea isn't new.  In fact, the United States has had a successful cap and trade plan in place for over ten years in an attempt to curb sulfur dioxide and nitrogen oxides in the atmosphere.  It is called the Acid Rain Program.

In the case of acid rain, an externality exists: coal-fired power plants (and other polluters) put sulfur dioxide and nitrogen oxides into the air, which then come back down and kill forests (among other bad things).  The residents and businesses that use those forests are harmed.  This is a negative externality.

Cap and trade programs aim to reduce these pollutants (and by extension the externality) by using the theory of free markets.  The government issues permits that allow the holder of the permit to pollute a certain amount per year.  The sum of the permits at the time of issuance will often be close to the current level of pollution.  The permits might be given to the current polluters for free or auctioned off, or some of both.  Then, these permits can be bought/sold at an exchange by anyone at prices that vary via market forces.  A new factory can choose between buying a pollution permit or investing in technology that pollutes less.  An environmental non-profit or the EPA can buy permits and then never use them to reduce overall pollution.

Cap and trade systems work; there isn't a substantive debate there.  The controversy around carbon emission cap and trade is that not everyone agrees that carbon emissions are a problem.  That is a debate for a different blog.

Moral Hazard & WaMu

Moral hazard has gotten a lot of attention throughout the financial crisis, and rightfully so.  There was lots of it going on, and not only at the top.  Investopedia defines moral hazard as "the risk that a party to a transaction has not entered into the contract in good faith."  For a better definition with examples, though, check out Wikipedia.  It does a pretty good job, at the moment.

Marketplace had a piece this week centering around the moral hazard that was going on at Washington Mutual (WaMu).  Marketplace didn't label it as such, but the behavior they report that WaMu's employees were engaging in was definitely moral hazard.  Bank employees were encouraged to give loans to risky borrowers.  None (or very little) of the risk of these mortgages was being borne by WaMu or its employees.  They made the loan and then quickly sold it, so the risk that they created by making the contract was no longer theirs but the new investor's.

WaMu employees were also given bonuses when they overcharged home buyers.  So WaMu was cheating both the home buyer and the mortgage investor, while profiting from the loan origination fee.  WaMu likely wasn't the only bank doing this...

Listen to or read Did WaMu's Fraud Lower Rest of Market? (April 13, 2010).

The Dow Broke Through 11,000 this Week! Who cares?

Every time an index, especially the Dow, approaches and goes beyond round numbers (e.g. 11,000), you'll hear about it on the news.  Look to the New York Times, the Wall Street Journal, and the Chicago Sun-Times for examples.  Some claim it provides a psychological boost for the market.

Concentrating on a particular number as a milestone is silly.  11,000 is better than 10,990 the same amount that 10,980 is better than 10,970.  You don't see articles about 10,980.  11,000 is only impressive, because we use a base 10 number system.  If we used binary, reporters would have been going nuts when we crossed 10,000,000,000,000 back in July 2009 (that's 8,192 for those of you who aren't engineers).

It is useful to stop and reflect now and then, and perhaps using such numbers is as good a marker as any.  The markers shouldn't be given any special meaning, though.  The importance of particular numbers is simply a human construct placed upon an otherwise insignificant label.  The value of dollars and gold has a similar issue, but that is a conversation for another day.

A Tax Refund Isn't a Good Thing

Tax Day is coming up this week.  If you haven't already filed, then get it done.

Many people get excited about the prospect of a refund on their taxes.  If you are a competent saver, though, you shouldn't be.  Getting a refund means that you overpaid taxes during the past year.  The IRS has been happily taking your money, earning investment income on it, and will give it back to you after you file.

Instead, you should arrange your W-4 with your employer to withhold less of your salary for taxes.  The goal is to owe a little to the IRS when you file your taxes.  That way, you keep your money as long as possible, and you earn interest on it instead of them.  Don't lower your withholdings too much, though, or the IRS will fine you.

This method also means you won't be waiting around wondering if your tax paperwork got to the IRS successfully.  You'll know when they cash your check.

Externalities

Externality is an economic term that everyone should know.  The Glossary of Research Economics defines it as "An effect of a purchase or use decision by one set of parties on others who did not have a choice and whose interests were not taken into account."  That may be a bit hard to digest, so I'll give some examples.  Externalities can be both positive and negative, meaning the effects on the party who was not involved in the choice can be good or bad.

Imagine a homeowner spends $1000 and twenty hours of his time planting a garden in front of his house.  He is not planning to sell his house any time soon; he just loves gardens.  If he did sell, though, this improvement could increase his asking price and/or sell his house faster, because when potential buyers first visit the house they will likely have a more positive outlook when they see the nice garden.  Now imagine his next door neighbor is trying to sell her house a month after he plants the garden.  Potential buyers of her house will see his garden and could have similar feelings.  She would benefit from his economic decisions, and it is highly unlikely that she will write him a check for a few hundred dollars when her house sells.  This is a positive externality: his decision to plant a garden (a decision she was not involved in) benefits her and she does not reimburse him for the benefit.

For a negative externality, imagine the same two neighbors.  Now, though, instead of planting a garden, he has a broken down Pontiac sitting on his front lawn that he works on perpetually.

Negative externalities get much more attention from economists and policymakers than positive externalities, understandably so.  They are especially important in environmental policy.  I think about them during social welfare debates, too.