Huh

In a previous post I argued for the idea of regulation within an economy. Today I want to take one example from the current economic crisis, of a types of regulation I think are beneficial. First a quick overview of the economic crisis. For those interested, I’d point to some good podcasts on the issue: Fresh Air’s show with Michael Greenberger and This American Life’s show, called “Another frightening show about the economy” both of which give a more in depth discussion than this blog. And, while both shows utilize overlapping sources, I’ve found other resources echo their conclusions. With that out of the way, here we go.

The first point I want to make, the overarching point, is the ability to trade across political boundaries, the use of information technology and financial engineering has resulted in both more prosperity and more risk. We are all connected in a real time complex adaptive system which can change direction quite quickly and without any predictability.  Credit default Swaps are the nexus of the current economic crisis and highlight the advantages and disadvantages of our current global economic system.

In the late nineties companies started offering Credit Default Swaps (CDS) as a form of insurance to buyers and sellers of corp. bonds. A CDS is basically a contract wherein a buyer gets insurance from a seller against a third party’s default on a bond. Kinda like house insurance where I insure my house against burning down by paying the insurance company money each month in exchange for them promising to make me whole if disaster should strike. So far so good, but a CDS can also be used for speculation, in other words, I can buy insurance against your house burning down even though I don’t have any ownership stake in your house whatsoever. Kinda strange, I know, but here’s the thing, if I have a hunch your house is going to burn down it would be cool to make money on my hunch. But, what if I’m not 100% convinced your house will burn down? No problem, I turn around and sell a CDS to someone else, this way I’m covered. If your house burns down someone pays me and I pay someone else, if it doesn’t burn down then while I’m paying the premium on the first CDS I’ll be collecting revenue from my sale of the second CDS. If I’ve done it right, my hunch came earlier than someone else’s, my premium being paid out will cost me less than the premium I’m receiving. These latter type of transactions, where everyone “netted” their trades (both a buyer and a seller of risk) was the rule rather than the exception. In fact, of the $5 Trillion in corp. debt there is an estimated $62 Trillion in CDSs. In other words, for every $1 of corp debt there is approximately $10 of speculation. That’s what’s called leverage and it’s all interconnected. As you can guess, if one party fails to pay off their obligation it will ripple and multiply throughout the system. On the other hand, if leverage works, it means credit is easier to get, more things are built, more investment is made, more jobs are created…

In 1998 regulators started arguing the CDS market should be regulated. The counter argument, made by both the Clinton administration as well as Phil Gramm Republicans, was the buyers and sellers of these products are sophisticated consumers, and, as such, let the free market work. In 2000 Phil Gramm slipped an amendment into an omnibus bill making it law that CDSs would not be regulated. As I understand it, not one senator (Democrat or Republican) opposed the amendment. But here’s the rub. The economy is situated within a larger interconnected system. If there is a disruption because of these financial instruments then a large number of “innocent bystanders”, people who had no part of the transaction, will be harmed. Meaning, there’s a role for government to at least regulate this market enough to know if harm is coming and to minimize some of the chances for harm.

Not allowing these instruments is draconian and counterproductive. Insurance has a long history of being useful in capitalist economies, it encourages risk taking and provides people with a partial shield against bad luck. Even the kind of speculation involved in CDSs where the owners of the bond were not involved has it’s advantages. It encourages the spreading of information and the interconnection of agents that allow for more leverage.

However, historically insurance as an industry has been regulated. Companies have to have a certain amount of capital reserved in case they are forced to pay off insurance policies. Further, there is a certain amount of transparency in the transactions so other players can adequately gauge risk and reward. These are the kind of regulations that should have been in place for the CDS market. As written right now, a CDS is a private contract between two consenting parties. There is no way for anyone to see how much was paid for a CDS or even how many players own or sold CDSs. Further, there is no mechanism to make sure the sellers of a CDS are adequately capitalized.

These last three points are key, without a transparent pricing system, if there’s a shock to the system (like the sub-prime crisis) there’s a lack of trust in the marketplace. No one knows who’s balance sheet is real, further due to the interconnection of all these transactions a bank failure in Indonesia can hurt an American hedge fund six steps removed. The lack of a central clearinghouse means no one knows where these, as Buffett called them, “financial weapons of mass destruction” are located. The govt. has no idea how bad things can or will get and neither does anyone else. Finally, because CDSs were not regulated there was no way of making sure a seller was adequately capitalized and it encouraged more players into the market thus increasing the likelihood there would be this kind of a crisis.

