Thursday, March 05, 2009

Objectivism & Economics, Part 22

Ayn Rand's insistence on the separation of the economy and the state means that she opposes all regulations, even those that would prevent serious market failures with widespread externalities. Indeed, there is a tendency among Objectivists to deny that regulations can ever have a positive effect. The implicit argument is that, because regulations infringe on individual rights, they are immoral; and since Objectivists insist on equating the moral with the practical, this suggests that any infringement of "individual rights" must lead to bad results (such as aversely affecting millions of people). But if this isn't true, if certain types of financial instruments produced by the market lead to extreme financial dysfunction which harms millions of people, shouldn't the government seek to regulate those financial instrumen? Martin Hutchinson over at prudentbear.com presents a convincing argument for regulating the CDS (Credit Default Swaps) market:


In the early years of the London insurance market, it was possible to buy a life insurance policy on a complete stranger. Then insurance companies noticed the high incidence of unexpected homicides among their lives assured, and the concept of insurable interest was devised, codified by the Life Assurance Act of 1774. Today, you can’t buy a life insurance policy unless you can demonstrate some loss by the assured party’s death. The business is safer that way!

The same consideration must surely apply to the CDS market. The legitimate hedging purpose of CDS today represents only a tiny proportion of contracts outstanding.... With multiple bankruptcies and huge market instability owing at least part of their provenance to CDS, the public policy consideration for closing or at least sharply restricting the CDS market is even clearer than that promoting the restriction of the insurance market in 18th century London (at least taxpayers weren’t expected to pick up the tab for insurance policies on murder victims!)

As a minimum, therefore, CDS writing should be restricted to those holding bond, loan or swap obligations against which CDS might reasonably hedge. CDS should be distinguished from stock short positions and stock options (which have similar theoretical possibilities) because their greater leverage and higher outstanding volume make them uniquely dangerous. Such a market would be highly illiquid, but it would fulfill CDS’s essential function of enabling credit risk transfer. CDS’s other advantages, of demonstrating credit spreads over a public marketplace, allowing the hedging of baskets of similar credits, providing an instrument for hedge fund “investment” and making huge returns for the major dealers, would be lost. However, CDS’s destabilizing effect on global financial markets would also be lost, and the cost to taxpayers of rescues for those major institutions which had either got the CDS market wrong or were victims of CDS “bear raids” would be eliminated.

The free market is a wonderful thing. However, allowing unrestricted free markets in everything, without regard to the real-world economic effect of those markets, is a Whig shibboleth similar to the “Repeal the Corn Laws” unilateral free trade policies that destroyed Britain’s economic strength in the 19th century. The great and economically highly sophisticated Tory Prime Minister Robert Lord Liverpool, a generation prior to the mid-century free traders, also believed in free markets, but was a realist in their application to the world in which he lived.

The real world is messy and does not conform to simplistic equations either mathematical or moral. The wise policymaker will legislate accordingly, providing the maximum market freedom but inserting restrictions where the temptations to malfeasance are too great. The CDS market forms an open and shut case for restrictive regulation.



11 comments:

Anonymous said...

Good post, but this part doesn't say what you want it to:

"... and since Objectivists insist on equating the moral with the practical, this suggests that any infringement of 'individual rights' cannot possibl[y] lead to bad results (such as aversely affecting millions of people)."

I think you mean to say that Objectivists believe any infringement on individual rights *will* lead to bad results - thus all regulations are immoral and impractical, in their view.

Incidentally, the widespread use of short ETFs may also be contributing to the market's rapid decline. Some people call these ETFs "weapons of mass destruction."

The uptick rule used to prevent a lot of short selling, but the SEC, under the leadership of Bush appointee and staunch free marketeer Chris Cox, repealed it. Hmm. How's that working out? Let me check my portfolio ...

- Michael Prescott (Blogger won't let me sign in)

Anonymous said...

Ayn Rand wrote little or nothing about financial markets, which probably matched her knowledge of them. In what seems to be his habit, Nyquist scans what she did write that he believes might apply to what he wants to write about. He reads it very uncharitably and misses other passages that might apply. For example, in her Nature of Government she wrote a little about breach of contract, including this.

Some of these actions are obviously criminal. Others, such as a unilateral breach of contract, may not be criminally motivated, but may be caused by irresponsibility and irrationality. Still others may be complex issues with some claim to justice on both sides. But whatever the case may be, all such issues have to be made subject to objectively defined laws and have to be resolved by an impartial arbiter, administering the laws, i.e., by a judge (and a jury, when appropriate). .... Such, in essence, is the proper purpose of a government, to make social existence possible to men, by protecting the benefits and combating the evils which men can cause to one another.

Do you think that just maybe this might apply to an insurance contract or CDS? Of course not, to Greg Nyquist. Consider what Ayn Rand might have said about a life, auto, or homeowner's insurance contract. Suppose some insurance companies sold policies and then refused to pay legitimate claims, which is obvious fraud. Do you really believe Ayn Rand would have said it was wrong for government to interfere simply because it was "an infringement of individual rights"? Yet that is essentially the view Nyquist expresses.

