What they tell you We should leave markets alone, because, essentially, market participants know what they are doing – that is, they are rational. Since individuals (and firms as collections of individuals who share the same interests) have their own best interests in mind and since they know their own circumstances best, attempts by outsiders, especially the government, to restrict the freedom of their actions can only produce inferior results. It is presumptuous of any government to prevent market agents from doing things they find profitable or to force them to do things they do not want to do, when it possesses inferior information.
What they don’t tell you People do not necessarily know what they are doing, because our ability to comprehend even matters that concern us directly is limited – or, in the jargon, we have ‘bounded rationality’. The world is very complex and our ability to deal with it is severely limited. Therefore, we need to, and usually do, deliberately restrict our freedom of choice in order to reduce the complexity of problems we have to face. Often, government regulation works, especially in complex areas like the modern financial market, not because the government has superior knowledge but because it restricts choices and thus the complexity of the problems at hand, thereby reducing the possibility that things may go wrong.
Markets may fail, but . . .
As expressed by Adam Smith in the idea of the invisible hand, free-market economists argue that the beauty of the free market is that the decisions of isolated individuals (and firms) get reconciled without anybody consciously trying to do so. What makes this possible is that economic actors are rational, in the sense that they know best their own situations and the ways to improve them. It is possible, it is admitted, that certain individuals are irrational or even that a generally rational individual behaves irrationally on occasion. However, in the long run, the market will weed out irrational behaviours by punishing them – for example, investors who ‘irrationally’ invest in over-priced assets will reap low returns, which forces them either to adjust their behaviour or be wiped out. Given this, free-market economists argue, leaving it up to the individuals to decide what to do is the best way to manage the market economy.
Of course, few people would argue that markets are perfect. Even Milton Friedman admitted that there are instances in which markets fail. Pollution is a classic example. People ‘over-produce’ pollution because they are not paying for the costs of dealing with it. So what are optimal levels of pollution for individuals (or individual firms) add up to a sub-optimal level from the social point of view. However, free-market economists are quick to point out that market failures, while theoretically possible, are rare in reality. Moreover, they argue, often the best solution to market failures is to introduce more market forces. For example, they argue that the way to reduce pollution is to create a market for it – by creating ‘tradable emission rights’, which allow people to sell and buy the rights to pollute according to their needs within a socially optimal maximum. On top of that, free-market economists add, governments also fail (see Thing 12). Governments may lack the necessary information to correct market failures. Or they may be run by politicians and bureaucrats who promote their own interests rather than national interests (see Thing 5). All this means that usually the costs of government failure are greater than the costs of market failure that it is (allegedly) trying to fix. Therefore, free-market economists point out, the presence of market failure does not justify government intervention.
The debate on the relative importance of market failures and government failures still rages on, and I am not going to be able to conclude that debate here. However, in this Thing, I can at least point out that the problem with the free market does not end with the fact that individually rational actions can lead to a collective irrational outcome (that is, market failure). The problem is that we are not even rational to begin with. And when the rationality assumption does not hold, we need to think about the role of the market and of the government in a very different way even from the market failure framework, which after all also assumes that we are rational. Let me explain.
If you’re so smart . . .
In 1997, Robert Merton and Myron Scholes were awarded the Nobel Prize in economics for their ‘new method to determine the value of derivatives’.
Incidentally, the prize is not a real Nobel prize but a prize given by the Swedish central bank ‘in memory of Alfred Nobel’. As a matter of fact, several years ago the Nobel family even threatened to deny the prize the use of their ancestor’s name, as it had been mostly given to free-market economists of whom Alfred Nobel would not have approved, but that is another story.
In 1998, a huge hedge fund called Long-Term Capital Management (LTCM) was on the verge of bankruptcy, following the Russian financial crisis. The fund was so large that its bankruptcy was expected to bring everyone else down with it. The US financial system avoided a collapse only because the Federal Reserve Board, the US central bank, twisted the arms of the dozen or so creditor banks to inject money into the company and become reluctant shareholders, gaining control over 90 per cent of the shares. LTCM was eventually folded in 2000.
LTCM, founded in 1994 by the famous (now infamous) financier John Merriwether, had on its board of directors – would you believe it? – Merton and Scholes. Merton and Scholes were not just lending their names to the company for a fat cheque: they were working partners and the company was actively using their asset-pricing model.
Undeterred by the LTCM débâcle, Scholes went on to set up another hedge fund in 1999, Platinum Grove Asset Management (PGAM). The new backers, one can only surmise, thought that the Merton–Scholes model must have failed back in 1998 due to a totally unpredictable sui generis event – the Russian crisis. After all, wasn’t it still the best asset-pricing model available in the history of humanity, approved by the Nobel committee? The investors in PGAM were, unfortunately, proven wrong. In November 2008, it practically went bust, temporarily freezing investor withdrawal. The only comfort they could take was probably that they were not alone in being failed by a Nobel laureate. The Trinsum Group, for which Scholes’s former partner, Merton, was the chief science officer, also went bankrupt in January 2009.
