With the New Year, I have been thinking about old problems: banks, risk management, prices and wages as signals in well-functioning markets, and the efficient allocation of capital. I've been marveling at the disconnect between what my economics textbooks assert and the realities I have observed lately.
Things that have been especially salient are the misallocations that have resulted from very distorted signals in financial markets. Remember that one of the foremost advantages of capitalism and well-functioning competitive markets is the wonderfully efficient way in which prices and wages (at least in theory) signal profits to be made and value to be added to the economy and to us all. When they work, the signals coordinate a large complex economy far better than any central planner (aka government) could do and they assure that resources are diverted to sectors and productive enterprise that most closely match people’s preferences. To the extent that individual preferences correspond to individual and societal well-being, both individual and societal well-being is also improved. (For an example of a case in which individual preferences do not necessarily correspond to individual or societal well-being, think "drug addict" or "alcoholic." For an example of a case where individual preferences correspond to individual well-being, but not in all cases to societal well-being, think "investment banker who required a bailout.")
Over the last several hundred years, as capitalism and commercial enterprise have come to dominate, there have been a series of cyclical downturns usually brought on by “irrational exuberance” or “animal spirits” in some market. Casino-like behavior aimed at capturing high short-term gains replaced sober, sound, long-term business investment supporting long-term corporate growth and survival. Notice that including “survival” rules out Enron-like "growth."
Economic theory is pretty specific about the characteristics of investors, producers, and consumers that will prevent animal spirit-induced bubbles: reason, self-interest, and full-information. It is not often explicitly stated, but reason and self-interest are taken to mean that the individual is rational and self-interested enough to take a long-term view of their own well-being, their reputation in the market, and their own or their firm’s survival. Full-information means that there is no uncertainty or risk, such as one might find in oh, say, futures markets, mortgage and health insurance markets, stock markets, bond markets. One could go on and on, but you must get the point.
Unfortunately, an entire cottage industry called the economics profession sprang up, firmly anchored on the shores of Lake Michigan, aimed at creating cultural narratives and myths about how “markets” (meaning some abstract aggregation of semi-rational, often ill-informed, but definitely self-interested points of light) would magically “know” and act rationally and with perfect foresight. In many ways, the birth of the cottage industry known as freshwater economics is a testimony to the power of markets. There was and is a lot of money to be made in that cottage industry, especially if one was willing to drink the “business as usual,” “just ignore the man behind the curtain,” “the business of business is business” kool-aid that until recently has characterized my profession.
One under-recognized effect of distorted price signals in a frothy economy is the distortion of intellectual curiosity and endeavor. While a course correction, championed by Keynes, Robinson, JK Galbraith and others in the past and now led by such notables as Paul Krugman, Brad Delong, Joe Stiglitz, Mark Thoma and many others is underway, I believe that considerable damage has been done. Not least because most non-economist Americans are unwittingly under the sway of several "defunct economists." The defunct economists have provided a convenient narrative in which government of, by and for the people can never act as a countervailing force against large corporations, but instead is viewed as promoting individual freedom only when allied with and strenuously promoting the financial well-being and increased power of those very same large corporations. Thank you, Milton and Friedrich and all the others who have piled on that beneficial for a few bandwagon.
Another effect of distorted price signals that is obvious to us all is the way in which trillions of dollars were siphoned away from alternative productive, life enhancing activities and diverted into housing; housing that now stands abandoned on overgrown lots throughout the US or that is siphoning off yet more consumer income to the banking and finance sector in the form of mortgage payments on principal that is now higher than the current market value of the property. Money that would otherwise be available to spend and stimulate other sectors of the economy.
However, I suspect that the longest term and most severe damage from the finance casino will not be from government deficits required to shore up too-big-to-fail banks and insurers. It will be from two powerful, long-standing price distortions that have distorted the composition of our labor force and the mix of human capital within it. The first distortion is the past diversion of some our best technical and mathematical minds away from physics, engineering, biology, chemistry, and, yes, even economics, to financial modeling, risk analysis, and all the other marvelous tools of speculation and gaming. Over the last 20 years or so, the financial sector has been diverting our future scientists and mathematicians into creating new derivatives aimed at managing risk (ha!) and into developing creative investment instruments aimed at obscuring risk.
The second long-term distortion is similar to the first. I'm thinking of all those bright, young, energetic non-quants who came out of some of our best universities and opted to go to work for investment banks, not in technical jobs, but as traders, ratings specialists, analysts, again to support the conversion of trillions of dollars into chaff. Many of them might have gone on to graduate work in psychology, sociology, English, history, political science, and public health, where they would have added more value than destroying wealth across the globe. Instead of a workforce that gained diverse skills that might one day transform the world in positive and substantive ways, we have a surfeit of MBAs with concentrations in finance and empty houses on overgrown lots.
But there were no jobs in public health, English, political science, etc, you say? Of course not, the financial sector distorted financial capital, which in turn distorted physical and human capital. You have to imagine what the world would have looked like without the casino siphoning resources into real estate. You have to imagine a world without a dot.com and a real estate bubble. Where would the dollars and people have gone? That is what we have lost.
In the long run, the present and future productivity losses from labor force and human capital distortions may well dwarf the more obvious losses from distortions in real and financial capital markets, both in magnitude and scope. At the very least, they add to them in ways that are important to counter if we are to have a solid economic recovery.
Market forces did this. In fact, free market forces did this. Prices and wages signaled money to be made. Rational, self-interested people did the rational, self-interested thing: they went to work where the pay was highest and the jobs were plentiful. Even had they been fully informed about the ultimate downturn (and even if they had believed that the ultimate downturn would not be cushioned by the (bad, intrusive) government) what rational, self-interested person would have behaved any differently with all that easy money to be made?
Don’t get me wrong. I'm not making a case for central planning. I remain committed to capitalism: free markets when they function well, regulated markets when they don’t. The above are simply additional arguments for reining in and regulating casino-like behavior and casino-like rewards in any market, not just capital markets. In the long run, we will all be dead, but as long as someone will be alive, they deserve a better world and a better life than one gets in a casino where the odds are disproportionately in favor of the house and the house is an unholy combination of corporate power and wealth backed by government laissez faire and largesse.