I won't deny there is a tendency among Objectivists to deny that regulations can ever have a positive effect. But to claim that Ayn Rand "opposes all regulations" is hogwash.

By the way, the change that occurred in the life insurance market Mr. Hutchinson wrote about in his first paragraph was not due to simply government regulation. It was in the self-interest of the life insurance companies to not sell policies without an "insurable interest." Government regulation was probably after the fact, as usual.

Anonymous said...

"The CDS market has long since ceased to be a means of hedging credit exposure, if indeed it ever really was. At its peak, its outstandings totaled $62 trillion, more than twice the world’s total outstanding loans." (convincing argument link)

From Wikipedia:

"By the end of 2007, the CDS market had a notional value of $45 trillion, of which the corporate bond, municipal bond, and structured investment vehicles market totaled less than $25 trillion."

"[T]he Depository Trust and Clearing Corp, which maintains a database holding around 90% of all credit derivative transactions, held $29.2 trillion of outstanding CDS trades as of 26 December 2008."

Maybe there was a spike between the two dates. Plausibly a chunk of that spike was based on Fannie Mae and Freddie Mac debt!

"According to Citi via the FT, there is some $400 billion of notional volume in Lehman CDS outstanding, perhaps 80% of the volume of CDS written on Fannie and Freddie's $1.4 trillion debt."
http://www.ft.com/cms/s/0/7a268486-93cd-11dd-9a63-0000779fd18c,dwp_uuid=11f94e6e-7e94-11dd-b1af-000077b07658.html?nclick_check=1

However, in the comments to Objectivism & Economics, Part 21 Nyquist says the notional amount was $600 trillion, nearly 10 times the $62 trillion cited above!! Not only did he present a misleading number, it looks false. And somehow Nyquist manages to give government a pass in the CDS market.

Kelly said...

Anonymous try typing in "notional value for derivatives of nearly $600 trillion" into Google. you'll get story's like the following:

http://www.business-standard.com/india/news/shankar-acharya-global-financial-crisis-an-asian-view/08/54/348801/

http://seekingalpha.com/article/99674-coming-soon-the-600-trillion-derivatives-emergency-meeting

http://www.fxstreet.com/fundamental/market-view/12-urgent-questions-for-2009-/2008-12-29.html

Anonymous said...

Kelly,

It was enough to look at your links, especially the second one. It says: "According to figures released in the quarterly review of the BIS (pp A103) in September the total notional amount of outstanding derivatives in all categories rose 15% to a mindboggling $596 TRILLION as of December 2007.
Two thirds of contracts by volume or $393 TRILLION fell into the category of interest rate derivatives. Credit Default Swaps had a notional volume of $58 TRILLION, seeing the sharpest relative increase after a volume of $43 TRILLION a year earlier.
Currency derivatives reached a volume of $56 TRILLION."

With his "$600 trillion" Nyquist was not clear about what kind of derivatives they were. However, the main subject of discussion was CDS. The above says the amount was $58 trillion. The other two sites also said $600 trillion w/o saying what kind.

Kelly said...

I missed the part about CDS's

Kelly

gregnyquist said...

Michael: "I think you mean..."

Thanks for the heads up. That's what I get for posting too quickly.

gregnyquist said...

As Kelly has point out, the notional value is, in fact, nearly $600 trillion, just as I said. So how does Anon respond? Well, he's annoyed because I "was not clear about what kind of derivatives they were." The reason I wasn't "clear about" this is because I was merely noting derivatives in general. If someone says "the notional value of derivatives is nearly $600 trillion," anyone with a free and open mind would understand right off the bat this meant "derivatives in general," not some particular type of derivative.

This sort of procedure is, alas, all too typical among advocates and defenders of Objectivism. They have no interest in understanding criticisms of Objectivism. They merely wish to find any pretext, however flimsy and non-logical, to dismiss it out of hand. Hence the preoccupation with peripheral issues, accompanied with the tendency to even get those wrong.

gregnyquist said...

Anon: "However, the main subject of discussion was CDS."

The main subject of which discussion? Here I think you have convinced this post with the previous post. CDS is the main subject of discussion of this post, not the previous post, where the notional value of derivatives in general was mentioned.

Anonymous said...

Nyquist: If someone says "the notional value of derivatives is nearly $600 trillion," anyone with a free and open mind would understand right off the bat this meant "derivatives in general," not some particular type of derivative.

Immediately before using the $600 trillion, you wrote, "the most serious dysfunction existed in the securities markets, particularly in the markets for derivatives." Were interest rate swaps and currency swaps in "serious dysfunction." No, so I think it was quite reasonable to assume you meant CDS.

Nyquist: They merely wish to find any pretext, however flimsy and non-logical, to dismiss it out of hand.

Change "it" to Rand, add "and criticize her" at the end, then look in the mirror.

mad dog said...

This article is almost a complete strawman, considering that Ayn Rand really focused on philosophy, fiction and art, not economics.

If you want to really criticize someone who supported lazziez faire on the economic side of things, then you should read someone like Ludwig Von Mises.