The limitations of markets

Economists aren't often as vocal as they should be about the limitations of markets -- especially the extreme assumptions required for them to deliver superior outcomes and some kind of "efficiency." I've documented here before some of the exuberant cheer-leading for the wonders of modern markets that was the norm before the financial crisis of 2008. No self doubt or balanced criticism about the dangers of markets there.

Now, only a few years after the crisis -- and with a global economic crisis just looming up before us -- the old hysteria is again getting underway with calls (especially from US politicians) for more privatization to get the damned inefficient government out of everything. For an intelligent, fact-based perspective, I'm simply going to quote the following extended discussion from economist Mark Thoma. He deserves a medal for saying what most other economists ought to be saying every day to everyone they meet:

To listen to some commentators is to believe that markets are the solution to all of our problems. Health care not working? Bring in the private sector. Need to rebuild a war-torn country? Send in the private contractors. Emergency relief after earthquakes, hurricanes, and tornadoes? Wal-Mart with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats government every time. Or so we are told. But this is misplaced faith in markets. There is nothing special about markets per se - they can perform very badly in some circumstances. It is competitive markets that are magic, though even then we have to remember that markets have no concern whatsoever with equity, only efficiency, and sometimes equity can be an overriding concern.

In order to work their magical efficiency, markets need very special conditions to be present. There must be full information available to all participants. Product quality, locations and prices of alternative suppliers, every relevant piece of information must be known. Not quite sure if the wine is good or not? That's an information problem. Not sure if the used car has problems? Don't know where any gas stations are except the ones beside the freeway in a strange town? No way to monitor the quality of the building built in Iraq with U.S. aid? No way to be sure if consultants are worth the amount they are being paid? Information problems are common and they can cause substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single buyer or seller's decisions can affect the market price. For example, if a firm can affect the market price by threatening to limit supply, the market does not satisfy this condition. If, as some claim, CEOs are in such short supply that they can individually negotiate their compensation, then the market is not producing an efficient outcome. Whenever there are a small number of participants on either side of the market - suppliers or demanders - this is potentially problematic.

In order for markets to work their magic, the product must be homogeneous. That is, the product or input to production sold by all firms in the market must be perfectly substitutable so that as far as the buyer is concerned, one is as good as the other. If some buyers favor one brand over another, if CEOs are perceived to have different and unique talents, this condition does not hold. In many cases the variety may be worth the inefficiency, not many of us would want just one style and color of shirt to be available in stores, but the inefficiency is there nonetheless.

In order for markets to work their magic there must be free entry and exit. Most people understand free entry, but free exit is sometimes less evident, so let me try to give an example. Starting a blog on Blogger or TypePad is easy. Entry is a snap and you can be up and running in no time at all. It's easy to join the competition and start supplying posts. But suppose that later you decide you want to switch to, say, TypePad from Blogger (or the other way around). That is not so easy. There is no way, at least no simple and convenient way, to export all of your old posts from Blogger and import them into TypePad, a significant barrier to exit if a large number of posts must be moved. Whenever barriers exist in markets that prevent free movement into and out of the marketplace or between firms within a market (on either side - there are sometimes barriers to purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can be no externalities, no public goods, no false market signals, no moral hazard, no principle agent problems, and, importantly, property rights must be well-defined (and I probably missed a few). In general, the incentives that the market provides must be consistent with perfect competition, or nearly so in practical applications. When the incentives present in the marketplace are inconsistent with a competitive outcome, there is no reason to expect the private sector to be efficient.

Markets don't work just because we get out of the way. When government contracts are moved to the private sector without ensuring the proper incentives are in place, there will be problems - waste, inefficiency, higher prices than needed, etc. There is nothing special about markets that guarantees that managers or owners of companies will have an incentive to use public funds in a way that maximizes the public rather than their own personal interests. It is only when market incentives direct choices to coincide with the public interest that the two sets of interests are aligned.

