Monday, October 24, 2011

A Laissez-Faire Market for Lemons

I haven't written about the Occupy Wall Street movement, mostly because I've found the movement somewhat confusing.  I wonder if all protests have at least a somewhat fractured feel to them, and even if this protest had an especially fractured one, it is probably an impossible standard to ask them to have a consensus, coherent position.  I can remember protesting the Iraq war in 2002, and disagreeing with almost as many signs as I agreed with, but there I was.  In the video below, Keith Olbermann gives a statement that is something of a list of injustices.  It's a spaghetti soup of wrongs that is all over the place politically.

This article moves over several important topics, but doesn't do as good of a job of blending them.  Clearly, I am not even as good as I would like the protesters to be in providing a clear and concise message.  Perhaps our problems are so complicated right now that clarity and brevity and not even possible.  The photos (somewhat) divide the topics.  The first one is our need for a greater degree of income inequality, and the second is a greater balance of transaction information in financial markets.

Dr. Nouriel Roubini recently wrote a very good article for Project Syndicate that is somewhat in step with an earlier article that I wrote on the Arab Spring and London riots.  Naturally, Dr. Roubini's article is much better written and more comprehensive than mine, but I was so worried about my own writings being too much of a pollyanna take on economics, that I almost didn't publish it.

To be earnest and honest, I think inequality is a difficult thing for economists to write about because inequalities are an inherent part of any market.  Any transaction ever happens because both parties have different valuations of each others goods.  When I buy tennis shoes, I'm judging those shoes to be more valuable to me than the $50 that I paid to get them.  On the same transaction, the person selling me those shoes values the $50 more than those same shoes.  Most economists aren't even particularly interested in ensuring equality in terms of income or wealth.  They would probably demand lawfulness, and argue that laws should attempt to ensure fair markets, but that all market participants have varying degrees of imperfect information all the time.  I've heard it said (I think in class) that markets were, in some ways, aggregates of imperfect information that led to the total (not perfect) amount of information.

(photo: Paul Stein)
Right now the Occupy Wall Street movement is continuing this Arab Spring.  The reasons for their protests are mostly but not completely different than the original Arab Spring in Tunisia and Egypt.  In Tunisia and Egypt, as in many other places in the world, long term dictators have ruled using power bases that bred inequality under corrupt shams of capitalism.  What Dr. Roubini argues is that Occupy Wall Street is not so different because all of these protests basically come from economic inequality.  He even goes so far as to call lobbying a form of legalized corruption.  This has to be considered a controversial statement, but perhaps it is not so far fetched.

He states that just as the European welfare state model has fallen on its face, the Anglo-Saxon laissez-faire model has fallen as well.  He concludes, "Any economic model that does not properly address inequality will eventually face a crisis of legitimacy.  Unless the relative economic roles of the market and the state are rebalanced, the protests of 2011 will become more severe, with social and political instability eventually harming long-term economic growth and welfare."

He said succinctly what I was trying to get at in August:

"Surely the American stimulus must be paid for, and it likely will not be worth it from a cost-benefit point of view.  What if these programs fail a cost-benefit analysis, but they maintain intangible, unobservable factors such as what is often called the "fabric of society"?  Nobody can really tell which factor exactly keeps the façade of civilization apparent to all of its citizens (or fabric of society), but surely that has a real benefit as well.

So what do these protests, riots, and demonstrations have in common?  Frustration with economic conditions is widely observed to be a contributing factor to all of these protests, demonstrations, and riots.  If we are to keep this "fabric of society" woven, we must have some degree of economic success.  Moreover, that success must be widespread throughout society.  As economists, we must address economic growth and equality in a way that is not a handout or a burden on future generations.  We must be serious about education both on a national and individual level, as skills disparity have been shown to be a main contributor to economic inequality.  If we are to institute programs of austerity, we must study to find a better way of promoting, establishing, and easing into them.  They will never be pain free, but simply making wholesale cuts is not the best answer either."

His version is not the same, rather it is much more audacious.  I'm not trying to say that I don't support a more laissez-faire or free market capitalism, but within our models of markets economists assume perfect information.  We also know that this is merely an assumption for the purposes of modelling, and that perfect information does not exist in real life markets.  I would assert that our real life markets need both parties to have more balanced amounts of information and to ensure that there is a bedrock amount of information for a transaction to be considered fair.

We will still (naturally) have different valuations, but both parties must be able to agree on what the exchange actually is.  When that threshold is not met, fraud can and will rule the day.  At the same time, we must not reduce individual responsibility to understand the exchange.  For example, if one party purchases derivative tranches that are AAA rated simply because of their AAA rating, that party cannot cry foul when the rating proves faulty.  Ratings agencies are good sources of information, but they cannot replace the purchasers responsibility to understand what they are purchasing because they are surely not purchasing a rating, but rather the asset.

(photo: Xeni Jardin)
The general public has probably trusted ratings too much, and misunderstood the financial services industry.  In the past, it has generally been thought that our brokers had our interests in mind because we were constant customers and often their profits were actually percentages of ours.  When a financial services firm creates a financial "product", that role can change somewhat or totally depending on the size of the transaction towards a more adversarial role.  The market for financial products can become something of a market for lemons, where asymmetrical information rules the day.

In the past decade financial markets have often become the worst type of market for lemons... one where the purchaser does not realise that it is one.  In some cases, these transactions have been outright fraud, in other cases they have been (merely) deeply unethical.  Either way, they have led to market instability, which has had enormous negative effects on our economy.

The sign in the last photo is referring a real life transaction.  The Goldman Sach's "Abacus" deal that the SEC investigated and recently settled for a record setting $550 million.  The SEC has been investigating and issuing fines on many major banks and investment houses like this for becoming a market for lemons.  The question is will these actions restore public trust?  Perhaps the better question is... did public trust in these large banks ever leave?

In George Akerlof's amazing article "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," (gated) he relates the common experience of used car shopping to the academic terms of quality, uncertainty, and asymmetric information.  In markets where there is asymmetric information and the value of the product is high (used cars, financial products) purchasers often confront the problem of identifying quality, but they are often met with problems of selection bias.  This happens because of a variation of Gresham's law where good automobiles or financial products are crowded out or priced out by lemons.  The result is an increase in market uncertainty which actually reduces the number of transactions and drives prices lower than they would be naturally.

This behavior actually happened when the derivatives market became what was called by pundits "toxic" and the Federal Reserve purchased assets that had practically no market value after the market for lemons effect took over to such an extreme degree.  These markets for lemons ultimately led to the financial crisis of 2008 and their eventual bailouts.

The woman in the final picture that is carrying the sign with the words, "It is wrong... " (written by The Atlantic's Conor Friedersdorf) is correct in a moral sense.  It most certainly is wrong, but continuing to ensure that this is also wrong in a legal sense is important as well.  The alternative is allowing laissez-faire capitalism to (often) become a market for lemons.  Then we will experience bad financial products driving out good ones, which will have negative effect on investment.  This is an appropriate and necessary role for government to ensure a basic foundation of information for both parties in a transaction.

Inequality is a trickier and longer term problem that probably stems from productivity inequalities more than anything else.  Widespread education that leads to productive skills is likely the only way to fix inequality issues in a long term sense.

Kenny Burrell - "Autumn in New York"

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