Who Determines Prices

There is a fire brewing in Europe these days. In fact, the fire has been brewing for quite a while. It jus so happens that those who never feel or see the fire are the one proposing solutions. I’m specifically referring to those in the financial policymaking world. Let’s take the example of Greece. Consider some financial facts, as reported by the Financial Times. We are told that the country:

"accounts for only 2 per cent of European gross domestic product. It has been in default for more than half of its history since 1832, running an average fiscal deficit of 7.8 per cent of gross domestic product since 1988.""There has been a centre-right government, until recently, which increased the government's share of GDP from 44 per cent to 52 per cent. The public sector is so inefficient that the cost of public administration is 7 per cent of GDP compared with an average of 3 per cent for the eurozone."

When investors finally awoke from their “Rip Van Winkle” sleep, they began not only to sell the government bonds but also to buy insurance in case the country defaulted. This insurance comes in the form of what is call “credit default swaps” (CDS). In simple english, a CDS is a contract that gives its seller, in exchange for a periodic fee, the contractual obligation to cover the loss of the underlying asset should an agreed-upon-event occurs. For example, a company that owns Greek government debt can make a deal with another company: The former agrees to pay X amount on a periodic basis, in return the latter agrees to pay the loss if the underlying asset (i.e. Greek debt) does not perform well.

What has begotten headlines lately is the so call “naked” buyers. No, this does not mean a trader is naked when he buys a CDS. On the contrary, the folks who trade in the swaps market are paid handsomely enough to fly to Milan to have their suits tailor-made. In any event, the practice of “naked” buying refers to those firms who buy CDS [i.e. insurance] without owning the underlying Greek debt. The logic goes that these individuals have a vested interest in seeing the government default because it means huge payouts. In other words, they benefit from the continued deterioration of the country’s finances and by extension the social unrest that inevitably happens. Of course, Greek politicians and international technocrats who have little understanding of how markets work latch on this issue as if it were the progenitor of the mess that is currently happening.

I will not enter into a missive about the morality, if you will, of CDS. In fact, there is nothing immoral about it. It is absolutely satisfactory whenever individuals, acting in a voluntary manner, come to whatever agreement they deem to be in their best interest. Government’s only role here would be to enforce the contractual obligation. The exponential growth of the CDS market, and derivatives in general, has been the result of an excessively loose monetary policy. Therefore, without completely exonerating financial firms, ultimately central bank officials are responsible for pumping this bubble.

Having digressed for a bit. The heart of the issue here is the misunderstanding of the law of supply and demand in determining prices. It doesn’t matter what politicians or other policymakers believe. This law is as solid as the law of gravity. In laymen terms, the law states that at any price higher than equilibrium, sellers are stuck with too much inventory and therefore must decrease prices to get rid of it. Sellers prefer a loss that is above zero. In other words, a seller will always prefer to sell something, say, at $10, which might have caused the individual to loose, say, $20; but this is always preferable to any loss exceeding $20. Conversely, at a price below equilibrium, there are more buyers than available supply. In this instance, prices must increase. The right price will be that which buyers and sellers mutually agree upon. That said, it is important to note that prices are ultimately contingent upon consumer behavior. This is the key insight, yet often overlooked and misunderstood by policymakers, into the supply/demand analysis.

Let me say it another way, always and everywhere consumers determine prices. In the case of “naked” buyers of Greek government CDS, they are essentially betting that the underlying asset will loose value. Said differently, these traders believe that prices are too high and therefore must fall. However, they have no firepower to influence the fall of prices, if in fact it does happen. What causes prices to fall is when consumers of Greek government debt (i.e. those who bought its debt) no longer believe it is worth holding the financial asset. Therefore, they sell. The seller may bid a price lower than what the consumer offered. The latter has an option: accept or do not accept. The other option is to buy insurance, i.e. buy CDS. In any event, the consequences are obvious. It’s that simple.

It is worth repeating the corollary of the law of supply and demand: consumers determine prices, not sellers. Speculators have no direct influence beyond proving market price information to other segments of the sector.