If there is no competition, or insufficient competition in the provision of government services by private sector firms, there is no reason to expect the market to deliver an efficient outcome, an outcome free of waste and inefficiency. Why would we think that giving a private sector firm a monopoly in the provision of a public service would yield an efficient outcome? If the projects are of sufficient scale, or require specialized knowledge so that only one or a few private sector firms are large enough or specialized enough to do the job, why would we expect an ideal outcome just because the private sector is involved? If cronyism limits the participants in the marketplace, why would we expect an outcome that maximizes the public interest?

There is nothing inherent in markets that guarantees a desirable outcome. A market can be a monopoly, a market can be perfectly competitive, a market can be lots of things. Markets with bad incentives produce bad outcomes, markets with good incentives do better.

I believe in markets as much as anyone. But the expression free markets is often misinterpreted to mean that unregulated markets are all that is required for markets to work their wonders and achieve efficient outcomes. But unregulated is not enough, there are many, many other conditions that must be present. Deregulation or privatization may even move the outcome further from the ideal competitive benchmark rather than closer to it, it depends upon the characteristics of the market in question.

For government goods and services, when incentives consistent with a competitive outcome are present, we should get government out of the way and privatize, and there are lots of circumstances where this will be appropriate. There is no reason at all for the government to produce its own pencils and pens, buying them from the private sector is more efficient so long as the bids are competitive.

When competitive conditions are not met but can be regulated, the regulations should be put in place and the private sector left to do its thing (e.g.  mandating that sellers disclose problems with a house to prevent asymmetric information or mandating that government funded projects be subject to competitive bidding and monitoring to ensure contract terms are met). There's no reason for government to do anything except ensure that the incentives to motivate competitive behavior are in place and enforced.

But rampant privatization based upon some misguided notion that markets are always best, privatization that does not proceed by first ensuring that market incentives are consistent with the public interest, doesn't do us any good. There are lots of free market advocates out there and I am with them so long as we understand that free does not mean the absence of government intervention, regulation, or oversight, even libertarians agree that governments must intervene to ensure basics like private property rights. Free means that the conditions for perfect competition are approximated as much as possible and sometimes that means the presence - rather than the absence - of government is required.

Lobbying pays off handsomely -- visual proof

From an article in The Economist, a graph showing the performance of the "Lobbying Index" versus the S&P 500 over the past decade. The Lobbying Index being an average over the 50 most intense lobbying firms within the S&P 500. It's pretty clear that lobbying -- a rather less than honourable profession in my book -- pays off:

The Fetish of Rationality

I'm currently reading Jonathan Aldred's book The Skeptical Economist. It's a brilliant exploration of how economic theory is run through at every level with hidden value judgments which often go a long way to  determining its character. For example, the theory generally assumes that more choice always has to be better. This follows more or less automatically from the view that people are rational "utility maximizers" (a phrase that should really be banned for ugliness alone). After all, more available choices can only give a "consumer" the ability to meet their desires more effectively, and can never have negative consequences. Add extra choices and the consumer can always simply ignore them.

As Aldred points out, however, this just isn't how people work. One of the problems is that more choice means more thinking and struggling to decide what to do. As a result, adding more options often has the effect of inhibiting people from choosing anything. In one study he cites, doctors were presented with the case history of a man suffering from osteoarthritis and asked if they would A. refer him to a specialist or B. prescribe a new experimental medicine. Other doctors were presented with the same choice, except they could choose between two experimental medicines. Doctors in the second group made twice as many referrals to a specialist, apparently shying away from the psychological burden of having to deal with the extra choice between medicines.

I'm sure everyone can think of similar examples from their own lives in which too much choice becomes annihilating. Several years ago my wife and I were traveling in Nevada and stopped in for an ice cream at a place offering 200+ flavours and a variety of extra toppings, etc. There were an astronomical number of potential combinations. After thinking for ten minutes, and letting lots of people pass by us in the line, I finally just ordered a mint chocolate chip cone -- to end the suffering, as it were. My wife decided it was all too overwhelming and in the end didn't want anything! If there had only been vanilla and chocolate we'd have ordered in 5 seconds and been very happy with the result.

