Sunday, February 28, 2010

Insider Trading, also known as Trading

Anyone who makes an investment is automatically assuming that to at least some extent, he knows something that the market does not know. After all, if the market already knew what the individual knows, then there would be no profit to be made for the individual as the market price would already reflect what the individual knows. This means that markets function precisely because of imperfect information, and a healthy functioning market means that it is always moving in the direction of digesting all of that imperfect information (it never actually reaches a "perfect information endpoint" since information is constantly changing, but it is constantly moving in that direction). If you want to easily understand how critical imperfect information is, imagine for a moment that every entrepreneurial idea that has ever been successful, was at the time it was thought of, also thought of by literally every other person on the planet. What would be the incentive to act on that insight if everybody else already knew it? We benefit from the insights others have that we do not (the entrepreneur went ahead with his project because he knew we did not know how to do what he wanted to do, and as a result we can now use whatever it is that he created). We benefit from imperfect information.

The reason why insider trading is called insider trading is because there is presumed to be something harmful about a single person or group of individuals knowing something about a company that all other investors do not know (as if it is even possible to make sure all investors have the same information). As a result, the individuals that have the inside information about the company might be able to profit significantly from this knowledge. But doesn't each person in the world have completely different information, about just about everything, from everyone else? And doesn't each person always try to better his own life using information he hopes nobody else has? If we don't punish the already infinite number of instances in which people differ in the knowledge they possess, why do we make this special exception when it comes to investing? Once we understand how a healthy market should function, it becomes clear that people profiting from information as soon as it is available is precisely what we should want.

Let's assume publicly traded Company X has very good news that is going to be released in a few days. Scenario A is such that all the good information about the company is effectively kept secret; this information is released only after those few days go by and investors only act on this information after those few days have gone by. Scenario B is such that some individuals inside Company X begin aggressively buying the stock in anticipation of the good news and leak the information to other individuals in the marketplace who also begin aggressively buying the stock so that the price of the stock goes up well in advance of those originally intended few days. Let's now compare the two scenarios. The purpose of a market is to efficiently allocate resources given all available current and future information. If Company X has good news to deliver in a few days, it is far more efficient for the price of Company X to have capital move in its direction now thus making its price rise now (Scenario B) rather than all of this happening in a few days (Scenario A). Why should we, as market participants, accept a few days of inefficient resource allocation when we don't have to? Don't we want good companies to get rewarded as soon as possible and bad companies to get punished as soon as possible? The benefits to the marketplace of these things happening at all are much greater than worrying about who pocketed a few extra dollars in the process! A market works most efficiently when it reacts immediately to all information. Keeping inside information forcibly secret by punishing its premature release is actually harmful to a healthy functioning market, and therefore harmful to society.

Once this concern over small groups of individuals profiting from information before many other people (as if this is the only way for profits to be made) is properly understood, it becomes apparent that the support for laws against insider trading, at its most fundamental level, is actually about nothing more than what I would call "information welfare." Information welfare is the concept of trying to provide everyone with as much equal information as possible so that somehow everyone can profit from this information at the same time (as if everyone having equal information will somehow allow everyone to benefit simultaneously). It is literally an attempt to create intellectual equality that hopefully leads to financial equality. But if, as we saw above, everyone were to actually possess the same information, what would be the incentive for acting on this information if everyone else had it as well? Similarly, in a theoretically perfect socialist system, what would be the incentive for people to produce more than average if they will immediately have the surplus taken away and redistributed? Both welfare in money and information welfare might be a result of having laudable goals in mind, but implementing them is disastrous to everyone involved.

There should exist no insider trading laws whatsoever, specifically for the benefit of everyone in society. Let all insiders trade on information as soon as it becomes available. This means faster exposure of corrupt businesses as well as faster exposure of successful businesses. The sooner capital flows away from where it shouldn't be and towards where it should be, the better. Don't we want to know which companies are succeeding and which are failing as soon as possible? Do you really care if someone gets rewarded while revealing a company like Enron is a fraud? Don't you care more about knowing the company is a fraud, than if a group of individuals inside the company made money exposing to you and the rest of society that the company is operating in a fraudulent manner (and allowing you to avoid ever unknowingly subjecting yourself to the harmful ramifications of doing business with this fraudulent company)?

