Tuesday, October 14, 2008

Objectivism & Economics, Part 3

Market failure: derivatives As is well known, Ayn Rand opposed any “interference” in the market by the government on moral grounds. Government intervention, for Rand, is immoral. Since Rand believed that the moral course is also the practical course, she held that any so-called “market failures” were ultimately caused by government intervention in the economy.

Is this true? Well, not entirely. Consider the role that derivatives played in the current financial meltdown, as outlined by Doug Noland at prudentbear.com:

I am of the opinion that derivatives have played a critical role in the ongoing global crisis. Importantly, the proliferation of derivatives has come to radically distort financial markets. As such, I see derivatives as a very close partner to credit excess. Both work to distort market-pricing mechanisms. It is certainly my contention that derivatives affect risk perceptions and change behavior. In this regard, when discussing derivatives I like to use a flood insurance analogy. Say we have a homeowner who would like to build his dream home along the river. Yet, if this homeowner lacks access to affordable flood insurance, the risk of building is likely to be perceived as too great. If, however, inexpensive flood insurance is readily available, the perceived risk of building on the river is acceptable and building begins.

Now, taking this analogy one step further, let’s say that there has been a very long drought, which has led to a stampede of companies writing flood insurance. Why not? Premiums in this environment are as close as it gets to "free money." Here, insurance only gets cheaper, encouraging more exuberant homeowners to build dream homes on the river. Despite the appearance of prosperity, risk grows for the entire system. Importantly, the proliferation of cheap insurance fosters a change in behavior – encouraging a building boom along the river and the acceptance of greater risk by individual homeowners and the insurance companies. So come the inevitable flood, there will be more homes destroyed, the solvency of the insurance companies will be in jeopardy, and the risk of failure for the entire system will be much greater than if the building boom had never occurred. Importantly, if a few homeowners purchase insurance and build on the river, flood insurance works fine. If everyone builds on the river and there is a flood, there is a big problem.

All the same, a very strong consensus led by Greenspan and Wall Street argues that derivatives reduce risk. I disagree. Derivatives simply shift risk from one party to another. Sure, an individual market participant can use derivatives to transfer risk. But if much of the market moves to transfer risk, there will simply be no one to take the other side of the trade. Entire markets can not hedge themselves. Indeed, for the system, the proliferation of derivatives significantly increases the risk of both market distortions and dislocations.

Noland’s analysis pretty much hits the nail on the head, but I think that nail could be driven in even further. Derivatives are often seen as a form of insurance. That’s what the whole notion of a hedge fund is all about. Investors are “hedging” their speculative bets, with the underlying idea that, if their investments turn sour, they’ll still get something out of it. Yet this is plainly irrational behavior. The economist Frank Knight distinguished between risk and uncertainty. Risk, Knight contended, is something calculable. For example, mortality is something that is fairly steady over time. Therefore, there is a calculable risk that an individual will die in a given year, and based on that calculable risk, a company can provide life insurance and still expect to make a profit. Speculative investments do not, on the other hand, involve calculable risks. They are, as Knight would say, uncertain. Hence, it is irrational to try to “insure” investments. For the reasons given by Noland, they can’t be insured.

Where is the market failure in all of this? Well, it’s quite simple: derivatives are a market phenomenon. They are the product of freely acting market participants. They prove, once and for all, that the market is no guarantee of rational behavior. Whenever the effects of irrational behavior are (1) not felt immediately and (2) profitable in the short-run, human beings will tend to behave irrationally. The question then is: should the government have intervened to stop or limit this irrational behavior, particularly the large consequences it has had over society at large?

15 comments:

Darren said...

Objectivism does not state that a free market is a guarantee of rational behavior. And the free market does not guarantee that success and growth will always happen. However, it doesn't guarantee that only those that take on those risks will suffer the consequences. Laissez faire capitalism (i.e. the free market) basically means that everybody is free to do what they wish with their own lives and property. Nothing more, nothing less.

If there was ever a situation that showed the dangers of government interference in the market, this "bailout" crisis would be it.

Damien said...

Darren,

I have to agree with you in that this crisis is not the argument against Laissez faire capitalism that many socialists think that it is.

gregnyquist said...

Darren: "Darren: "The free market does not guarantee that success and growth will always happen. However, it doesn't guarantee that only those that take on those risks will suffer the consequences."

No, but it would like to evade some of the problems related to this. The implication of Objectivism (and nearly all defenders of laissez-faire) is that penalizes irrational behavior, so those that engage in it our appropriately punished. But in the current crisis we have a situation where market incentives have spontanously arisen which, in the short-term, rewarded widespread irrationality but in the long-term led to consequences suffered even by people who played no role in bringing the crisis about. So why shouldn't the government have stepped in to stop it? To say people should be free to do as they wish is all fine and good; but when their freedom puts the rest of us in jeopardy, isn't that taking a mere shibbeloth of ideology a bit too far? This is why so few (and no one who has first hand experience running a state) ever supports an uncompromising laissez-faire. It defies common sense. By all means, extend freedom as far as you can. But don't extend it so far that it puts all of us in jeopardy.

