No Free Lunch No Free Market

“The market is a human creation. It is based on rules that humans devise. The central question is who shapes those rules and for what purpose,” Reich concludes. “The coming challenge is not to technology or to economics. It is a challenge to democracy. The critical debate for the future is not about he size of government; it is about whom government is for.” [Robert Reich]

Bingo!  Adam Smith, in Wealth of Nations, offered the Invisible Hand – and economists have been grabbing it ever since. IF, they mused, if all buyers and sellers were truly free then markets would achieve equilibrium and all will be well.  Everyone will act in their own self-interest, and the competition induced will benefit all.  There will be an equilibrium price – for anything – when the demand and the supply are equal.  However, there’s always been a flaw in this argument.

The cracks begin showing when it’s noted that “price” and “value” are not the same thing.  Truly, there is a “market value,” i.e. the price at which an asset would trade in a competitive auction setting, but this isn’t a definition of value.  Value is a qualifier we assign to things that are beneficial, significant, advantageous, or useful. Let’s digress a moment and review why this differentiation between price (even market price) and value is important.

Finance works best when it acts as the conduit for moving capital from places of surplus to places of scarcity.  In the simplest possible terms, finance allows the money in someone’s savings account to be invested in someone else’s business enterprise.   The owner of the savings account benefits from the earnings; the owner of the business enterprise benefits from the extra cash to expand his operations.   Not to put too fine a point to it, but when finance doesn’t move capital from surplus to scarcity then it’s not finance – all too often it’s merely gambling.

Additionally we should note that the the system itself is a gamble.  If I put in a $1000 investment in Widgets International Inc. then I’m betting my shares will either pay dividends, gain in price, or preferably both.  And now to return to “value.”  I’m taking a risk with my money, but I’m also hoping to invest in something of value – perhaps WI Inc. manufactures the best product on offer which helps nurses prevent bed sores from afflicting their patients.  I have $1000 on hand (surplus), Widgets International Inc. needs to expand to meet the demand for its product (scarcity) and finance allows the conduit to work toward mutual benefit.

However, what if I behave as though my $1000 really isn’t surplus? What if I make a side bet that the price of Widget International will go down?  In this instance I am buying a “financial product” which has precious little to do with the product the company is manufacturing, a bit more to do with how the company is managed, and a great deal to do with how a hedge fund can be used to “manage wealth.”   Or, to put it another way – to reduce risk.  Money (capital) slathered about in an effort to reduce risk isn’t part of that conduit for moving capital from surplus to scarcity, and it (as we’ve seen) is fraught with consequences.  The word “behave” is the key term.

If the concepts of price and value are problematic in a discussion of American economics, then our Economic Man as described by Adam Smith is also at issue:

“Economic Man makes logical, rational, self-interested decisions that weigh costs against benefits and maximize value and profit to himself. Economic Man is an intelligent, analytic, selfish creature who has perfect self-regulation in pursuit of his future goals and is unswayed by bodily states and feelings. And Economic Man is a marvelously convenient pawn for building academic theories. But Economic Man has one fatal flaw: he does not exist.” [Harvard]

The “convenient pawn” became the cornerstone of neoclassical economic theory.  The theory elevated the pawn, and the pawn returned the compliment by rationalizing everything from child labor to global out-sourcing.   The Magic Market would “equalize” everything, and all would be well.  In fact, there is no such thing as a free lunch, and there is no such thing as a free market.

In fact, if we skip the jargon (such as a trader saying “I make markets”) what we understand is that traders in the financial sector are sales personnel who have products to sell to prospective buyers.   Last time we looked those sales personnel, the buyers, and the sellers were all human beings – or human beings managing various and sundry enterprises.  Even if  trading is  computerized, someone – some human being – had to program those computers, which still have no innate capacity to count beyond 0 to 1.  There are some benighted souls who believe that if we have just enough “self monitoring,” and more elegant algorithms those messy, inconsistent human beings will no longer screw up the financial markets.  Again, we’d have to ask, “Who is writing those algorithms?” And,  how much “self-monitoring” is good enough?   There are markets, but they are certainly not free of human beings – humans being the brokers, the agents, the buyers, and the sellers.

“Who shapes the rules, and for what purpose?”

We have rules for all manner of human transactions.   When sharing a meal we don’t eat the mashed potatoes with our hands. When getting an invitation with an “RSVP” we don’t wait until after the event to respond.  A soccer match is played with only 11 on each side.  The FAA has rules for take offs and landings to minimize the risk of collisions.   And we have rules for financial markets.   Why? Because a market is simply a transaction between two human agents – buyer and seller – no matter how computerized.