Rather than vilifying and punishing inside traders, we should be thanking them for the critical and irreplaceable function they serve in the market.

Friday, February 26, 2010

Friedman refutes... himself

Milton Friedman, both prior to and after his passing, was one of the 20th century's most influential economists. Friedman was the leader of the Chicago School of Economics which generally posits that the free market is the ideal economic system to pursue, except when it comes to money (Friedman helped create the withholding tax, contrary to free market principles, but I am giving him and the Chicago School the benefit of the doubt by saying they still tend to support free markets even though they deviate enough from the free market that my benefit of the doubt might be unwarranted!). I would like to focus here on Friedman's support of a central bank, because I consider it most ironic that an individual who really was so often a supporter of the free market, found one glaring part of economic theory in which he supported intervention in the market.

One of the reasons why Friedman defended having a central bank that controls the currency, against proponents of a gold standard, was because he saw in the gold standard a significant cost to the market in utilizing it. There are extraction costs, for instance, to take the gold out of the ground. Friedman concluded that if under a gold standard the quantity of gold will grow by approximately 3% per annum, there is no reason why we could not have something grow by a similar 3% per annum at a lower cost (like paper currency) without the gold at all.

In a 1986 paper in the Journal of Political Economy called "The Resource Cost of Irredeemable Paper Money," Friedman writes:
In earlier discussions, other monetary economists and I took it for granted that the real resource cost of producing irredeemable paper money was negligible, consisting only of the cost of paper and printing.
In this manner, Friedman admits that when determining the cost of a paper standard in contrast to a commodity standard, his analysis of cost was based on solely the cost of creating the money (and in fact he is correct that printing paper is cheaper than mining gold). But what Friedman overlooked, and admits as much, were the other costs to society of using the paper rather than using the gold (this error that he made is a basic economic fallacy first explained by the economist Frederic Bastiat, called "the seen vs. the unseen"). He continues:
Experience under a universal irredeemable paper money standard makes it crystal clear that such an assumption, while it may be correct with respect to the direct cost to the government of issuing fiat outside money, is false for society as a whole and is likely to remain so unless and until a monetary structure emerges under an irredeemable paper standard that provides a high degree of long-run price-level predictability.
Friedman is saying that our experience with a paper money standard has shown that the price level is far from stable and/or predictable, the way that it was for decades in the 19th century under the gold standard. As a result of this instability and unpredictability, there are costs to the economy that he did not originally consider. And since the costs to the economy of a paper money standard might be greater than those of a commodity standard, one of the main reasons why Friedman originally supported the paper money standard, vanishes.

Unlike Keynes whose refutation of his own work was never explicit, Friedman eventually realized the error of his ways. It is true that Friedman still adamantly opposed returning to a gold standard (I believe mostly for practical reasons), but at least he came to some sort of realization that the free market alternative is beneficial in ways that are not even apparent at first glance (something I might arrogantly argue he, of all people, should have realized at the outset). To that extent one could say that by the end of his career, Milton Friedman truly had a better grasp of how the free market functions than he did during the majority of his career. If only this could be said of all economists, some of whom unfortunately reveal that they can't tell the difference between a free market and a managed economy, blaming the former for a crisis that occurred as a result of the latter.

Thursday, February 25, 2010

Lord of the Housing Market

I came home, opened Bloomberg to see the latest financial news, and found out that, President Obama might ban foreclosures. I was more humored by reading this than shocked, the latter being the likely reaction of the average person who might instinctively just be surprised at the blatant exercise of power (and rightfully so).

The reason I found this to be so funny is because banning foreclosures it not very different from setting a price floor on the price of houses. In economics, we know that price fixing of any kind (price ceilings or price floors) always fails. The reason is because there is a market-clearing price for every good and service, so if you artificially set a price that is either above or below the market-clearing price, you end up with either shortages or surpluses. Price floors lead to surpluses.

In this instant, the surplus we are talking about is in individuals who will want to sell their houses at artificially higher prices. The problem is that buyers will not want to buy the houses at artificially higher prices. They would want to buy them at the lower market price, which is of course why this ban is being instituted in the first place (foreclosures would bring housing prices down).

