Arbitrage and Monopolies

I cannot think of a more worthwhile read for those who are interested in credit markets and banking (and don't have the money to subscribe to Grant's Interest Rate Observer) than The Institutional Risk Analyst.

This week's article discusses credit arbitrage and bubbles. I think the key passage of this essay is:

The "bank monopoly" problem was well-outlined in Adam Smith's treatise and well-documented in the past decade by the Cruikshank Report in the U.K. (March, 2000). In simplest terms, whenever the arbitrage process that balances markets is monopolized, crises become commonplace. It is almost definitional that a financial market monopolist cannot "hedge" its "bets." As with the famous Hunt brothers' attempt to corner the silver market, when a monopolist buyer decides to sell, there are no other buyers, so the value of the monopolized commodity falls rapidly. When that commodity is loans, the result is a financial crisis. It is the alternation of "shoot the moon" and "fire sale" which arises when government policy monopolizes credit markets that causes financial markets to vacillate between euphoric bubbles and climactic crises.

I think that it is foolish for policy makers to believe that they can regulate or legislate away volatility, and absolve the markets of booms and busts. Economic booms and busts are offshoots of human behavior: human creativity, fears, greed - all these aspects lead to the change for better or worse.