Mark to Market?

(this article was written on April 12, 2009 and posted on my facebook)

Today, I read this article at the request of a friend. It describes the new policy that will ease the use of mark-to-market accounting. Under the new policy, banks will be able to "set a price that would be received by a bank in an 'orderly' transaction in the current, inactive market".

The fact is, these "toxic" assets are worthless. The banks should take write-downs because the assets are not worth the prices they were selling for. The prices were inflated.

The only observable value of any asset, good, or service, in exchange, is subjective. The price of a good is the amount of money someone is willing to pay and another is willing to take as payment for said good. In a market such as the ones in which stocks, bonds, swaps, and other securities are traded, prices are free to float about and change constantly. They are not "sticky" as are prices for other things (such as gasoline, books, or shirts).

The prices of these "toxic" assets have fallen because no one is willing to pay an inflated price for them. This new accounting policy, as well as the policy of expanding the money supply (or credit), will do nothing more than re-inflate the prices. This may seem, to the man in the street, to be no problem. Just keep the prices up and we'll be fine! No. This inflation only makes it more and more difficult for people to value the assets. The economy cannot recover if failed companies and worthless assets are not allowed to fail or their prices to fall.

The idea that we need the prices to rise is absurd. If you are going shopping, do you want bread to be expensive or cheap? Obviously, falling prices are a good thing for people who are buying them. Not only that, but they are good for the people selling them. Entrepreneurs depend on prices to tell them whether or not they are providing benefits to the people they are serving. If they are not, they will have to adapt or fail. In their place, then, can rise someone who may have a better grasp on how to better serve the preferences of the people. The failed entrepreneur, then, can find employment where he or she is better suited.

The most absurd thing that this policy assumes is that some group or another can determine what the value of these assets should be. Should we rely on the banks to determine this? Should we rely on the government to value them? How exactly do these small groups of people know any better what value people will place on these assets than the mass of people themselves?

If we say this will depend on moving averages of past prices, we tacitly assume that past preferences and valuations are proper for the current circumstances. This is patently absurd. Yesterday, company X may have been a wonderful company. Today, it may have made some egregious error and tomorrow the news of this error may come out. Is the value of that company tomorrow the same as it was yesterday? If the error is large enough, it is certain that some will value the company less. Company Y may value a credit default swap at some rate yesterday, but today may have received some other information about its debt position or its performance that may drive its managers to value another interest rate higher than the one previously swapped for. It is the same for any other security, asset, good, or service. New information provides for new valuation.

What can be said of this new policy? It seems to me that it may be the beginning of a financial dark ages. If so, we can be sure that our economy will not experience real growth for a long time.