In discussing this problem of choice, Aldred refers to a beautiful paper I read a few years ago by economist John Conlisk entitled Why Bounded Rationality? The paper gives many reasons why economic theory would be greatly improved if it modeled individuals as having finite rather than infinite mental capacities. But one of the things he considers is a paradoxical contradiction at the very heart of the notion of rational behaviour. A rational person facing any problem will work out the optimal way to solve that problem. However, there are costs associated with deliberation and calculation. The optimal solution to the ice cream choice problem isn't to stand in the shop for 6 years while calculating how to maximize expected utility over all the possible choices. Faced with a difficult problem, therefore, a rational person first has to solve another problem -- for how long should I deliberate before it becomes advantageous to just take a guess?

This is a preliminary problem -- call is P1 -- which has to be solved before the real deliberation over the choice can begin. But, Conlisk pointed out, P1 is itself a difficult problem and a rational individual doesn't want to waste lots of resources thinking about that one too long either. Hence, before working on P1, the rational person first has to decide what is the optimal amount of time to spend on solving P1. This is another problem P2, which is also hard. Of course, it never ends. Take rationality to it's logical conclusion and it ends up destroying itself -- it's simply an inconsistent idea.

Anyone who is not an economist might be quite amazed by Conlisk's paper. It's a great read, but it will dawn on the reader that in a sane world it simply wouldn't be necessary. It's arguing for the obvious and is only required because economic theory has made such a fetish of rationality. The assumption of rationality may in some cases have made it possible to prove theorems by turning the consideration of human behaviour into a mathematical problem. But it has tied the hands of economic theorists in a thousand ways.

Economists on the way to being a "religious cult"...

A short seven minute video produced by the Institute for New Economic Thinking offers the views (very briefly) of a number of economists on modeling and it's purposes (h/t to Moneyscience). Two things of note:

1. Along the way, Brad DeLong mentions Milton Friedman's famous claim that a model is better the more unrealistic its assumptions, and that the sole measure of a theory is making accurate predictions. I'd really like to know what DeLong thinks on this, but his views aren't there in the interview. He mentions Friedman's idea but doesn't defend or attack it, just a reference to one of the most influential ideas on this topic, I guess. Shows how much Friedman's view is still in play.

In my view (some not very well organized thoughts here) the core problem with Friedman's argument is that a theory with perfect predictions and perfectly unrealistic assumptions simply doesn't teach you anything -- you're left just as mystified by how the model can possibly work (give the right predictions) as you were with the original phenomena you set out to explain. It's like a miracle. Such a model might of course be valuable as a starting point, and in stimulating the invention of further models with more realistic assumptions which then -- if they give the same predictions -- may indeed teach you something about how certain kinds of interactions, behaviours, etc (in the assumptions) can lead to observed consequences.

But then -- it's the models with the more realistic assumptions that are superior. (It's worth remembering that Friedman liked to say provocative things even if he didn't quite believe them.)

2. An interesting quote from economist James Galbraith, with which I couldn't agree more:

Modeling is not the end-all and the be-all of economics... The notion that the qualities of an economist should be defined by the modeling style that they adopt [is a disaster]. There is a group of people who say that if you're not doing dynamic stochastic general equilibrium modeling then you're not really a modern economist... that's a preposterous position which is going to lead to the reduction of economics to the equivalent of a small religious cult working on issues of interest to no one else in the world.

Basel III -- Taking away Jamie Dimon's Toys

Most people have by now heard the ridiculous claim by Jamie Dimon, CEO of JPMorgan Chase, that the new Basel III rules are "anti-American." The New York Times has an interesting set of contributions by various people on whether Dimon's claim has any merit. You'll all be shocked to learn that Steve Bartlett, president of the Financial Services Roundtable -- we can assume he's not biased, right? -- thinks that Dimon is largely correct. Personally, I tend to agree more with the views of Russell Roberts of George Mason University:

Who really writes the latest financial regulations, where the devil is in the details? Who has a bigger incentive to pay attention to their content — financial insiders such as the executives of large financial institutions or you and me, the outsiders? Why would you ever think that the regulations that emerge would be designed to promote international stability and growth rather than the naked self-interest of the financial community?