There is not a single episode in history when price fixing has worked. The most recent glaring example (aside from rent control which exists to this day and causes shortages in housing) were the price ceilings on oil during the 1970s. Not surprisingly, this caused oil shortages all over the country. There is no reason to believe that President Obama will be the first individual in the history of mankind to institute price fixing and have it work.

Market prices exist for a reason, which is to efficiently allocate resources throughout the economy. When prices are manipulated because you don't like where they are, it doesn't mean that your manipulation will be a success (unless resource dislocation is defined as successful). If we do actually end up with a ban on foreclosures we can expect it to take longer for the housing market to recover (which will happen only if and when the price fixing is ceased and the market can clear). Not only will buyers be unwilling to buy, banks will also be less willing to lend since they don't have the ability to foreclose (would you make a loan to someone if his default didn't give you the ability to take ownership of his collateral?). Considering what the administration is trying to achieve in this financial crisis (presumably, a resumption in house purchases and a resumption in bank lending) does this sound like the proper way of going about doing so?

Wednesday, February 24, 2010

How does one disprove an infinitely open-ended belief?

The argument that fiscal and monetary stimulus is guaranteed to stave off a recession at some adequate quantity, has made me start thinking about other similarly infinitely open-minded beliefs. For instance, the claim that if one were to jump hard enough, one could get 100 feet in the air. How does one disprove such a belief? The reason it is difficult is because the proponent can simply say "well if you aren't reaching 100 feet, then you aren't jumping hard enough which is the requirement."

In the financial realm right now we hear that if the current quantity of fiscal and monetary stimulus is not turning the economy around, it means that we need more. But does there come a point when we can say that fiscal and monetary stimulus, no matter how large, does not in fact turn an economy around?

We know that during Japan's lost decade its government made it the most indebted nation in the world. In addition, its monetary authorities pumped incalculable quantities of money into their economy but that did not work either. In the United States right now the government has already passed the largest stimulus plan in history and the Federal Reserve has pumped trillions of dollars into the banks. But we have not yet recovered.

When will it be safe to say that there is something fundamentally flawed about the theory of fiscal and monetary stimulus being able to turn around an economy? Is it possible that in the past, in less severe economic situations, it only appeared that the fiscal and monetary stimulus turned the economy around when in actuality it was something else?

Tuesday, February 23, 2010

What is the purpose of the U.S. Constitution? A Practical Inquiry

Strict constructionists believe that the U.S. Constitution should be interpreted exactly as it was written. Even if certain words found in the document have a meaning today that is different from the meaning at the time of ratification, the meaning at the time of ratification should be used. Based on this understanding, society today obviously does not reflect the society that the U.S. Constitution would support. In that case, the U.S. Constitution has failed to function in one of the two manners it could have been intended to function (strict vs. loose interpretation).

On the other hand, loose constructionists suggest that the interpretation of the U.S. Constitution can change over time. Theoretically, the manner in which it is interpreted today could be entirely different from the way it was interpreted yesterday. In that case, the U.S. Constitution is pointless. What is the point of having the Constitution beyond its functioning as a simple procedural tool (since any of the non-procedural sections of it can change at any time and therefore don't have much eternal meaning) whose otherwise grand function is to tell us how to re-interpret the document any which way we desire? That is, not to mention the fact that the procedural sections aren't always followed either. And what makes the procedures in the Constitution (assuming those are the only aspects of it left that remain static, given that all the substantive aspects can be re-interpreted) any better than a different set of procedures we might design today that could also allow us to re-interpret it (or another document for that matter) any which way we desire?

The U.S. Constitution has either failed to achieve its purpose of restricting the government or it has no meaning since it can always be re-interpreted. What is the purpose of the U.S. Constitution?

Monday, February 22, 2010

Can we ever do too much for our children?

While riding in an elevator today, I was made aware on a TV screen that pediatricians want hot dogs and candy to be redesigned to prevent children from choking. No, I'm not joking. This advice is straight from the American Academy of Pediatrics.

