Free Markets
I've been thinking a lot about the economy recently - who isn't? - and one thing that has been bothering me is the ferocious attack on the concepts and theory behind free markets. The Economist calls this schadenfreude, which is entirely appropriate. While, like everyone, I see the financial destruction occurring all around us, and can readily see the link between irrational actions by many individuals (brokers, bankers, investors, consumers) and the results, I wonder. It smells like the case of the thief's hat burning.
First of all, the behavior may not have been that irrational; a lot of people made a lot of money out of thin air in the past few years, with the end result being a monumental shift of riches from those at the top to those at the middle. I posted about this several months ago, but it's worth repeating - the vast majority of damage has been borne by bank shareholders (who can presumably afford it), executives, hedge-fund managers, the super-rich, sovereign wealth funds, and the like. When a borrower buys a house with no down and sells it to the market again one year later for a $50K gain - something that happened a lot during the boom - that's completely rational. When the investor has an easy way to turn around and sell that debt, making a nice chunk of change in the process while eliminating risk to himself, that's pretty rational too. And when the government continues to encourage the entire behavior (by, for example, keeping interest rates very low and the mere existence of institutions like Freddie and Fanny) it makes perfect sense to continue doing so, hoping that at the end of the day, someone else will be left holding the bag.
The reason I claim there has been such a shift is simple: a lot of people did manage to buy and sell, sometimes multiple times, during the boom, creating nice (and sometimes borderline obscene) income streams for themselves that they used for all sorts of things to improve their own life style. Quite a few of these folks have simply created a foundation for themselves for the future. You don't hear about those who made these profits, while taking risks with maybe token amounts of cash for the first transaction. After that, they were playing with the house money (pun intended). Heck, quite a few of them are now, rather ingeniously, clamoring for government protection because they got stuck with the last house they bought using the same mechanism - completely ignoring the profits they made on the last three. Some of this money came from an actual shift in underlying asset prices, but most of it from somewhere else. That somewhere, if you trace it through all the twists and turns, is the shareholder value that has been wiped in the past few months in the financial industry, and the people paying it are all those much wealthier folks.
In fact, it's a bit disturbing to see us turning around and saving sub-prime borrowers right now, not because they don't deserve it (and they don't), but because it strongly reinforces the entire underlying psychological behavior that has led to this disaster in the first place.
Anyway, we all know this, and we also know that the above is an incomplete picture. Which brings me, in a long and torturous fashion, to the point I wish to make:
Free markets work very well in theory because they rely on the notion of full information. However, in the real world, information is never full. And even if it were, no one can actually process it to make split-second decisions in the world of electronic trading.
Once you take away the idea that information is fully available at all times to all people and that they can actually act on it in reasonable fashion, the entire theory behind free markets crumbles quickly. This is the reason why some folks - like Andrew Lahde - who have good access to information and are extremely talented at processing it quickly can make money off droves of other relatively smart folks who have the same access but much less talent.
This leads to some interesting thoughts. For example, it seems to indicate that free markets are never really possible except in highly limited circumstances, such as when two kids at school trade pokemon cards. In their world, they do have access to full information, and they are both under similar constraints to make their rational decisions. But the entire thing fails miserably to scale and extrapolate. That, in turn, leads to the thought that maybe the answer is forced specialization by market participants. I wonder what new financial model will replace pure free market thinking, but one has to emerge. But I'll tell you one thing - it won't be socialism. Capitalism is alive and well, and for the most part, the majority of us know deep down that we have enjoyed its fruits in the past few years.
First of all, the behavior may not have been that irrational; a lot of people made a lot of money out of thin air in the past few years, with the end result being a monumental shift of riches from those at the top to those at the middle. I posted about this several months ago, but it's worth repeating - the vast majority of damage has been borne by bank shareholders (who can presumably afford it), executives, hedge-fund managers, the super-rich, sovereign wealth funds, and the like. When a borrower buys a house with no down and sells it to the market again one year later for a $50K gain - something that happened a lot during the boom - that's completely rational. When the investor has an easy way to turn around and sell that debt, making a nice chunk of change in the process while eliminating risk to himself, that's pretty rational too. And when the government continues to encourage the entire behavior (by, for example, keeping interest rates very low and the mere existence of institutions like Freddie and Fanny) it makes perfect sense to continue doing so, hoping that at the end of the day, someone else will be left holding the bag.
The reason I claim there has been such a shift is simple: a lot of people did manage to buy and sell, sometimes multiple times, during the boom, creating nice (and sometimes borderline obscene) income streams for themselves that they used for all sorts of things to improve their own life style. Quite a few of these folks have simply created a foundation for themselves for the future. You don't hear about those who made these profits, while taking risks with maybe token amounts of cash for the first transaction. After that, they were playing with the house money (pun intended). Heck, quite a few of them are now, rather ingeniously, clamoring for government protection because they got stuck with the last house they bought using the same mechanism - completely ignoring the profits they made on the last three. Some of this money came from an actual shift in underlying asset prices, but most of it from somewhere else. That somewhere, if you trace it through all the twists and turns, is the shareholder value that has been wiped in the past few months in the financial industry, and the people paying it are all those much wealthier folks.
In fact, it's a bit disturbing to see us turning around and saving sub-prime borrowers right now, not because they don't deserve it (and they don't), but because it strongly reinforces the entire underlying psychological behavior that has led to this disaster in the first place.
Anyway, we all know this, and we also know that the above is an incomplete picture. Which brings me, in a long and torturous fashion, to the point I wish to make:
Free markets work very well in theory because they rely on the notion of full information. However, in the real world, information is never full. And even if it were, no one can actually process it to make split-second decisions in the world of electronic trading.
Once you take away the idea that information is fully available at all times to all people and that they can actually act on it in reasonable fashion, the entire theory behind free markets crumbles quickly. This is the reason why some folks - like Andrew Lahde - who have good access to information and are extremely talented at processing it quickly can make money off droves of other relatively smart folks who have the same access but much less talent.
This leads to some interesting thoughts. For example, it seems to indicate that free markets are never really possible except in highly limited circumstances, such as when two kids at school trade pokemon cards. In their world, they do have access to full information, and they are both under similar constraints to make their rational decisions. But the entire thing fails miserably to scale and extrapolate. That, in turn, leads to the thought that maybe the answer is forced specialization by market participants. I wonder what new financial model will replace pure free market thinking, but one has to emerge. But I'll tell you one thing - it won't be socialism. Capitalism is alive and well, and for the most part, the majority of us know deep down that we have enjoyed its fruits in the past few years.
posted by Blinkered at 7:31 AM
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