Tuesday, October 23, 2012

Market Failures

It is very difficult to figure out the proper fundementals when decisions are mixed with real outcomes for the individuals involved.  A case in point is the argument about whether the current trend for government bonds to yield "zero" is a problem.  On the face of it, this should encourage governments to borrow.  Instead we see a lot of arguments for austerity because, sooner or later, these yeilds have to go up.  But, as has been pointed out, these are extremely liquid and efficient markets.  So it is hard to completely avoid this type of cyncism: 

This is, I think, coherent. But there is, nevertheless, an inconsistency here. Mr Halligan wants the government to do something about the (possible) failure in bond markets - cut spending. But he - and more significantly those who think like him - seem relaxed about the failures in goods and labour markets that cause at least 2.5 million people to be out of work.

It's strange how some market failures demand action and some don't, isn't it? If I didn't know better I'd suspect the right of merely pursuing class interest without regard to intellectual consistency.
 This sort of intellectual consistency is something that seems to be sadly absent in a lot of the current thinking about financial issues.  Being out of work is a serious harm to the people involved, even mroe so in the United States (where even more of one's benefits are linked to employment), but I am sure it is no picnic in the United Kingdom, either.

Now, I dislike the Ad Hominen argument because it could be made about any argument, no matter how valid it was should it happen to have the potential to benefit the speaker.  But I do think that we need to have a much cleaner conversation on what we think markets are able to do.  If we think "bubbles" and "irrational exuberance" can occur in financial markets then we really don't believe in the strong form of efficient market theory. 

Now when you project this to areas with information asymmetry (think health care, where prices are opaque, or casualty insurance, where you have to trust the insurer to pay if the adverse event occurs) then it becomes even more silly.  This problem is even more severe once you realize that trust is occasionally broken.  I am sad Karl Smith doesn't really blog any more because he cut to the heart of the matter with this post

The assumptions required for markets to simply manage themselves are pretty extreme.  Why does Ragnar Danneskjöld become a pirate on the high seas instead of looting the (much closer) wealth of John Galt?  Does he give the money back if he discovers his victim happened to be a "maker"?  And how would he know? 

So it is worth keeping in mind that this stuff is a) very hard and b) nobody seems to really hold the extreme versions of these views. 

1 comment:

  1. The efficient market theory requires all market participants to have the same information and that is not the case.

    One thing to consider about interest rates is the mantra used by mortgage brokers "lock in rates while they're at lows". If interest rates are low at some point they do have to revert back to the mean. However, this also led me to think that perhaps our perception of normal interest rates has been skewed by the time frame starting with the mid-70s till the early 2000s. Looking at the graph of the Fed prime rate from 1930-2011, you'll see a huge bulge in the middle.