Wednesday, July 23, 2008

Learning about markets

Despite its academic cachet and theoretical appeal, I've never been much of a believer in the idea that markets are truly efficient. Free and open markets are a pretty good tool in a wide variety of circumstances. They are an equilibrium tending process both theoretically and (usually) in practice. However, they consist of monkeys buying and selling stuff (capitalism is an animal behavior pattern after all) and they occasionally suffer from the flaws associated with this status. I've never believed markets were completely efficient, because if they were, I wouldn't have a job and companies would in general not have profits, both of which predictions are verifiably false.

What I don't understand about the current market crisis is all the people who claim we have recently learned something fundamentally new about markets. Even a cursory knowledge a financial history extending beyond the last 10 years will show you that a boom-bust credit cycle tied to over-investment in real estate is the most often repeated error in all of capitalism. We've got literally two centuries of examples of this phenomenon, from all over the world, with all different kinds of economic backdrops, states of technological development, and monetary conditions. We've got an entire century of data about how this phenomena occurs even when there is a lender o last resort. The current situation is the most predictable, least surprising economic fact I can think of. We have run this experiment literally hundreds of times; we know how it ends.

So, when someone like Paul De Grauwe in the linked article, claims that we have now had a cherished myth about markets destroyed, that only now it has become apparent that unregulated financial markets are not perfect, I go nuts. On two levels.

First, I can't possible see how this is surprising. All the fancy econo-physical models about risk and volatility and rational expectations and whatnot were obviously and transparently wrong right from the beginning. Anybody who has spent any time at all actually looking at how a business or a stockmarket works knows this immediately and intuitively -- the only way to make money is precisely to avoid the places where there is an eficient market. Make whatever model you want, but don't ask me to be shocked when it turns out that assuming the cow is a point in space isn't good enough to turn you into a dairy farmer.

Second, stop coming to conclusions about how markets have failed us when in reality all that has happened is that the reality of these markets hasn't corresponded to the toy model you made of them. It reminds me of the idiocy of people in the 90's saying that the USSR collapse somehow proved that "communism doesn't work". The truth is that you can't come to any conclusions about "markets" from the current experience, because the financial system doesn't even come close to resembling a free, open, and transparent market. The problem here is that there are three definitions of "market" involved in this discussion -- the economist's efficient market, real functioning markets (of which they are many concrete examples called 'commodities businesses' which no one is very excited about owning in general, the current euphoria for this sector aside), and the most common type of market, which is not at all free, but a system which whole going under the name of the 'free' market is actually rigged by the biggest players to their own advantage via the political system. The implosion of Freddie and Fannie has absolutely nothing to do with the first two definitions of the market because these companies never ever operated in a truly free market. They have always been the classic example of a government sponsored private monopoly -- the precise opposite of what a market is supposed to be.

This is why it drives me so nuts when the opportunistic moralists come out of the wood-work to proclaim that "unregulated markets have failed". Because there is no such thing as an unregulated market -- it's a complete oxymoron. The only unregulated market is the one where we go around hitting each other over the head with sticks and dragging women back to our caves by their hair. All real markets are regulated extensively with legal systems defining and enforcing property rights, contracts, etc ... There can be no market without regulation. The question is whether the regulation puts everyone who wants to play the game on the same foot, or whether it unfairly advantages the biggest players in the game. The current crisis is a failure of regulation -- that regulation failed to create the conditions of a free market because (among other things) it let people who knew they would be bailed out by the government gamble with other people's money. The current crisis is not a failure of anything resembling a "market" -- but it is a dramatic failure of something vaguely resembling a government.

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