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29-Jun-2006
Market Imperfections, from Victor Niederhoffer

The book Market Failure or Success, edited by Tyler Cowen and Eric Crampton, is a collection of articles about when and if markets fail, and the solutions that the market comes up to preclude failure. It deals extensively with the role of prices in providing information. Two contrasting views are tested:

  1. Prices are signals that takes account of our imperfect knowledge to balance supply and demand.
  2. Prices are set to ration demand so that those with better information will not be induced to purchase at the market price.

The book deals with such topics as credit rationing, price rigidities, path dependence, quality uncertainty, frictional costs, lock-ins, opportunistic behavior, prisoner's dilemmas, loan guarantees, kinked demand curves. Articles presenting the modern idea that government intervention is necessary everywhere because markets don't work, mainly based on the work of Akerlof, David, Samuelson and Williamson, are presented. Next, empirical tests and market-solution articles are presented to show that such market imperfections are solved by the market.

The articles get me thinking about the current moves by the Fed to remedy what they see as a market imperfection. The question is whether individuals are not alert enough to the dangers of inflation, and businessmen are too ready to pass on prices because they mistakenly feel inflation is going to be more likely than it would be with a vigilant Fed. Thus, the dignitaries at the Fed and their counterparts all over have been dispatched to pass on the message that the Fed will prevent inflationary expectations from taking root. The minutes, the statements, and everything else have been coordinated in this direction.

The market solution would be that market prices provide a better signal of what inflationary expectations are then the anecdotal feel and ideas as to the resoluteness and steadiness of the head man at the Fed.

I notice there is a cyclical pattern of moves following Fed meetings, where the signaling effect of one regime, kicked off by a meeting, is followed by an opposite effect following the next meeting. Such a solution would be consistent with a Hayekian view of stock prices, which provide relevant information about the activities of an extended order of sophisticated buyers and sellers of equity capital.

In line with the signaling effects of Fed meetings, I note that when there is a big decline in S&P 500 from one meeting to the next, measured from the close one day before the meeting, there is a tendency for a reversal in conjunction with the next meeting as measured from the close one day before to the close one day after:

Date of Price Change(%) since Price Change(%) from Day Before
Meeting Previous Meeting to Day After Meeting
10 31 2005 -2.4 1.4
05 02 2005 -1.4 1.0
08 09 2004 -6.1 1.1
03 15 2004 -3.0 1.7
01 28 2003 -4.1 -1.6
09 23 2002 -7.7 0.8
08 12 2002 -7.1 1.8
06 25 2002 -7.5 1.9
05 06 2002 -9.6 3.4
01 29 2002 -3.6 2.6
10 01 2002 -11.5 3.0
08 20 2001 -3.1 -0.7
06 26 2001 -3.1 0.5
03 19 2001 -14.8 -3.4

As the total correlation between price moves the month prior and the next two days is insignificant and close to zero, this was approved by the Minister of Non-predictive Studies.

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