Dr. Lee Sanders, an associate professor at the University of Miami Miller School of Medicine, sums up the article by stating, "I think it's very reasonable to strengthen regulations to prevent choking injuries for children." I couldn't help but start thinking about all the other potential causes of accidents we see in society, and what it would take to try to prevent them all. There is always a cost.

If we pretend that, purely for the sake of argument, the cost of making these changes to hot dogs and candy amounts to approximately $100 zillion (a large amount of money), it should be easy to convince most people that the changes are probably not worth the cost. In fact, there are probably many other more pressing things that the $100 zillion could be used for. So just having parents be vigilant of what their children consume would be much more sensical. But if we can see that a cost so large would make these regulations irrational to enforce, however good-hearted they may be, then we should also say that if the marginal cost of these regulations is even a tiny bit above the marginal benefit of having them then enforcing them in such a scenario would also be foolish. After all, if the marginal cost were greater than the marginal benefit, this is by definition telling us that there are better uses of capital than spending it on modifying hot dogs and candy.

Well then who exactly did the analysis to determine these regulations are worthwhile? And how did they determine this? The answer obviously is that nobody bothered to calculate the costs since the benefits are automatically taken to be a good thing no matter what. Side note: this could actually describe the vast majority of legislation and regulation that comes out of the government, unfortunately. It is likely the case that modifying the shape of hot dogs and candy is going to cost far more than having parents take responsibility for what children consume. Therefore, these regulations should never be permitted to pass until someone even begins to do a cost-benefit analysis.

And by the way, the best entities to conduct these calculations are the businesses who produce hot dogs and candy, because they eat (yes, pun intended) the consequences of making food that could cause children to choke and therefore force the businesses to lose customers. The very fact that these businesses still exist in society profitably means that the public finds there to be more benefits than harm from the food that these businesses produce. Rest assured that if this children-eating-hot-dogs-or-candy-often-choke pandemic were really as bad as these doctors imply, the businesses would have gone the way of history long ago. After all, would you take your children to eat food that is widely known to cause other children to choke?

Sunday, February 21, 2010

Keynes refutes... himself

In response to the financial crisis, governments around the world have engaged in unprecedented fiscal and monetary measures to try to avert catastrophe. Since the bulk of these policies are generally deemed to be "Keynesian" in nature, I thought it might be interesting to re-evaluate what it is that Keynes actually prescribed for economic downturns. The Spring 1995, Volume 17, No. 3 issue of the Journal of Post Keynesian Economics, in a piece called "What Keynes Really Said About Deficit Spending," differentiates between the beliefs that have been ascribed to Keynes with that which Keynes actually advocated based on his writings. There is much wrong with Keynesian economics from a pure economic theory perspective (such as the supposed instability of the free market, the ability of extra-market institutions to improve upon the free market, etc.) but there is something more basic that is wrong about Keynesian economics that both economists and non-economists should understand. It is not enough to be an advocate of a certain policy on its own immediate merits, one must take into account the implementation aspects of that policy as well as the practical implications of its acceptance.

The authors summarize Keynes' policies for the capitalist economy when it appears unstable as follows.
1. As the normal circumstance of a capitalist system would result in insufficient private investment, where total investment is less than the amount of saving that would be generated at full employment, social investment would be necessary to maintain full employment. Further, since fluctuations in private investment are likely to occur, the investment plans of public and quasi-public entities should be designed so that they could be varied in a countercyclical pattern.
Throughout the article the authors emphasize that the misunderstanding people have about Keynesian economics is with its nuances, most of which people typically ignore. In the above summary, it is argued that far from advocating widespread and significant government investment in an economy during a downturn, Keynes specifically advocated social investment. The authors of the piece do not give examples of what they mean by social investment, but the idea is that it is investment in an industry that serves some type of general public benefit. Furthermore, government investment should vary in a counter-cyclical manner, meaning it should increase during a downturn and decrease during an upturn.

The non-economic problem with this admittedly more nuanced explanation of Keynes' beliefs is that from an implementation and practical perspective, those nuances mean almost nothing. A metaphor is now in order. Imagine a scientist comes up with the theory that if a man jumps off a building but flaps his arms fast enough, he will be able to fly rather than fall to his death. I guess it is theoretically plausible that if a man did flap his arms fast enough he might fly (though who knows exactly how fast that might have to be), but we can say very confidently that any man who tries to do this is going to fall to his death. So the nuance is that the scientist said the man has to flap his arms very fast, but practically speaking that isn't going to happen so the man will just fall to his death. What this means for Keynes is that his advocacy of only certain government investment at only certain times is irrelevant because the government as an institution is not built to differentiate between those distinctions.