There is a saying in Korea that even a monkey can fall from a tree. Yes, we all make mistakes, and one failure – even if it is a gigantic one like LTCM – we can accept as a mistake. But the same mistake twice? Then you know that the first mistake was not really a mistake. Merton and Scholes did not know what they were doing.
When Nobel Prize-winners in economics, especially those who got the prize for their work on asset pricing, cannot read the financial market, how can we run the world according to an economic principle that assumes people always know what they are doing and therefore should be left alone? As Alan Greenspan, former chairman of the Federal Reserve Board, had to admit in a Congressional hearing, it was a ‘mistake’ to ‘presume that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms’. Self-interest will protect people only when they know what is going on and how to deal with it.
There are many stories coming out of the 2008 financial crisis that show how the supposedly smartest people did not truly understand what they were doing. We are not talking about the Hollywood big shots, such as Steven Spielberg and John Malkovich, or the legendary baseball pitcher Sandy Koufax, depositing their money with the fraudster Bernie Madoff. While these people are among the world’s best in what they do, they may not necessarily understand finance. We are talking about the expert fund managers, top bankers (including some of the world’s largest banks, such as the British HSBC and the Spanish Santander), and world-class colleges (New York University and Bard College, which had access to some of the world’s most reputed economics faculty members) falling for the same trick by Madoff.
Worse, it isn’t just a matter of being deceived by fraudsters like Madoff or Alan Stanford. The failure by the bankers and other supposed experts in the field to understand what was going on has been pervasive, even when it comes to legitimate finance. One of them apparently shocked Alistair Darling, then British Chancellor of the Exchequer, by telling him in the summer of 2008 that ‘from now on we will only lend when we understand the risks involved’.1 For another, even more astonishing, example, only six months before the collapse of AIG, the American insurance company bailed out by the US government in the autumn of 2008, its chief financial officer, Joe Cassano, is reported to have said that ‘[i]t is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of the [credit default swap, or CDS] transactions’. Most of you – especially if you are an American taxpayer cleaning up Mr Cassano’s mess – might find that supposed lack of flippancy less than amusing, given that AIG went bust because of its failure in its $441 billion portfolio of CDS, rather than its core insurance business.
When the Nobel Prize-winners in financial economics, top bankers, high-flying fund managers, prestigious colleges and the smartest celebrities have shown that they do not understand what they are doing, how can we accept economic theories that work only because they assume that people are fully rational? The upshot is that we are simply not smart enough to leave the market alone.
But where do we go from there? Is it possible to think about regulating the market when we are not even smart enough to leave it alone? The answer is yes. Actually it is more than that. Very often, we need regulation exactly because we are not smart enough. Let me show why.
The last Renaissance Man Herbert Simon, the winner of the 1978 Nobel Prize in economics, was arguably the last Renaissance Man on earth. He started out as a political scientist and moved on to the study of public administration, writing the classic book in the field, Administrative Behaviour. Throwing in a couple of papers in physics along the way, he moved into the study of organizational behaviour, business administration, economics, cognitive psychology and artificial intelligence (AI). If anyone understood how people think and organize themselves, it was Simon.
Simon argued that our rationality is ‘bounded’. He did not believe that we are entirely irrational, although he himself and many other economists of the behaviouralist school (as well as many cognitive psychologists) have convincingly documented how much of our behaviour is irrational.2 According to Simon, we try to be rational, but our ability to be so is severely limited. The world is too complex, Simon argued, for our limited intelligence to understand fully. This means that very often the main problem we face in making a good decision is not the lack of information but our limited capability to process that information – a point nicely illustrated by the fact that the celebrated advent of the internet age does not seem to have improved the quality of our decisions, judging by the mess we are in today.
To put it another way, the world is full of uncertainty. Uncertainty here is not just not knowing exactly what is going to happen in the future. For certain things, we can reasonably calculate the probability of each possible contingency, even though we cannot predict the exact outcome – economists call this ‘risk’. Indeed, our ability to calculate the risk involved in many aspects of human life – the likelihoods of death, disease, fire, injury, crop failure, and so on – is the very foundation of the insurance industry. However, for many other aspects of our life, we do not even know all the possible contingencies, not to speak of their respective likelihoods, as emphasized, among others, by the insightful American economist Frank Knight and the great British economist John Maynard Keynes in the early twentieth century. Knight and Keynes argued that the kind of rational behaviour that forms the foundation of much of modern economics is impossible under this kind of uncertainty.