Which brings me back to regulation. In a complex adaptive system, like an economy, regulation must allow for changes, growth and the death of individual agents but minimize the risks of the whole system suddenly going through a radical reorganization. Not because radical reorganizations are neccesserily bad in and of themselves but because humans and human society needs time to react and adjust. Further, regulation should minimize some of the more extremes of group psychology (like panic) while also combatting harmful concentrations of power and knowledge.  In retrospect, we can only wonder if things in the CDS market would be as bad if pricing was transparent, purchases were registered with a central clearinghouse and sellers were forced to be adequately capatilized.

Free markets are the best means for efficiently allocating society’s economic resources… except when they’re not. Given the U.S.’s current economic morass I thought I’d blog a little about why a free market needs regulation.  First off, it’s worth noting an economy is a complex adaptive system. Meaning, it consists of interactions by a large number of semi-independent agents all focused on their individual goals. Via this complicated web of interactions, larger patterns, emerge, merge and perish. Alternatively one could view these patterns (read: organizations, businesses, relationships etc.) as going through evolutionary algorithmic searches for optimal solutions to their current environment.  The whole becomes greater than the sum of it’s parts. Companies get built, resources get leveraged and, overall, economic progress lurches forward.  So why is government regulation desirable? Why isn’t the libertarian view of unfettered free markets the right approach. I can think of three reasons, each residing at a different scale within society.

1) Humans can not be consistently counted on to be economically rational.

2)  The potential problem of “Increasing Returns” as identified by the economist Brian Arthur.

3) The Economy resides within a larger social political system.

Behavioral Economics is the branch of economics studying how humans make (sometimes irrational) choices. Some of the findings suggest humans are quite susceptible to heuristic biases and framing. Heuristic biases can be thought of as “rules of thumb”, an example might be, if someone I perceive as a leader does X then I should do X as well, even if I’m not sure why I should do X or if X will get me anything. Framing describes the ability for human choices to be swayed by how options are presented to them. My current favorite example (typically given regarding morality) is the oncoming train question. If there is a train track that branches into two tracks. Down track A five people are working while down track B one person is working. An out of control train is hurtling down the track, you can do nothing and the train will go down track A, killing five people or you can pull a switch and send the train down track B killing one person but saving the other five. Will you pull the switch. Most people say they would pull the switch thus, saving five people while killing one person. But, if you frame the question differently, and tell them five people are working on a train track below you. You see an out of control train hurtling down the track and you know if you push the obese person next to you, onto the train tracks, it will stop the train, save the five workers but kill the obese person. Would you push fatso onto the tracks. Most people would say no, even though, the economics of the question are exactly the same in each case.

So what’s the problem? As companies get more and more sophisticate in their marketing efforts, their ability to override an individual’s rationality becomes stronger. If people are not making choices based on maximizing their own self interest, the philosophical underpinnings for arguing the ethical advantages to free markets disappear.

A second problem can be found in the study of group psychology. As Keynes (quoted by David Ignatius) notes: “It is of the nature of organized investment markets . . . that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force,” he wrote. “Once doubt begins it spreads rapidly.” In other words, when your mother asked you if you would jump off a bridge just because your friend did, the honest answer is: “Sometimes”.

2) Increasing Returns describes the idea of markets becoming dominated to such an extent that the winner will continue to win just because they won previously. Increasing Returns are sometimes illustrated through “the Network Effect”, the example usually given is the dominance of the PC. Once everyone starts using a specific technology, it will make sense for the individual to choose that technology not because it is necessarily superior to its competitors, but because barriers to entering the network are too costly without the “winning” technology. Now, its true that over the long term the network effect can be overcome through the introduction of a “game changing” new technology, but its also true that the system can reach a state of equilibrium where innovation is permanently stifled and the system lodges in an evolutionary cul de sac.

3) The Economy resides in a larger Social Political system: In order for any economy to work right it must reside within a society of laws. Contracts must be enforceable, property rights respected… For the rule of law to be respected there must be some mechanism for enforcement, punishment and redress. Mechanisms of this sort require a concentration of power. Concentrated power invites corruption and secrecy. Without mechanisms for insuring fairness and the rule of law a free market cannot hope to stay free.

Further, there must also be mechanisms in place to minimize negative externalities and the ability of larger entities to socialize costs while privatizing profits. You know, like if an industry got into trouble so everyone was forced to give money to bail out said industry without the givers getting equitable compensation for their forced largess. I’m sure there’s an example of this issue though none come immediately to mind.

In short, I do not believe, given society’s current level of technological sophistication and interconnectedness that a free market is even possible, let alone desirable. Having said that, I am quick to acknowledge economies as complex adaptive systems. Too much regulation can send the economy into a state of equilibrium, effectively killing the goose that lays the golden egg. But, that argument will be made in a future post.