It's Time to Break the Bubble Cycle

We wrote an earlier piece on July 17 called Socialism for the Rich (Jim Rogers and Nouriel Roubini later came up with similar terminology). Some people are indeed worried that the nature of American capitalism is fundamentally changing. They do have a point. But it can be restored.

In the last couple of decades, the business cycle seems to have been replaced by a 'bubble cycle'

Briefly, what has happened is the following:

• Loose regulation and monetary policy (often a leftover of the previous bubble) enables some asset classes to form bubbles.
• These bubbles (the latest were sub-prime mortgages and the related financial products) create large and very concentrated amounts of wealth for just a very small group of people.
• The bursting of these bubble creates such risks (often systemic risks) that large-scale bailouts are often the only means of dealing with these.
• Funny enough, many of the institutions that created/and or profited from the mess in the first place are the prime receivers of those bailouts (private gains, social losses).
• The bailout and loosening of monetary policy to deal with the mess sets the stage for the next bubble.

Some, like Luigi Zingales (Robert C. Mc Cormack Professor of Entrepreneurship and Finance University of Chicago) and others lament the consequences of the bail-outs. They see it as a fundamental change in the nature of American capitalism, with its emphasis on free markets.

Although we have a good deal of sympathy with his views, unfortunately, most of the measures and bail-outs were probably necessary to preserve a modicum of integration of the financial system. So that is not the problem. Then, what is?

At the core, the problem is one of ideology. The free markets that the supporters purport to defend are a myth. Their version of free markets is a highly abstract one, in which any kind of public mingling is bad almost by definition. "Government is not the solution, it's the problem" sums the whole thing up pretty nicely. The reality isn't nearly as black and white as this old Reagan election slogan suggests.

It's not hard to imagine that in times when the Government is the solution (and the markets are the problem), supporters of the abstract belief in free markets find that their world-view is upset and they cry wolf. But it is that abstract belief in free markets that is wrong.

Any market, to be able to function, needs regulation and institutions which take care of that regulation. No one would question that in order to enforce the execution of contracts, property laws, we need institutions to enforce those laws and mediate conflicts.

Take that away, and sooner rather than later you'll end up with privatized enforcement of contracts, Mafia style (ask the Russians in the early 1990s) and tit-for-tat settlement.

Another increasing problem for markets, in times of increasing complexity and division of labour, is asymmetric information. This is a situation in which one party has an informational advantage over its counterpart in a transaction, the classic example is the market for second hand cars (thanks to George Akerlof, the author of a seminal 1970 article called 'The Market for Lemons' which won him the 2001 Nobel prize in economics).

Asymmetric information can be exploited in transactions, for instance, those assurances you received from the seller of that second hand car might, on closer inspection be just that, assurances. They do not necessarily reflect reality.

For any good or service for which quality is difficult to assess at first hand, this problem potentially exist. Regulation is not always necessary to deal with some of the aspects of the problem, there are market based solutions, for instance:

• Reputation. Works best in repeat business and/or community setting.
• Information transparency. For instance, rank doctors on performance on specific interventions.
• The 'wisdom of crowds'. For instance, website aggregating consumer experiences.
• Independent review. For instance, testing and rating agencies.

Financial markets are rife with asymmetric information problems:

• Managers usually do know more about their company than shareholders, a knowledge advantage that can be exploited. (Which is the main reason we're not against legitimate short selling).
• Do you know more about the financial product than the person you bought it from?
• Is the information your broker provides really that dispassionate and impartial as he claims?

Financial markets also are largely anonymous (you rarely know the counter party of a transaction), and characterized by extreme differences of wealth and power. Now, consider the following problems with these mechanisms in financial markets:

• The anonymity often makes the reputation solution defunct.
• The extreme differences in wealth and power multiply the incentives to deal with information advantages in an opportunistic way and frequently blunt what's left of the incentive to build a reputation.
• The 'wisdom of crowds' is prone to collective waves of manic-depressive alterations of fear and greed.
• The independent reviews often turn out to be, well, somewhat less than totally independent.

Only information does work, but here the problem is that there is too much of it. And which info can you really trust? A website might have a great reputation, but are you really sure the journalist that contributed a nasty piece about a stock you happen to own doesn't have a private agenda? How sure can you be?