We know the government differs from private business because it does not have a profit and loss mechanism. A private business makes money by offering a good to the public that the public in turn voluntarily purchases. If the public buys enough of the good, the business prospers. If the public does not buy enough of the good, the business might fail. The government on the other hand "makes money" through taxes, which means that the public is required to give up its money. There is no comparable voluntary component the way there is with a private business. If the government fails in a certain policy and runs a deficit, it need only increase taxes. Imagine a private business failing and then requiring that people hand over their money to keep it afloat!

As a result of these characteristics of the government, it will never come close to staying true to what Keynes might have said. Why just have social investment when you can have social and private investment, that way every interest group in society can benefit (and re-elect the individuals who enacted those "charitable" policies). Why increase social investment only during a downturn if you can increase social investment perpetually? Remember that the government bears little cost for these policies as a result of not being subject to the profit and loss mechanism that every other institution in society is subject to. If you didn't have to bear the cost of what you did, would you restrict yourself? Obviously not. So how can we (or more importantly Keynes, the 20th century's most admired economist) expect the government to do that?

Criticism of ubiquitous and perpetual government spending and deficits as an equivalent criticism of Keynesian economics might not be entirely fair given Keynes' nuanced thoughts on government spending and deficits, but at the same time Keynes does nothing more than refute himself by not thinking through the implementation and practical implications of what he suggested the government do in a downturn. It is therefore not unreasonable to consider modern day government policy as Keynesian, all those nuances notwithstanding.

Update from Taylor:

"you may wish to clarify that deficits dont occur when policies fail, but when expenditures outstrip tax revenues, and theyre made up for with borrowing, which is just future taxation"

Taylor is correct. I was making the assumption that a failed policy, similar to a "policy" that fails in a private business, is one that ends with a loss (in the case of government, one that ends with a deficit). Strictly speaking, a deficit occurs when expenditures outstrip tax revenues, whether or not one considers the policy to have failed. 

Thursday, February 18, 2010

Marshmallow Test

I recently read a fascinating article in New York Magazine by Jennifer Senior about the intense competition that 4 year olds face (or more likely their parents face) in New York City when it comes to both taking exams (yes, as 4 year olds) and getting accepted to the best schools (for kindergarten). While I have neither a degree in education nor a degree in child psychology, and therefore would not normally post on such a subject, there was one paragraph near the end of the article that really got me thinking because of its nuanced connection to the field of economics. After delineating in the article some of those different exams that 4 year olds are often expected to take, and the evaluation process associated with picking which children go to which school, the author ends with this tidbit:
But my money’s on the marshmallow test. It’s quite compelling and, apparently, quite famous—Shenk talks about it with great relish in The Genius in All of Us. In the sixties, a Stanford psychologist named Walter Mischel rounded up 653 young children and gave them a choice: They could eat one marshmallow at that very moment, or they could wait for an unspecified period of time and eat two. Most chose two, but in the end, only one third of the sample had the self-discipline to wait the fifteen or so minutes for them. Mischel then had the inspired idea to follow up on his young subjects, checking in with them as they were finishing high school. He discovered that the children who’d waited for that second marshmallow had scored, on average, 210 points higher on the SAT.
What immediately struck me after I read this was that the psychologist took the economic concept of time preference, which is the basis of the phenomenon known as the interest rate, and decided to observe it on a micro level in children to see if it correlates with success. Time preference is the idea that we would be willing to forgo consuming something right now, if we could have more of it at some point in the future. Obviously, if offered to have an equal quantity in one or the other time period, we might as well take it now.

Most interesting is how we typically see time preference play out in society: individuals who are more financially successful have a low level of time preference, which means that they are willing to defer consumption to the future. In contrast, less financially successful individuals have a higher time preference, which means that they are more inclined to consume today rather than wait until tomorrow. Keep in mind that financially successful individuals could have achieved their success through any of a number of different paths with any of a number of different character traits or skills, but they generally share in common the characteristic of low time preference. And while correlation does not imply causation, it seems reasonable to consider that at least some ability to look forward is required before an individual becomes successful, rather than becoming forward-looking after success has already been achieved.

