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?

Objectivism & Economics, Part 1

My original intention was to start a series of posts on Objectivism and politics. But the seriousness of the crisis in the credit and finance markets suggests that our focus should turn to economics. What is happening to finance capitalism is extremely serious—more serious even then what happened in October 1929. While much of what has happened in the last 20 years can easily be laid at the hands of government interference, it is not clear that everything that has happened is the government’s fault. No specific ideology comes out of this mess looking like it has all the answers.

Yaron Brook from ARI has issued the following statement about credit debacle:

But the mounting financial problems reveal that Paulson and Bernanke are as clueless as any other central planners who try to control an entire economy. They are not saving us from anything; they are delaying some of the pain that necessarily follows from a Fed-induced credit bubble, and redistributing that pain to innocent victims. They are punishing responsible individuals and rewarding irresponsible individuals.

“The bailouts must stop. The government must make clear that from now on, those who are in financial trouble must turn to the private market for help if they are to avoid failure; the government must no longer foist their failures on others, and invite another crisis in the future.”



For better or worse, Brook’s "do-nothing" approach to the problem is not a viable option. Any politician who stood for it would be immediately discredited in the eyes of the electorate. The political reality is that market solutions are not allowed in crisis situations like the one we are facing. Hence we find former Objectivist Alan Greenspan (who understands the underlying political climate better than any of the ARI folks) suggesting another approach. "We need laws that specify and limit the conditions for bailouts -- laws that authorize the Treasury to use taxpayer money to counter systemic financial breakdowns transparently and directly rather than circuitously through the central bank as was done during the blowup of Bear Stearns," Greenspan has written in the paperback version of his autobiography, The Age of Turbulence. In other words, Greenspan is arguing that, since the government is going to intervene anyway (no preventing that), at least it should intervene in as rational a way as possible.

Can the government intervene without making things worse? Well, given how dire the situation really is, it may not really matter. If market forces were allowed to do their thing, the consequences would be little short of catastrophic. There is at least $2 trillion dollars in bad debt out there (and this is not even including bad derivative-related debt, which may be in the tens of trillions). If you allow company A to go under, then it can’t pay it’s obligations to company B. But then company B can’t pay company C, which in turn can’t pay company D, etc. etc. In other words, if the market it allowed to do its thing we would almost certainly see a collapse of a good portion of the financial system. Even more serious, such a collapse could trigger a very serious deflation, as the credit bubble bursts and suddenly you have massive contraction in the money supply (some of this deflation has already occurred, but it has been confined to the housing and asset markets). Deflation is one of the worse things that can happen to an economy in peacetime. If the United States went through a major deflation, that would greatly strengthen the anti-capitalist left in this country, which would put the nation in serious peril (and put an end to any hope for a market solution).

Perhaps the real truth is that nothing can be done one way or the other. Whatever we do, we’re screwed and there’s an end to it. As Doug Noland, the financial analyst who more than ten years ago saw what would happen as a result of wildcat financing of the nineties wrote:

As we are witnessing today, the issue is not some manageable amount of new “capital” to replenish banking system losses.  Instead, the predicament is the massive and unmanageable amount of new Credit necessary to, on the one hand, sustain a mal-adjusted Bubble Economy and, on the other, the Trillions more required to accommodate a gigantic speculative de-leveraging.  I have a very difficult time seeing a way out of this terrible mess.