Which leaves an important role for regulation -- to keep excesses within reasonable boundaries. But this happens only after a big crisis (like the Glass-Steagall act of 1933). Slowly but surely, existing regulation has been dismantled, or financial innovation has worked its way around it.

The ingredients of what brought us into the present mess are really not terribly complicated to grasp:

1. Loose regulation enabled opportunistic behaviour (taking advantage of information asymmetries) in mortgage markets, and then in the securitization of the risks associated with these (essentially, they were put in a blender and the resulting risks spread as invisible confetti over the financial system).
2. Too much leverage and typical herd behaviour in financial markets magnified the initial problem.

Banks know (or should know) their customers at least to such a degree that the knowledge enables them to make some assessment of default risks. It's not always perfect, but what we have seen in the markets for financial products related to mortgages is that the assumption that markets always come up with the right price signals is not necessarily true, and this has become blatantly obvious now. The 'invisible hand' is not always better than the 'visible handshake'.

Yes, the unprecedented interventions and bail-outs by the authorities are largely necessary. Yes they do change the character of the US capitalism (which indeed has become a form of 'Socialism for the rich', as we earlier argued), but this is born out of necessity, there is no theoretical justification for it.

We need to break the cycle of bubbles inflating on the loose monetary policy and moral hazard leftovers of the authorities dealing with previous bubbles. We need sensible regulation that can prevent much of it. Those that made deregulation a religious belief and regulation always and everywhere a dirty word have a lot of explaining to do.

There is no a-priori argument against a US style free market capitalism (and much to recommend it) as long as it is accepted that markets do not function in a vacuum and need a modicum of regulation and institutional support. And markets for complex (financial) products might actually need a little bit more of that, as opportunities for opportunistic behaviour (taking advantage of asymmetric information abound.

What kind of regulation is necessary? We'll leave the details to the specialists, but the broad direction is not hard to paint:

• Limit leverage
• Force maximum transparency
• A bit more specific, don't allow short-selling before stocks are borrowed. Arguments that naked shorting helps 'liquidity', let alone 'price discovery' are completely nonsensical.

Disclosure: None

Comments

[JasonC:]

Next we can break the cycle of breathing, then the cycle of the heart beating, and the blood flowing (after all, just look at that phrase, "blood flowing", why it practically spins itself).

Stop trying to outlaw nature and economics and reality, and try living with it instead. The American people are the richest in the history of the world, and for a reason. It isn't because they were all clueless and lost until you came along to write strident leading editorials showing them the way out of their hidebound darkness.

It is because they are free.

Free includes free to screw up. Trying to remove risk or instability from economics or markets is trying to remove freedom from life. You can. It results in a state much of mankind has been in for eons, and where many more flock to join them, all the time.

They are dead.

2008 Sep 22 04:31 PM

[css1971:]

You'd have to replace Fractional Reserve Banking with Full Reserve Banking to remove the bubbles, the "business cycle" is just another name for a bubble. It hasn't happened over the last 300 years and it's not going to happen because the people with the controls are making too much money at it.

2008 Sep 22 05:19 PM

[epistemopathy:]

This article is a very nice and concise summary on the problem; one of the best I've seen so far. When will people realize that the popular Neo-Smithian conception of Adam Smith's "invisible hand" is purely magical thinking? Markets cannot be free without laws just as people cannot be free without laws. This is not a paradox if the laws are within reason. Without laws (regulations), we have anarchy, not liberty, and fall prey to those non-governmental forces that have gained their own forms of power. Sadly, the neo-Smithians cannot tell the difference.

2008 Sep 22 06:11 PM

[The Bounty ...:]

This author needs to understand what regulation is first. Regulation is the application of rules. Now, what government does is to apply arbitrary rules. In that case, the regulation is unfruitful and in fact is very detrimental to the free market. As we arrive back at free market capitalism, we see that the rule of law prevails and not the arbitrary rules that are against property rights and individual rights. From these rights stem free enterprise, free markets, free trade, and the best school of all, which is, "Leave us alone!".

2008 Oct 09 03:06 AM