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?