Sunday, February 29, 2004


Writing about the Law of One Price in the Fall, 2003, Journal of Economic Perspectives, Owen A. Lamont and Richard H. Thaler remind their readers that it’s all about arbitrage. They cite Steve Ross’ quip, “to make a parrot into a learned financial economist, he only needs to learn the single word ‘arbitrage.’” The LT piece qualifies all this; they also want the parrot to learn “short-sale constraints,” among other things.

The Economist (Feb 28) reports that the current U.S. economy is going through A phoney recovery because consumer spending is driven by asset price growth rather than by real income growth --and that asset prices reflect a cheap-money-induced bubble – and that the FRB should prick the bubble by tightening credit. The Economist articled cited a recent WSJ op-ed by European Central Bank chief economist Otmar Issing where the writer warned Alan Greenspan not to ignore asset prices. I remember the piece and recall that Issing was remarkably unclear about exactly what AG should actually do about asset prices, besides keeping an eye on them.

Bubbles are defined as price rises that reverse sharply (pop) rather than deflate smoothly -- those cases where short-sellers “lose their nerve” too soon.

Just another hindsight-guided fudge? Wherever asset price appreciation continued unabated, it was because market foresight worked as expected. Where it reversed sharply, short-sale constraints kicked in because (among other things) short-sellers lost their nerve. Is this a thin reed to rest on when making predictions and forming policies? Short-selling is one of those hazardous speculative activities that people in a market economy self-select into, when they choose it as an endeavor. Only the best survive to do it again. As with all speculation, those of us on the sidelines benefit when the players get it right. Sometimes, they will fail. That’s life.

Social engineering is hard work and, therefore, to be avoided. The same applies to economic engineering. Yet, Milton Friedman, of all people, recently wrote that the FRB under AG is finally getting it right. If so, can he please bottle it?