While tests administered to children might evaluate various skills, it is not as though future successful individuals necessarily possess all of those evaluated skills or even some of those evaluated skills. It seems more likely, with successful individuals spanning the gamut in just about every way (type of success, method of success, personality, beliefs, etc.), that a better gauge of success is not something concretely tested on an exam like math or writing, but something that could vaguely be described more as the individual's "approach," "outlook," or "way of being" that, when combined with any of those concrete traits (or maybe even none of those concrete traits), will produce a successful individual. Is it therefore possible that this seemingly primitive marshmallow test, based on a theoretical economic precept, is superior to all those exams that evaluate how well a 4 year old puts blocks together because it actually tests for something that successful individuals generally share in common?

Wednesday, February 17, 2010

Growing Debt Paradigm (GDP)

The study of modern economics gets broken up into the macro and the micro. Of all the complex equations that one solves while studying macro and micro, one of the few that probably gets remembered is that of GDP, or gross domestic product. GDP is composed of consumption, investment, government expenditures, and net exports. Now that my studies in this field have long been completed, I can't help but wonder about the logic behind the premise that we measure growth in an economy through the four components listed above. If economic growth is desirable, doesn't it take no more than every consumer to take out as big a loan as possible and spend it in the economy to make GDP go up? And doesn't it also take no more than the government to decide on a few trillion dollar expenditures (or more) to make GDP go up? And doesn't it also take no more than the central bank to print the currency ad infinitum to weaken its exchange rate versus foreign currencies, and therefore make our exports and subsequently, GDP go up? There is something fundamentally wrong with each of these actions moving the supposed growth parameter upwards. In fact, based on the above descriptions and how consumers, government, and the central bank actually behave in reality, GDP is more of a measure of growth in debt than it is of legitimate economic growth. The next question then is: so what is an accurate measure of economic growth? I would argue that this is largely irrelevant given that what we are trying to do is measure the health of the economy. Let me elaborate.

The most important function of an economy is that it satisfies consumer wants; it is not important, necessarily, to produce and then consume as much as possible. Here is an example: imagine a small economy on an island whose inhabitants don't like to work very much. They produce very little and consume very little and this makes them perfectly happy. A modern economist would look at this situation and gasp that the economy might not even be growing year after year. But is this a problem? The inhabitants, by their actions, don't want the economy to grow. They are happy because the economy is satisfying their wants. The more accurate measure of the health of this economy is if there are no institutions that in some way hamper consumer demands from being satisfied, or even add a minor cost to the satisfaction of consumer demands. Would it be an improvement if we had a government-like entity on this island that took resources from the inhabitants and made them work longer hours so that it could "produce" and then "consume" more? Or what if this government-like entity borrowed in the inhabitants' names and then required that they work off these debts for years to come. These actions would make the island's GDP go up.

The GDP metric fails even for its stated purpose of calculating economic growth because it actually calculates growth in debt. But irrespective of this wish to determine the level of growth, we should be determining how free an economy is from artificial impediments so that we know whether or not consumer demands are being met to the fullest extent. We should not necessarily be concerned about how quickly or slowly an economy is growing, ignoring entirely these more vital questions.

Tuesday, February 16, 2010

To stop, or not to stop?

The 20th century economist F.A. Hayek developed the concept of spontaneous order, which he described as, "that which is the result of human action but not of human design." Taken to the extreme, spontaneous order could imply that humans are entirely capable of organizing and progressing themselves without the existence of individuals or institutions such as the government, which direct society in a certain manner rather than allowing it to direct itself. Spontaneous order exists all around us if we stop for a moment to realize just how astonishingly pervasive it really is. This is precisely why I found it to be of no particular surprise that when traffic lights were installed in the city of Las Cruces, New Mexico, accidents increased by 18 percent. In fact, this type of outcome is the reason why the cities of Drachten in the Netherlands and Bohmte in Germany have decided to remove their traffic signs: to improve road safety.

