Should regulators call the market? It has been a matter of vigorous debate in the regulatory community since the crisis. ‘Cleaners’ think you shouldn’t mess around with the market, although be prepared to clean up if markets collapse. ‘Leaners’ take the opposite view, divided between those who want to lean on the asset side of overheated balance sheets, principally by increasing capital requirements, and those who want to lean on overheated liabilities, using an ingenious accounting method called ‘matching adjustment’, which allows firms to reduce the present value of future liabilities by increasing the rate at which they are discounted. If spreads blow out on your assets you are allowed to add some of that spread to the discount rate for your liabilities, which cushions the impact in the short term.
This article focuses on whether economists can identify trends or bubbles in the residential property market. The question is important for insurers, whose balance sheets have been damaged by the protracted fall in long gilt yields, and who are hunting for yield in alternative assets such as commercial and residential property. I asked three economists for their views.
John Cochrane of Stanford’s Hoover Institution, author of the magisterial Asset Pricing, complains about a common misunderstanding: ‘people say the market can’t be efficient, because it didn’t predict the 2008 crash. That’s exactly backward. Efficient markets theory says that the market aggregates all information that people have – and no more. The market is not clairvoyant. Consequently, the central empirical prediction of the efficient markets hypothesis is precisely that nobody can reliably tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences.’
…click on the above link to read the rest of the article…