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Free markets have been absolutely great in providing incentives for entrepreneurs and as a way to allocate resources to their best uses. However, markets have great strengths, but also some weaknesses and limitations.

We feel it is of the utmost importance participants in financial markets have a keen understanding of these, as financial markets in particular have certain weaknesses that are not always fully considered. Most notably the information asymmetry problem, which we will discuss below.

We will argue below that a proper understanding of the weakness of financial markets could have prevented countries building up a total debt nearing 10x their GDP, for instance. In fact, it could have prevented much of the 2008 credit crisis. But first some basic understanding.

What are 'free' markets?

What one really has to realize is that real-life markets are quite different from the textbook version you get in economics101. In real life, there is no auctioneer, who keeps announcing prices until all markets clear (that is, supply exactly equals demand) before which no trading can take place (that is, there isn't any trading away from equilibrium).

Markets are social institutions that do not exist in a void. For instance, they need an institution that guarantees and enforces property rights. Without that, trading partners cannot be certain that the other side of the trade will keep their part of the bargain. Often, 'alternative' types of property rights enforcements will emerge, like the Mafia (which has its historical roots exactly in this).

Markets need also need predictable, impartial institutions to settle disputes, that is, Courts of Law. People who feel aggrieved by a transaction need to have a method of redress.

Transaction cost

While in textbook versions of markets, parties can instantly find one another, costlessly assess each other's capabilities and offers, instantly compare them with all other offers, effortlessly settle on price and terms, monitor the other side of the transaction to see whether they perform as promised, having costless redress if they don't, etc..

In short, textbook versions of markets have no transaction cost, but in real life, these are substantial. So substantial, in fact, that in many cases, transactions are actually handled by other institutions than markets, a fact that is often overlooked.

Apparently it's more efficient to execute numerous transaction within the context of a firm, rather than over arms-length market relations. There is even a branch of economics ('transaction cost theory') researching what transaction characteristics and under what conditions are more efficiently carried out within a firm.

We won't go into that literature here, but the conclusion that can be drawn from it is that markets are apparently not so perfect as to not to leave room for other mechanisms of resource allocation to operate, like the firm (or hybrid forms). Even under conditions of free choice.

The textbook version of perfect competition might be the dream of the free-marketeers, it basically is a nightmare for firms who would have to operate under these circumstances, as they're simply reduced to price takers, not being able to differentiate in any way from the competition, and therefore earning no rents. It's a completely commoditized world.

Which is why you see a host of strategies to gain 'market power,' some of them conducive to economic growth (innovation, for instance), some of them not (like collusive behavior).

Which is why markets need enforcement of rules, like a competition policy and agency. This to keep a level playing field, as markets left by themselves have a tendency to tilt that field to the advantages of a few companies.

Luckily enough for firms, the textbook version of perfect competition is extremely unlikely in real life.

Market failure

Of course the economic literature is rife with other cases of market 'failures' apart from firms. For instance, public goods (for which no price exists as the consumption is both non-rival and non-excludable, that is, buyers have to be forced to pay for them, like national defense).

We have external effects (welfare consequences falling on others than those directly involved in the transaction, like pollution), we have the 'tragedy of the commons' (creating incentives for overuse of a commonly owned resource, like the world's fishing stock) and many more. But perhaps the most important one, especially for financial markets, is the following.

Information asymmetries

Life is getting ever more complex, due to increasing division of labor, and specialization. Products and services are also getting more complex. This has enormous repercussions.

For an increasing number of products and services, it simply becomes impossible to ascertain their quality and other characteristics and claims. If you hire a lawyer, buy a second-hand car, select a dentist, buy a medical insurance program, basically any complex product or service, you're basically taking a leap of faith.

The leap of faith is that the claims regarding the quality (and other characteristics) of these products and services are facts. The combination of information advantages (the proverbial second-hand car dealer knowing more about the car than the buyer) and opportunistic behavior (the propensity to exploit these information advantages) can become quite problematic to the unaware or the trusting. Many a buyer of the proverbial second-hand car has found this out the hard way.

There are mechanisms that provide some counterbalance to the risk of being exploited by transaction partners having informational advantages:

  • Seller's reputation, which might suffer if the product/service doesn't live up to the claims. This works best in a business with repeating customers (or community setting, where people exchange information)
  • Warranties: producers can offer warranties, which makes them suffer if they don't perform
  • Information transparency, for instance, one could rank doctors on performance of specific interventions. Or we could simply force companies to explain on labels what is really inside 'fresh' orange juice
  • The 'wisdom of crowds,' For instance, websites aggregating consumer experiences.
  • Independent review, for instance, testing and rating agencies.

However, these mechanisms only go so far.

Information asymmetries can easily lead to a low-quality equilibrium. In a famous paper, George Akerlof ("The Market for Lemmons") described how this worked in the market for second-hand cars. Since people can't readily assess the quality of the car, they have little incentive to pay premium prices for supposedly premium cars.