One way to see this mechanism at work is through a simple thought experiment. Let's envision two main scenarios, each with two sub-scenarios. The two main scenarios are: one scenario in which you are sober and another driver is sober, and the second scenario in which you are sober and another driver is drunk. The two sub-scenarios are: one sub-scenario in which there is a traffic light, and the second sub-scenario in which there is no traffic light.

So what happens if you and another driver, both sober, approach an intersection with a traffic light? Whichever one of you has the red light will stop, and the other driver will continue on his merry way. You are both following the established rule that red light means stop and green light means go. What happens if the same two drivers approach the intersection and there is no traffic light? Both drivers are likely to slow down (out of fear of not knowing who should go first) and through common gestures/courtesy determine who is to go first. In both of these cases, the outcome is similar (there will be no accident) because when both drivers are sober, many accidents can be avoided no matter what the circumstances. So this first set of scenarios does not reveal very much.

Now we can look at the scenarios in which you are sober and the other driver is drunk. If you both approach an intersection in which you have a green light and the other driver has a red light, there is a good chance that as a result of being drunk, the other driver will continue through the red light and crash into you as you go through the intersection. The institutionally imposed rule that red means stop, now means nothing at all. In contrast, if you both approach an intersection (you sober, he drunk) in which there is no traffic light, you are likely to notice that as you approach the intersection, the other driver is not paying any attention to you and/or not slowing down (remember, he is drunk). Common sense would have you slow down and simply let the other driver do as he pleases so you stay out of harm by waiting for him to pass. In these two scenarios we see that at a time when we want traffic lights to function best (when a driver is drunk, careless, daydreaming, etc.), they are likely to function worst.

These scenarios could all be made more complex/nuanced/realistic but the point is that humans spontaneously adapt when having to create their own norms rather than relying on and having those norms created for them by an external person or institution.

As a side note, in the case of two drunk drivers, there isn't necessarily something that can save them based on these simplistic scenarios that I created, but we can at least see that not having traffic lights is superior in the case of one sober driver and one drunk driver. But I am also willing to bet that, though I can't think of a way at the moment, spontaneous order would find a way to safely deal with multiple drunk drivers. That above all is spontaneous order's most impressive characteristic: the ability to create spontaneously and unexpectedly.

Monday, February 15, 2010

Does size matter?

In the February 8, 2010 issue of New York Magazine, Hugo Lindgren analyzes the politics behind the proposed regulatory reform in response to the recent financial crisis. Though he posits that politically, the reforms are a good idea, he suggests that the reforms might not actually serve their intended function. It is this latter point that I wish to focus on here. Lindgren perceptively asks the following questions:

If the size of institutions is at the core of the problem, what explains the 140, mostly tiny failed banks last year that cleaned out the reserves of the Federal Deposit Insurance Corporation? Was it really proprietary trading that drove banks to the brink…?

These are questions that not only expose the flaws in current regulatory proposals, but also beg an even more important question that I will address shortly. But first, let’s unpack some of the above insights. For all the fanfare about “the big banks” and “too big to fail,” there is something peculiar about the stigma applied to these large financial institutions when their smaller counterparts faced the exact same fate. As a result, we can state definitively that size had absolutely nothing to do with bringing down the banks. Size just makes for exciting news segments.

In terms of the proprietary trading element, the analysis is very similar. Proprietary trading desks are no doubt risky ventures with bank capital exposed to levered trading, but again, if smaller financial institutions with no proprietary trading desks whatsoever failed as well, then we can state definitively that proprietary trading had absolutely nothing to do with bringing down the banks. It is a fundamental component of economic analysis that correlation does not equal causation; it is true that the big banks had proprietary trading desks and it is true that the big banks failed, but it is not necessarily true that having proprietary trading desks means that banks will fail. Volcker, are you listening?

And finally, it is most critical to take Lindgren’s argument one step further. If we observed that banking institutions, consumer businesses, real estate, and just about every other element of the modern economy tanked in unison, then the culprit we should be looking for in some way spans the entire economy, not just a few specific segments of it. I can think of only one piece of the modern economic puzzle that fits this description: money. Well, who controls the type, quantity, and price of money? The central bank.