I do not believe it’s a coincidence that Basel I and II blew up in a way that enriched insiders at the expense of outsiders. To expect Basel III to yield a better result (now that we've supposedly learned so much) is to ignore the way the financial game is played. Until public policy stops subsidizing leverage (bailouts going back to 1984 make it easier for large financial institutions to fund each other’s activities using debt), it is just a matter of time before any financial system is gamed by the insiders.

Jamie Dimon is a crony capitalist. Don’t confuse that with the real kind. If he says Basel III is bad for America, you can bet that he means "bad for JPMorgan Chase." Either way, he’ll have a slightly larger say in the ultimate outcome than the wisest economist or outsider looking in.

Sadly, this is the truth, even though many people still cling to the hope that there are good people out there somewhere looking after the welfare of the overall system. Ultimately, I think, the cause of financial crises isn't to be found in the science of finance or of economics, but of politics. There is no way to prevent them as long as powerful individuals can game the system to their own advantage, privatizing the gains, as they say, and socializing the losses.

But not everyone is convinced of this by a long shot. Just after the crisis I wrote a feature article for Nature looking at new thinking about modeling economic systems and financial markets in particular. Researching the article, I came across lots of good new thinking about ways to model markets and go beyond the standard framework of economics. That all went into the article. I also suggested to my editor that we had to at least raise at the end of the article the nexus of influence between Wall St and the political system, and I proposed in particular to write a little about the famous paper by Romer and Akerlof, Looting: The Economic Underworld of Bankruptcy for Profit, which gives a simple and convincing argument in essence about how corporate managers (not only in finance) can engineer vast personal profits by running companies into the ground. Oddly, my editor in effect said "No, we can't include that because it's not science."

But that doesn't mean it's not important.

But back to Basel III. I had an article exploring this in some detail in Physics World in August. It is not available online. As a demonstration of my still lagging Blogger skills, I've captured images of the 4 pages and put them below. Not the best picture quality, I'm afraid.

Financial Times numeracy check

This article from the Financial Times is unfortunately quite typical of the financial press (and yes, not only the financial press). Just ponder the plausibility of what is reported in the following paragraph, commenting on a proposal by José Manuel Barroso, European Commission president, to put a tax on financial transactions:

Mr Barroso did not release details of his plan, except to say it could raise some €55bn a year. However, a study carried out by the Commission has found that the tax could also dent long-term economic growth in the region by between 0.53 per cent and 1.76 per cent of gross domestic product.

The article doesn't mention who did the study, or give a link to it. But there's worse. If reported accurately, it seems the European Commission's economists -- or whoever they had do the study mentioned -- actually think that the "3" in 0.53 and the "6" in 1.76 mean something. That's quite impressive accuracy when talking about economic growth. In a time of great uncertainty.

I would bet a great deal that a more accurate statement of the confidence of their results would be, say, between 0 and 2 percent crudely, or maybe even -1 and 3. But that would be admitting that no one has any certainty about what's coming next, and that's not part of the usual practice.

High-frequency trading: taming the chaos

I have an opinion piece that will be published later today in the next few days in Bloomberg Views. It is really just my attempt to bring attention to some very good points made in a recent speech by Andrew Haldane of the Bank of England. For anyone interested in further details, you can read the original speech (I highly recommend this) or two brief discussions I've given here looking at the first third of the speech and the second third of the speech.

I may not get around to writing a detailed analysis of the third part, which focuses on possible regulatory measures to lessen the chance of catastrophic Flash Crash type events in the future. But the ideas raised in this part are fairly standard -- a speed limit on trading, rules which would force market makers to participate even in volatile times (as was formerly the case for market makers) and so on. I think the most interesting part by far is the analysis of the recent increase in the frequency of abrupt market jumps (fat-tail events) over very short times, and of the risks facing market makers and how they respond as volatility increases. I think this should all help to frame the debate over HFT -- which seems extremely volatile itself -- in somewhat more scientific terms.

I also suggest that anyone who finds any of this interesting should go to the Bank of England website and read some of Andrew Haldane's other speeches. Every one is brilliant and highly illuminating.