It’s not so hard to explain:

The conditions under which transactors can use the market (repeat-purchase) mechanism of contract enforcement are examined.  Increased price is shown to be a means of assuring contractual performance.  A necessary and sufficient condition for performance is the existence of price sufficiently above salvageable production costs so that the nonperforming firm loses a discounted stream of rents on future sales which is greater than the wealth increase from nonperformance.  This will generally imply a market price greater than the perfectly competitive price and rationalize investments in firm-specific assets.  Advertising investments therefore becomes a positive indicator of likely performance.

That’s Klein and Leffler, JPE, 1981, who shy away from making the prurient explicit.  This is one easy way to get a demand curve sloping upwards, namely you only trust the person if she is receiving lots of money.  But what’s the point of preventing shirking if you’re going to be self-incriminating?

Investors collectively spend around $100 billion a year trying to beat the stock market. That’s the finding of a rigorous effort to measure the total costs of Americans’ efforts to surpass the returns they would have received by simply holding a stock index fund. The huge price tag helps explain why beating a buy-and-hold strategy is so difficult.

Here is much more, and from Felix Salmon.  You can think of this sum as the amount it costs to keep markets relatively efficient, a source of societal fraud and rent-seeking, a Nash equilibrium mixed strategy (no one tries to beat the market on every margin), a donation to the broader social good, or most properly all of the above.  Interfluidity adds comment.

Here is a very interesting article in German on the controversy surrounding Stan Liebowitz, Felix Oberholzer-Gee, and Koleman Strumpf and the issue of whether illegal file-sharing has hurt music sales.  An English translation is here; Craig Newmark reports as well.  The upshot is that Liebowitz has been attacking the Oberholzer-Gee and Strumpf claim that illegal downloads do not much hurt music sales.  Liebowitz claims that the original paper, published in the JPE, is incorrect.  In English, here is Liebowitz’s side of the story.  Here are our earlier posts on the Oberholzer-Gee/Strumpf paper.  Here are quotations by Koleman Strumpf.  Does anyone have a link to a further defense by the paper’s authors?

Paul Krugman runs through some basic scenarios.  Remember when Philip Cagan asked why open market operations are performed in terms of money and T-Bills rather than other assets?

The final whammy may be this: the socialist calculation debate (remember that?) is now working against rather than for recovery.  Market prices communicate vital information but that assumes a critical mass of market participants is actually trading.  When trading dries up, prices go away.  When prices go away, the costs of trading rise and fewer people wish to trade.

Felix Salmon notes:

My feeling is that the credit markets are hysterical. They’re
not clearing, they’re not acting efficiently, and spreads, especially
on highly-rated debt, are much higher than credit risk alone could ever
account for.

Trading in junk bonds hasn’t been "right" since the fall.  Many of the markets for short-term debt securities are becoming illiquid as well.  Why markets are self-destructing in this way remains a puzzle; dump on markets all you want but why here and now?

Loyal MR readers will know that I am usually an economic optimist but at the moment I am worried.  I don’t see the so-called "real side" of the economy as intolerable by any means.  But a weird financial dynamic seems to be feeding on itself in an unusually violent fashion.  Steve Waldman has an insightful albeit overstated argument; consider this:

The distinction between debt and equity is much murkier than many
people like to believe. Arguably, debt whose timely repayment cannot be
enforced should be viewed as equity. (Financial statement analysts
perform this sort of reclassification all the time in order to try to
tease the true condition of firms out of accounting statements.) If you
think, as I do, that the Fed would not force repayment as long as doing
so would create hardship for important borrowers, then perhaps these
"term loans" are best viewed not as debt, but as very cheap preferred
equity.

Is/was the subprime crisis simply a mask for a more general revaluation of the meaning and extent of liquidity?  Are such revaluations always so bumpy and so lacking in locally stable iterative processes?  As the Chinese would say, we live in interesting times.

Can the real interest rate be negative in a world where some but not all goods can be stored costlessly? Consider for illustration an economy with two goods, immortal potatoes and transient haircuts, with both items currently selling for $1 and both given equal weights in the CPI. If you put $2 into a 1-year TIPS with a real interest rate of -1% in that world, next year you’d have the ability to purchase 0.99 potatoes and 0.99 haircuts.

Why buy the TIPS when you could simply save the $2 in the form of 2 potatoes and still have those same 2 potatoes a year from now? If nothing else changes, and 2 potatoes were still worth 2 haircuts a year from now, everybody would want to do just that. If we were in long-run equilibrium before the real rate went negative, in response to a negative real interest rate, everybody would want to buy potatoes today as an investment vehicle. The price of potatoes today would have to be bid up to a point above the long-run equilibrium so that from here, potato prices are expected to rise less quickly than the price of hair cuts. Your 2 potatoes might be worth 2 haircuts today, but if they’re only worth 1.96 haircuts next year, you might be just indifferent between an investment in TIPS or physically storing the commodity.

Here is much more.  Greg Mankiw, among others, has pointed out that we are seeing negative real rates of return in some credit markets.  I don’t read this as a reflection of intertemporal preferences and constraints.  I read this as a (scary) sign of how segmented some credit markets have become.  More concretely, lots of people are running to Treasuries but out of a general sense of fear rather than from rational calculation.  Right now rational calculation is very difficult, agency problems are causing people to avoid the possible blame that can result from risky assets, and credit market arbitrage isn’t much working.  It’s no longer clear how much information prices are reflecting.