As a result, sellers have no incentives to sell premium quality cars either, as they can't fetch premium prices. The market gets stuck in a 'low-quality equilibrium,' clearly a market failure as both parties could be made better off without this problem.

Information asymmetries plague the insurance market, for instance. Medical insurance companies want the most healthy clients, but exactly these have the least incentives to join. And because they know more about their health than the insurance companies, this leads to the adverse selection problem where the health risks of the insured are considerably worse compared with the overall population.

Once insured, people have less incentives being careful as some of the consequences (like those of a burglary) are shifted to the insurance company.

Markets simply need regulation in order to protect against the worst of information asymmetries. If you belief this isn't necessary, why not take that to its logical conclusion and abolish the FDA, for instance. Do you really want to take the claims of drug companies about new medicines face value, without any independent vetting?

Would you really eat anything if the quality of food additions was no longer independently assessed and done away with in the name of useless regulation hindering business creating jobs, leaving you to take the claims of food processing companies face value or not buy them at all?

Without regulation, how much longer would cigarette companies have been able to claim that smoking isn't related to a host of serious illnesses or isn't addictive? Would they still be able to hire doctors to blurb in adverts that 80% of doctors smoke X brand, as was done in the early 1960s?

We can go on and on. The upshot is, that with increasing complexity of products and processes, the need for regulating to protect consumers from being exploited by informational disadvantages is increasing as well, and perhaps even more so in financial markets, where information often is the main component of a good or service.

Financial markets

Financial markets are largely anonymous, which makes any reputational remedy inoperative. The wisdom of crowds often gyrates between greed and fear and independent reviews often turn out to be considerably less independent. So none of the remedial mechanisms that mitigate the risk of being exploited by information asymmetries is working well in financial markets.

If you have any doubt about how information asymmetries in financial markets might constitute a rather serious problem, think what you are actually buying when you buy a share in a company. Have you ever wondered whether the person you bought the share from (which you're unlikely to know) knows more about the company (and hence the real value of the share you just bought) than you?

If you still think that entirely unregulated markets are a wonderful thing, have you ever considered what would happen if we remove important regulation and the institutions that are enforcing these, like the SEC? Have you ever invested in companies that are listed in exchanges with regulation 'light,' like the pink sheets?

The exploitation of information advantages is absolutely rife there, it's perhaps the most dominant game in town. Look at the myriad of penny stock letters promising you the next 10 bagger (almost invariably selling these shares when the gullible are buying and/or getting a nice commission from the company).

The 2000-2008 housing bubble is almost a textbook case where multiple parties were ruthlessly and methodically (robocop signing, anyone?) exploiting information advantages. Many banks sold mortgages to people who they knew (or could have known) couldn't possibly afford them, and repackaged these mortgages into triple A rated securities to get them off their own balance sheets as fast as possible. Not only to shift the risk on others, but to clean the balance sheet to rinse and repeat.

This stuff was so complex they came with prospectuses of several hundred pages and opened great avenues for more opportunistic exploitation of information asymmetries. Investment banks like Goldman Sachs could stuff this onto clients, tell other clients to short it (or even design the product) and get commission both ways (or even trade themselves).

Regulators either looked the other way or had been co-opted through revolving doors or given insufficient means or funds. And so it could happen that massive private debt, a giant shadow banking system, a housing bubble, a near completely unregulated giant derivatives market and other curious phenomena of the wild heydays of unregulated finance emerged, with little benefits to the economy as a whole and an in-build capacity for disaster. The best rendition of quite how this happened is probably still from Simon Johnson (former chief economist of the IMF) "The Quiet Coup."

The United Kingdom, where at least part of the financial markets were equally lightly regulated, now sits on a total debt of almost ten times GDP as a result. Most of that debt is private and originated in the financial sector.

Simple regulation could have prevented stuff like the financial crisis of 2008 or the massive debt in the UK today. Maxima on leverage, maxima on short-term funding of banks, keeping mortgages related to income and house values, requiring downpayments, Capital adequacy for banks, too big to fail meaning too big to fail, or, in relation to the MF Global scandal, simply prohibiting or at least limiting re-hypothecation of client securities, stuff like that.

Not all countries suffered from exploding finance. There was a time, not long ago, that banks were boring and concentrated on financing real business, rather than betting the bank on the next synthetic financial product on unregulated markets. The difference invariably was better regulation. But these lessons are already being forgotten with the reappearance of the narrative that less regulation is always better and concrete efforts to reverse course.

So the simple but rather profound conclusion is that markets, more especially financial markets, cannot perform their wonders for society in getting resource there were they're most productive if they aren't properly regulated. There is a wealth of theoretical and empirical evidence of what can happen if this simple truth is violated. The recent credit crisis is only one, albeit a rather destructive one.

Markets are finely-tuned mechanisms, but they need fine tuning in order to provide the best results for society as a whole, and not just for a few participants.

And we haven't even touched other problems in financial markets, like herd behaviour and self-reinforcing feedback loops.

Source: Why Free Markets Are Not Always The Best Solution