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Transparent Inefficiency

April 20, 2010

My economic libertarianism has waned pretty significantly in the wake of the financial crisis, but I’ve always said that my version of libertarianism countenanced the possibility of systematic market failures arising from externalities, information asymmetries, network goods, and so on.  That’s simply written into economic theory.  Perfect competition, as so many economists will tell you, is almost always theoretical rather than actual, and it’s where the theory runs into practice that room for legitimate political disagreement emerges.  After all, politics is often called “the art of the possible.”  Reminds me of a joke I like to tell:

A priest, a politician and an economist are stuck in the bottom of a well.  The priest says to the other two, “Come brothers, let us pray, and God shall deliver us forth from this well because we have faith in the Almighty.”

The politician and economist look at each other, shake their heads, and scoff at the priest.  “That’ll never work,” says the politician.  “What we need to do is put ourselves on the line here.  Here’s the plan: economist, you stand on this priest’s back, and I’ll climb up both of you to get out.  As soon as I’m out, I’ll call for help and come back for both of you.”

Now it’s the priest and economist who are openly skeptical and laugh at the politician.  The priest says, “Yeah, I’ve heard that sort of thing from a politician before.  You’ll get out and you’ll never look back for us.  I’m not trusting a politician on this one.”

The economist all of a sudden snaps upright, and exclaims, “Guys, it’s really quite simple!”  The politician and priest listen expectantly.  The economist explains, “All we have to do is assume a ladder.”

The question of how understanding that markets usually don’t act the way they should in theory ought to affect one’s politics relates to which “systematic inefficiency” is going to outweigh the other: is it the result of the market’s natural inefficiencies or the potentially fraught, misguided, and often corrupt attempts of government to meddle in those problems that will create worse overall results?  Most people who identify as Democrats believe the former, most who identify as libertarian believe the latter.  In the wake of both the financial crisis and the Obama Administration, I have come to believe that unregulated markets has the potential to cause much more havoc than a decidedly well-intentioned administration.

Back in the day when products were more often traded outright, rather than in the form of bundled financial products, the price signaling of free, everyday transactions was a pretty effective way to ensure efficient and well-regulated markets.

The economist’s presumption is that freely-chosen acts of market exchange are good things: win-win. This presumption can be overturned:

  • Perhaps those buying do not understand what they are really buying.
  • Perhaps the seller is misleading the buyers.
  • Perhaps the active exchange itself the motive for other bad actions outside the narrowly economic sphere (when the existence of British demand for tobacco, sugar, and cotton triggers the growth of plantations in and around the Caribbean and makes it worth people’s while to wage war in Africa to steal slaves, then that market for cotton, sugar and tobacco is a bad thing, even though both the sellers and the buyers of cotton, sugar and tobacco like it).

I would posit that now, more than ever, information asymmetries define our markets.  The reason for this is that everything has become traded in the form of a financial product at a much earlier and more removed stage than simple exchanges of goods.  Therefore, since every financial product involves an element of information being traded, asymmetries are much more likely to arise between traders.  I think Brad DeLong’s recent post conceptualizing the nature of financial markets in market theory does a damn good and pithy job of explaining this on a conceptual level.  It’s short and worth your time to read the whole thing.  Thankfully, DeLong does point out that the financial system is not an entirely mistaken venture; information exchanges (essentially hedging and day-trading are, in essence) can create huge win-win trades:

  1. Trading money now for money later: people who want to save now and spend later can make win-win trades with people who want to spend now and save later.
  2. Risk: people who are unusually averse to risk in general can make win-win trades by trading off some of the risks that they are bearing to people who are unusually tolerant of risk in general.
  3. Insurance: people who are holding a lot of one big risk can reduce the risk of catastrophic loss by paying a great many others to each take a small piece of that risk.
  4. Information: people who have information that prices are going to rise can make win-win deals with people who have information that prices are going to fall–although here the win-win is not for the participants in the trade: for them it is zero-sum, and the winners are those others who observe the market price at which the trades occur.

As trite as it sounds, knowledge is power.  And when all transactions are potentially impaired by unequal knowledge–and therefore, bargaining–positions, government needs to step in and knock heads to prevent the economy from becoming a lemon.

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One Comment leave one →
  1. April 20, 2010 3:46 pm

    slickricks notes:

    “* Perhaps those buying do not understand what they are really buying.
    * Perhaps the seller is misleading the buyers.
    * Perhaps the active exchange itself the motive for other bad actions outside the narrowly economic sphere”

    Precisely.

    Add to this the high level of feed-back skewing and essential non-linearities in economic systems ( Nicely elaborated upon in Paul Ormerods “The Death of Economics”) together with the vagaries of nature (of which the results of volcanic activity are a current reminder(, our lack of ability to usefully predict or control economic outcomes should be blindingly obvious. But (to put metaphors into the blender) our species still insists in sticking its head in the sand and clutching at straws!

    So what does determine outcomes? My own book “Unusual Perspectives” explains how important evolutionary processes rather than human intentions are the active component. (Adam Smith and Keynes are among those who have previously glimpsed such processes) The electronic edition can be freely downloaded from the eponymous website. However, those who live and breath economics without taking full account of the real world will be totally lost in this wild landscape.

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