How can Markets be Reformed (and What is Wrong with Existing Answers)?
A crisis of ideas
We are facing a crisis of ideas about what to do about financial reform. Policy debates recirculate endless versions of the same old alternatives–market self-regulation self correction versus government regulation–in the guise of argument about what is really the same old toolkit of policy interventions: taxes on certain kinds of transactions (eg the Tobin rule, recycled from the 1960s)? An outright ban on certain forms of trading or investment (eg the Volker rule, recycled from the 1980s)? capital adequacy requirements (eg a proposed Basel III that largely just raises the bar on Basel II)? more vigorous prosecution of insider trading (same regime, just more of it) ? New regulatory institutions aimed, for example, at protecting consumers (a return to the solutions of the 1930s)? At each stage proponents of one approach or another highlight the legitimate merits of their view and the legitimate problems with the alternative view. Separating banking and investment activities is the only way to protect innocent third parties–no, separating banking and investment would not have prevented the problems of 2008. Moving derivatives trading onto exchanges, or increasing capital adequacy requirements, will prevent future instances of the “domino effect”. No, any such rule can always be circumvented through clever accounting or derivatives engineeering. And on and on.
At this stage several things are clear. First, both positions in the free markets-versus-regulation debate are right. Markets do not always self correct, but regulators do not always make wise decisions. There is no perfect point of balance, no way to square the circle. Lets face it: there is no Big Idea for how to rebuild and restabilize the economy. We are going to have to live with a market out of balance.
A simplistic debate about human motivation
One recurring feature of this debate is its worry about human motivations on all sides. On the one hand, there is a great deal of worry about government officials: the view is that these basically selfish and often irrational actors need to be properly controlled–through transparency and accountability mechanisms like Congressional hearings–to keep them from becoming “captured” by certain large financial interests (consider the debate about whether Treasury officials are too close to Goldman Sachs for example). On the other hand, there is a great deal of worry about market participants: motivated by selfishness, irrationality, passion, herd mentality, and so on, they pursue short term personal profits at the expense of long term gains. They too need to be properly controlled–through limits on bonuses, or bonus programs that incentivize long-term profits, or through criminal prosecutions, or firewalls that limit traders’ access to particular kinds of information.
This view of everyone involved as selfish, brutish and irrational is just a flip flop of the old view of market participants as brilliant wizards of finance embodying the collective wisdom of the free market on the one hand, and benevolent regulators bringing the wisdom of their elite educational training to the table in the service of the public welfare.
From the point of view of state of the art social science, these caricatures seem remarkably inadequate. Sociologists, anthropologists and psychologists know that there are few real angels and real devils in the world; most of us are a complex bag of motivations, ideas and aspirations that often we ourselves do not fully understand.
But these caricatures get one thing right: Markets are made up of people–real people, and their ideas, their tools, their strategies, their skill sets, their contacts and relationships. Nothing less, nothing more. Every possible form of market intervention–from monetary policy to criminal prosecutions–is only effective if it somehow causes a change in human behavior. So we need a more practical approach to market stability that works for real people in real market situations.
Consequences of the financial crisis
Meanwhile, if we turn away from the headlines on the front or business page, there are a set of other stories proliferating about the “consequences” of the financial crisis on people’s lives. In the United States, unemployment and underemployment (particularly among young people), housing foreclosures, the reduction in real wages and job insecurity even among the employed has generated confusion and deep anxiety among many people at all but the very highest echelons. Popular anger at both Wall Street and the government has spawned growing nationalism, far-right activism, and even calls for “revolution”. In Japan, as Yuji Genda has discussed, suicide is up, and for the first time most Japanese do not believe that life for their children will be better than their own. Young people do not see the point of taking up the kinds of careers their parents had. Mid-career people are facing layoffs and a loss of a sense of purpose about their work. The question of what to do about a pervasive hopelessness in the market and society has become a serious policy problem.
Out of Balance
In response, the pundits, the preachers, the career consultants and the self-help experts descend on the public with a singular message: Balance. As an employee, you are responsible for maintaining a proper work-life balance, they tell us, and you also need to balance the increasing demands on you brought about by downsizing. As a consumer, you need to get what you spend in balance with what you earn. Moving from consuming to saving requires emotional balance, Suzi Orman says. As a citizen/taxpayer, you need to balance the short-term injustice of financing Wall Street bailouts against the long-term benefits of economic stability, Obama reminds us. This call to balance often has a moralistic tone: we feel guilty, as though it is our fault, when things are out of balance. It is also an attractive fantasy–the promises of everyone from Oprah and her New Age gurus to the Golden Door Spa to the latest management consulting paradigm paints a picture of a perfect state that is just around the corner, if only we were a little more disciplined about our exercise routine or a little more efficient about our task management.
This kind of balance talk–whether it is about balancing the benefits and the costs of government intervention in the market, or balancing the interests of different economic constituencies in defining economic policy, or about entreating employees to balance the demands of their job, is ineffective and worse, irresponsible. It is irresponsible because systemic problems–the mortgage crisis, or the collapse of the derivatives market, or the health care crisis–are passed off as attributable simply to individual failure or lack of proper motivation–greedy consumers, or greedy traders, or individual obesity and lack of exercise. It is ineffective because it directs our attention away from the search for new alternatives to market stability and growth and towards a witch hunt for the guilty party–the corrupt bureaucrat, the rogue trader, the luxury-addicted consumer. Economists understand that market equilibrium is a kind of fictive assumption–something useful to think with but impossible and probably not even desirable (in arbitrage, for example, the moment of equilibrium is the moment at which there is nothing left for market participants to do since all the arbitrage opportunities have been taken). This impossible quest for balance, this endless search for the perfect way to square the circle between work and leisure, for example or between government regulation and industry self-regulation, gets in the way of our noticing how markets actually cope in a practical way with the real imbalance that pervades every aspect of market institutions and activity.
So What to Do?
We need a new way of thinking, and a new way of taking personal responsibility for the market. See my post here on what lawyers can do.