Damien said...
This comment has been removed by the author.
Darren said...

Hi Greg, I'd like to make a few points to what you said:

1.) Capitalism does not penalize irrational behavior -- reality does. For example, if I choose to try to make more money by burying my credit cards in my garden and waiting for a money tree to grow, I won't succeed because that's not how reality works. For the same reason, if I choose to loan money out to people who don't have the means to pay it back, I will probably lose my money. It's not fair to blame capitalism for the negative results of irrational actions.

2.) It's very possible to be "rewarded" -- if that's the term you want to use to describe what many did during the lead-up to today's situation -- for irrational actions, especially in the short term, but you can't evade the consequences. As another example, if I maxed out my credit in order to go on a video-game shopping spree, would you consider my new toys as an example of how capitalism rewards irrationality? Of course not, because we both know that I'll have an enormous credit card billing coming in a month.

And who will have to pay that bill? Me. My irrational actions, my consequences.


3.) The government didn't just break into the free market now -- they've been in it for years, and on a level that makes the $700 billion bailout look like nothing. When you say that "market incentives" arose that caused this problem, I think you've overlooking a *LOT* of government interference that pushed us here.

4.) I think a lot of people assume that laissez-faire capitalism means that the government does nothing and everybody gets to do whatever they want, but that's not the case. Freedom and anarchy are not the same thing. Under a capitalist system (which we don't have today), every company that acted irrationally would have to suffer the consequences of their actions. There would be no bailout, and there would have been no incentives by the government for some companies to try to make a quick buck. The government would only step in if someone used force or fraud to interfere with another person's rights.

JayCross said...

Darren said exactly what I intended to say. Irrational behavior will always exist, but markets at least punish that behavior and make continued irrational behavior (at least the same kind) less likely.

JayCross said...

I would also add that the virtual guarantee of government bailouts for large companies is what fuels a lot of the irrational risk taking. These banks knew damn well they would be deemed too big to fail.

gregnyquist said...

Darren,

Your points, while in many respects true, don't answer my own points, which are, to clarify once again:

1. Unfortunately, it's just the irrational actors who are going to be punished in this situation. Their irrational actions have imperiled the world financial system, which, if it were to collapse, could imperil Western Civilization itself. The problem were facing is the market cannot guarantee that only the irrational will pay a price. We may all pay a price.

2. The derivatives is one of the least regulated markets out there. It spontaneously developed out of market forces itself. While it is obviously true that derivative-related irrationality was exacerbated by Fed and Treasury policies, if we wish to be scrupulously honest and fair, we have to admit that there is a market failure here. Consider the following news report: "Throughout the 1990s, [J.P. Morgan] was a major player in persuading lawmakers to allow the derivatives markets to remain unregulated—a move regulators are now reevaluating." Why are they reevaluating it? Because one of the main factors behind the credit crisis is credit derivatives, invented by J.P. Morgan.

3. There are an estimated $300 Trillion in derivative financial obligations out there, and an estimated 80 to 90 percent of them are bad. It's an unparalleled disaster that's going to greatly strengthen anti-market forces around the world, thus reversing all the progress made since the early 70s against socialism and over-regulation. And this disaster could have been prevented by merely adding a few regulations of derivative finance (such as forbidding leveraged speculation on derivatives).

3. Would the removal of all safety nets force be to more rational. Up to a point, they obviously would, but to assume that they would stop all irrationality is not supported by the facts. We had no safety nets before the 30s yet we had plenty of market panics stemming from irrational "wildcat" financing. Market bubbles and catastrophic failure occur with or without moral hazards.

4. Privately, I prefer the libertarian ideals of freedom and self-responsibility. But if we want to get to the truth of the matter, we have to put our private sentiments aside and face the facts squarely. We have to be willing to accept hard facts that may go against our private inclinations.

Darren said...

Greg,

The only reason people are being punished today for the irrational actions of others is the fact that the government is forcing us to. If the government left those companies to face the consequences for their actions, then they would and we wouldn't. We'd get to keep the money that otherwise will be thrown away for these companies.

Yes, it's true that other people will be affected. Jobs could be lost, credit could be tight, retirement accounts could drop, etc., but those aren't punishments and their cause isn't just those companies making irrational decisions. One, a lot of people chose to invest in those businesses, and therefore they accepted the risk that they could lose that money. Second, we're not owed anything by anyone else. If someone won't offer something that they used to offer (like a long-term car loan or a no-money-down low-interest mortage rate), we haven't lost anything that we had to begin with.

