David French | 2/03/2009 11:01:52 AM

This article was originally published as 'Current market forces taking away all the fun' in The Morning Bulletin on 22nd November, 2008.

In my last column I attempted to explain the difference between price and value. In the current dreadful financial markets, the distinction between price and value is the reason why most financial professionals do not recommend selling into bad markets. It is also at the core of one of the biggest and most damaging fads espoused by regulators and the setters of accounting standards in recent history – marking the carrying value of assets to the current traded price.

Marking to market involves adjusting the value of assets in a company’s balance sheet to the last traded price. Right now, that fad is causing a lot of pain – as market prices fall, so company balance sheets are adjusted. Banks look closely at balance sheets, and noticing the falling asset prices, call in loans. This forces assets to be sold, again forcing prices down. Marking to market exacerbates problems in bad markets, and accentuates unbridled optimism in good times. It completely ignores the fact that prices are only a good approximation of underlying value if certain conditions apply.

The value of any particular asset can be thought of as the sum of the stream of benefits derived from that asset into the future. Price, on the other hand, is the amount for which the asset changes hands, on any particular day. Markets work best when there are lots of buyers and sellers, and where all the buyers and sellers have ample information. If markets are well informed, then over time, we would expect price to approximate value. Right now information is scant, and there are few buyers, so price and value are poles apart.

Some commentators have said that the current turmoil proves that markets do not work. Markets have been around for centuries. They are primarily an information exchange between self-interested individuals, and that exchange of information results in a price being set. Market failure is also nothing new. We have Newstart because the labour market does not work perfectly. We have public hospitals and schools because self-interested individuals will not provide these things of their own accord.

In their current state, financial markets are no fun at all. But what’s the alternative – command economies like China or Russia? Forgive me for my simplistic view, but unless you like the jackboot approach to life, I seem to recall those countries have had a few issues of their own.

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