EMH and Financial Bubbles

From the starting point of rational investors came the idea of the efficient market hypothesis, a theory first elucidated by my colleague and golfing buddy Gene Fama. The EMH has two components that I call “The Price is Right” and “No Free Lunch”. The price is right principle says asset prices will, to use Mr Fama’s words “fully reflect” available information, and thus “provide accurate signals for resource allocation”. The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.

In the world of the EMH, as it is known, bubbles are nothing to seriously worry about because prices cannot deviate from proper valuations for too long.

In economics, the invisible hand, also known as the invisible hand of the market, is the term economists use to describe the self-regulating nature of the marketplace. This is a metaphor first coined by the economist Adam Smith in The Theory of Moral Sentiments, and used a total of three times in his writings. For Smith, the invisible hand was created by the conjunction of the forces of self-interest, competition, and supply and demand, which he noted as being capable of allocating resources in society. This is the founding justification for the laissez-faire economic philosophy.

But what if that invisible hand is working in its own interest rather than for the interest of all the participants in the market.

Can Goldman Sachs, the profit-seeking missile of high finance, really make money by investing $450 million in Facebook, at a vertigo-inducing price that values the social-networking company at $50 billion? Facebook’s shares were said to be trading on a private-market exchange at a valuation of $42.4 billion. Thanks to Goldman’s imprimatur, Facebook’s value increased 20 percent virtually overnight. Can Goldman really expect to squeeze more water from this stone? Sadly, yes. To understand why, we have to go to the heart of the many problems in the way the Wall Street cartel does business, despite the promised reforms of the Dodd-Frank law. With Goldman’s investment in Facebook, we have a front-row seat to the process by which Wall Street creates and inflates financial bubbles. Goldman has almost certainly locked up the role of lead manager of the inevitable Facebook initial public offering. Fees for underwriting public offerings are generally about 7 percent of the value of the stock sold. Facebook could easily sell $2 billion of stock or more, generating fees to Goldman and the other underwriters of at least $140 million. The other benefit for Goldman in leading the public offering — aside from major bragging rights — is that it can use its marketing, sales and distribution muscle to make sure the value of Facebook at the time of the offering exceeds the $50 billion valuation at which Goldman invested.

It seems that Goldman has set up a "special purpose vehicle" and alerted top clients that through this SPV they will have the opportunity to invest in an as-yet-unnamed company, which reportedly is Facebook. The way this looks to Felix Salmon over at Reuters, and his explanation makes a lot of sense to me, is that this SPV is potentially a way around SEC reporting requirements for publicly-traded companies. But to me this just looks like a funky retro take on many of the IPO scams of the late nineties and early 2000s, where the investment bank sucks in herds of overstimulated investors, hides the true value of the firm in question from everyone, and then roasts the whole cattle-crowd of wealth-seekers to a crisp through fees and commissions and hidden markups. Back then the carrot was a wave of excited news-media coverage about the "new paradigm" that was going to make financial behemoths out of every online university for dogs or web-based dental floss warehouse that came up the IPO pipeline. This time around it's fantasies like the notion that Facebook is somehow worth fifty billion dollars (it's been interesting to watch which news outlets credulously report that figure).

The first thing you need to know about Goldman Sachs is that it's everywhere. The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled dry American empire, reads like a Who's Who of Goldman Sachs graduates. The bank's unprecedented reach and power have enabled it to turn all of America into a giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumer credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth — pure profit for rich individuals. They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s — and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet.If you want to understand how we got into this financial crisis, you have to first understand where all the money went — and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long — including last year's strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn't one of them.

Financial institutions that are large in absolute size may have deep and well-filled with which they can among other things hire lobbyists, support individual political parties and election candidates, and, under the recent Supreme Court reinterpretation of the U.S. Constitution's first amendment, mount advertising campaigns in direct support of or opposition to election candidates.  In Federalist Paper No. 10, James Medison warned against the political power of factions resulting from "the verious and unequal distribution of property" ... " who are united and actuated by some common impulse of passion, or of interest, adverse to the rights of other citizens, or to the permanent and aggregate interests of the community."

Here I offer only one additional strand of historical evidence ‐‐ Figure 1, drawn by artist Joseph Keppler for Puck magazine, January 23, 1889 ‐ a year before the Sherman Act was passed. 

One cannot view it without recognizing that the U.S. public was alarmed at the time about the political power of the great trusts, for which we might now substitute bloated figures for JP Morgan Chase, Bank of America, and Goldman Sachs.  It would be hard to deny that public concerns over the trusts' power in federal and state legislatures were an important stimulus to the Sherman Act's passage.   And now, 120 years later, there is abundant reason to fear the enormous political power of the financial institutions, said by one writer to own Washington "lock, stock, and barrel."   In 2008, for example, the finance lobby is said to have contributed $475 million to political candidates and their supporting party organizations ‐ more than twice the level of contributions from the second largest lobby, the health care industry.