The best explanation of the concept of uncertainty – or the complexity of the world, to put it another way – was given by, perhaps surprisingly, Donald Rumsfeld, the Defense Secretary in the first government of George W. Bush. In a press briefing regarding the situation in Afghanistan in 2002, Rumsfeld opined: ‘There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.’ I don’t think those at the Plain English Campaign that awarded the 2003 Foot in Mouth award to the statement quite understood the significance of this statement for our understanding of human rationality.
So what do we do, when the world is so complex and our ability to understand it so limited? Simon’s answer was that we deliberately restrict our freedom of choice in order to reduce the range and the complexity of the problems that we have to deal with.
This sounds esoteric, but when you think about it, this is exactly what we do all the time. Most of us create routines in our life so that we don’t have to make too many decisions too often. The optimal amount of sleep and the optimal breakfast menu differ every day, depending on our physical conditions and the tasks ahead. Yet most of us go to bed at the same time, wake up at the same time and eat similar things for breakfast, at least during the weekdays.
Simon’s favourite example of how we need some rules in order to cope with our bounded rationality was chess. With only thirty-two pieces and sixtyfour squares, chess may seem to be a relatively simple affair, but in fact involves a huge amount of calculation. If you were one of those ‘hyper-rational’ beings (as Simon calls them) that populate standard economics textbooks, you would, of course, figure out all the possible moves and calculate their likelihoods before you make a move. But, Simon points out, there being around 10120 (yes, that is 120 zeroes) possibilities in an average game of chess, this ‘rational’ approach requires mental capacity that no human being possesses. Indeed, studying chess masters, Simon realized that they use rules of thumb (heuristics) to focus on a small number of possible moves, in order to reduce the number of scenarios that need to be analysed, even though the excluded moves may have brought better results.
If chess is this complicated, you can imagine how complicated things are in our economy, which involves billions of people and millions of products.
Therefore, in the same way in which individuals create routines in their daily lives or chess games, companies operate with ‘productive routines’, which simplify their options and search paths. They build certain decision-making structures, formal rules and conventions that automatically restrict the range of possible avenues that they explore, even when the avenues thus excluded outright may have been more profitable. But they still do it because otherwise they may drown in a sea of information and never make a decision. Similarly, societies create informal rules that deliberately restrict people’s freedom of choice so that they don’t have to make fresh choices constantly. So, they develop a convention for queuing so that people do not have to, for example, constantly calculate and recalculate their positions at a crowded bus stop in order to ensure that they get on the next bus.
The government need not know better So far so good, you may think, but what does Simon’s theory of bounded rationality really have to say about regulation? Free-market economists have argued against government regulation on the (apparently reasonable) ground that the government does not know better than those whose actions are regulated by it. By definition, the government cannot know someone’s situation as well as the individual or firm concerned.
Given this, they argue, it is impossible that government officials can improve upon the decisions made by the economic agents.
However, Simon’s theory shows that many regulations work not because the government necessarily knows better than the regulated (although it may sometimes do – see Thing 12) but because they limit the complexity of the activities, which enables the regulated to make better decisions. The 2008 world financial crisis illustrates this point very nicely.
In the run-up to the crisis, our ability to make good decisions was simply overwhelmed because things were allowed to evolve in too complex a manner through financial innovation. So many complex financial instruments were created that even financial experts themselves did not fully understand them, unless they specialized in them – and sometimes not even then (see Thing 22). The top decision-makers of the financial firms certainly did not grasp much of what their businesses were doing. Nor could the regulatory authorities fully figure out what was going on. As discussed above, now we are seeing a flood of confessions – some voluntary, others forced – from the key decision-makers.
If we are going to avoid similar financial crises in the future, we need to restrict severely freedom of action in the financial market. Financial instruments need to be banned unless we fully understand their workings and their effects on the rest of the financial sector and, moreover, the rest of the economy.
This will mean banning many of the complex financial derivatives whose workings and impacts have been shown to be beyond the comprehension of even the supposed experts.
You may think I am too extreme. However, this is what we do all the time with other products – drugs, cars, electrical products, and many others. When a company invents a new drug, for example, it cannot be sold immediately. The effects of a drug, and the human body’s reaction to it, are complex. So the drug needs to be tested rigorously before we can be sure that it has enough beneficial effects that clearly overwhelm the side-effects and allow it to be sold. There is nothing exceptional about proposing to ascertain the safety of financial products before they can be sold.
Unless we deliberately restrict our choices by creating restrictive rules, thereby simplifying the environment that we have to deal with, our bounded rationality cannot cope with the complexity of the world. It is not because the government necessarily knows better that we need regulations. It is in the humble recognition of our limited mental capability that we do.
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