It might be easier to explain with a few quick examples. Let's say that the owner of the company I work for makes a couple bad, irrational business decisions that cause the business to close. Am I being "punished" with the loss of my job for his irrational decisions? I'd say no. Yes, my job no longer exists, but my job was always tied to my employers desire to employ me. The reason *why* they don't want me is irrelevant next to the fact that they don't want me. Or let's say that I want to get a no-money-down mortgage (which used to be very easy), but my bank will no longer offer it. Am I being "punished?" I'd say no. I am not owed credit by anyone.

From what I've read it seems that you're treating these types of effects as a problem with capitalism itself, as if each individual should be able to completely isolate him or herself from all effects brought on by the irrational decisions of others. And since it can't (and nothing can, by the way), perhaps the government should step in to protect individuals from the effects of others. Or at least, they should when some think that it's big enough to threaten Western civilization, right? I think that as soon as you replace our right and ability to act by his own mind with government force, even if what you're forcing others to do is the best thing for them to do, only bad things can happen.

I agree with you that we have to put our sentiments aside and look squarely at the facts, but that's what I'm doing. Based on what I've learned of man's nature and the thousands of examples of government interference that I've seen, I think the case is closed about the benefits of capitalism.

merjet said...

Barnes: As is well known, Ayn Rand opposed any “interference” in the market by the government on moral grounds. Government intervention, for Rand, is immoral.

This is not wholly true. She supported government intervention to protect property rights and for the prevention and resolution of force and fraud.

Yes, derivatives have had a role in the financial crisis. However, blaming credit default swaps for the mortgage mess is like blaming your insurance policy when your house burns down as the cause of the fire.

Also, the biggest sellers of the equivalent of credit default swaps have been Fannie Mae and Freddie Mac. I have yet to see that acknowledged or even mentioned in the media, e.g. the 60 Minutes segment on credit default swaps aired October 5. What Fannie and Freddie do isn't called "credit default swaps", but that is the essence. They sell protection, in exchange for a small slice of the mortgage interest (and maybe other related fees) against default.

merjet said...

Oops. I attributed the quote in my previous post to Barnes. It should have been Nyquist.

Darren said...

I don't think it's fair to consider the government's protection of individual rights as "intervention" or "regulation." It's not like there are two extremes, pure anarchy and pure statism, with law (including objective law) falling somewhere in the middle. I think two extremes are actually the complete protection of individual rights versus the negation of individual rights, with anarchy and statism both falling into the latter group.

gregnyquist said...

Darren,

I still don't think you're facing what is at stake here. Whether we say people are being "punished" is an issue of semantics. They are certainly being hurt economically in part because of wildcat financing involving the irrational use of derivatives to "insure" risky loans. This irrational use of derivatives, along with loose monetary policy of the Fed, the over-extension of safety nets by the government, and the encouragement of risky loans both by the financial sector and the government, have brought about the present crisis. Champions of the laissez-faire model of capitalism are quick to point out all the areas where government interference contributed to the problem, but they turn a blind eye to where letting economic actors do as they please made things worse. What is so bad about having a few regulations against irrational (and possibly fraudulent) economic behavior? Capitalist finance was basically trying to transform bad credit into good credit by insuring it with derivatives. "This isn't bad credit," they were saying. "It's good credit, because it's insured." Now you can't insure credit: credit is not a calculable risk, like mortality or the chance of a person getting an automobile accident. So, in a sense, these insurance derivatives were fraudulent. Why shouldn't the government intervene to stop it? Yet Objectivists and libertarians oppose such regulations on principle because it violates their ideology. Here's an example of ideology trumping common sense.

Is this a complaint against capitalism itself? No, only a complaint of the type of capitalism advocated by Rand and other supporters of so-called laissez-faire. The notion of regulating the irrational (and fraudulent) use of derivatives would be perfectly compatible with the forms of capitalism advocated by Hayek, Roepke, or Alexander Hamilton. Government plays an instrumental role in defending and nourishing markets. Where market "failures" exist, adjustments have to be made.

Anonymous said...

Dan here: A good deal of what would or would not happen in a "free-market" as opposed to the current situations is nothing more than mental masturbation.

So, allow me some pleasure also --- I submit that our current security exchanges, the methods of organizing businesses, in fact, the entire methods of "doing business" would NOT exist under a government free form of capitalism.

Everybody needs to remember, the near-monopolies that we see, the gargantuan-mega-sized corps only exists with the help of government. The notion of a "runaway" business somehow taking over the world if it were not for governments' interventions is a bit sloppy.

Daniel Barnes said...

Dan:
> A good deal of what would or would not happen in a "free-market" as opposed to the current situations is nothing more than mental masturbation.

Yes.

>So, allow me some pleasure also ---

We aim to please...;-)