One thing we did learn during the debacle of 2007-2008 was that some investment houses were selling products on which they could calculate a price but they were incapable of determining the product’s value. In some instances the artificiality of the product and its distance from anything tangible, such as a home mortgage, made it impossible to determine what the product was actually worth.  All too much of the Stuff had a “market price” but turned out to have no value in the last analysis.  Thus the demise of Lehman Brothers.

There are some questions at the intersection of economics and politics in 2016:

  • Do we want an unfettered market for financial products? Do we want rules advantageous to the sellers of products in the financial markets? Do we want rules advantageous to the buyers in financial markets? Do we want rules which protect the general public from irresponsible or anti-social behavior on the part of the buyers and sellers?
  • Do we want those who write the rules for the transactions in the financial markets to have the interests of the general public in mind?
  • Do we support agencies which enforce rules designed to restrain the behavior of buyers and sellers in the financial markets?
  • Do we encourage investment or speculation?
  • Should our system of taxation reward work or wealth?

We can focus down on a single issue illustrative of the general regulatory environment – this past July a Senate Committee was taking testimony on a proposed rule that investment advisers place the client’s interest first when deciding upon investments in retirement accounts. One member of the panel offered that the rule would “cost” the investors some $80 billion because financial firms would simply raise fees to make up the profit differential if they couldn’t put their own interests before the interests of their retirement account clients. [Litan pdf]  However, what didn’t go unchallenged was that the study cited by the panel member was financed by the Capital Group, a corporation which definitely stands to benefit if the proposed rule from the Department of Labor is not implemented. [BostonGlobe]

The question highlights the element of freedom:  Is the investment adviser free to purchase elements in a portfolio which enhance the profitability of his firm, or must the adviser give first priority to those investments which will best serve the clients’ interests?  Is the client free to assume his agent (investment adviser) is acting in his or her best interests?  Is the client free to know how investment portfolio decisions are made?  It isn’t a question of whether or not the “market” is “free,” it’s a question of who is free to do what.

Consider for a moment a situation in which a large employer has selected a financial advisor to manage its retirement program.  There are three human agencies at play: the employer, the employees, and the financial advisors.  And, because there are human beings involved we should assume that these relationships are contractual. If the financial advisors are placing their own interests above those of the retirees, then must the employer seek to break the contract? Under what conditions and at what expense?  Are the employees free to take their contribution elsewhere? But, what of the employer’s contributions?   In the rarefied theoretical academic version of a Free Market this would never happen – all the pawn would march neatly across the board. However, this isn’t a theoretical academic version – this is real life – and if the financial advisor is “free” to act in his or her firm’s interest, what happens to the contributions of the employer and the employee? If they act in their self interest then they must cut ties with the advisors.  If the adviser is “free” to act in his or her self interest the employer and the employees lose value in their retirement investments; if the employer and employees are “free” to act in their own self interest the adviser loses the account.   We are left asking: Who is going to write the rules of our economic game? Or to put it in economic-political terms:

“The most important political competition over the next decades will not be between the right and left, or between Republicans and Democrats. It will be between a majority of Americans who have been losing ground, and an economic elite that refuses to recognize or respond to its growing distress.”  [Reich]

References/Recommended Reading:  John Lanchester, “Money Talks: Learning the Language of Finance,” New Yorker, 8/4/2014.  Craig Lambert, “The Marketplace of Perceptions.” Harvard Magazine, March-April 2006.  Michael Blanding, “The Business of Behavioral Economics,” Forbes, August 2014.  Adam Ozimek, “The Future  Irrelevancy of Behavioral Economics,” Forbes, September 2015.  Dan Ariely, “The End of Rational Economics,” Harvard Business Review, July-August 2009.  Paul Krugman, “How did economists get it so wrong?” New York Times Magazine, September 2009.  Noah Smith, “Finance has caught on to behavioral economics, Bloomberg View, June 2015.  Robert Litan, Senate Subcommittee on Employment and Workplace Safety, Senate HELP, July 21, 2015. (pdf) Annie Linsky, “Warren…Brookings Institution,” Boston Globe, September 29, 2015.  Robert Reich, “How the pro-corporate elite has rigged the system against the rest of us,” Alternet, September 29, 2015.

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