Thursday, December 29, 2011

The Free Market Is Not Efficient: Unfettered Greed Undermines Fair Competition

Thanks to Jesse for his great comments on my previous post.

>> I think it is useful to separate profits by their source: value added vs rent seeking.

I completely agree.  This is an idea I've thought about for a while.  In the simple competitive equilibrium model, there's no distinction between the sources of profit.  All agents are acting rationally, so they are all made better off by participating in the market.

But economics does not do a great job of addressing two key distortions: deception and manipulation.  Even behavioral economics models focus on behavioral biases like time inconsistency, prospect theory, overconfidence, etc.  But we almost completely overlook the possibility that wide swaths of the economy make money through deception and manipulation.

Preferences are malleable - this fact is at the heart of consumerism.  How do we compute the welfare implications of a market system if it creates needs in order to fulfill them?  Are people better or worse off if they would have been perfectly happy without a smart phone, but felt compelled to buy one because everyone else had one? Sometimes marketing is innocuous - simply informing us that a useful product is available.  Most marketing, however, contains elements of deception and manipulation, creating subconscious and emotional associations that gin up sales but ultimately leave us empty.

Once we confront the mercurial nature of human preferences, separating "true" value-creation from profiteering becomes philosophically, psychologically, and especially economically confounding.  Because economists don't know how to deal with it, we just ignore it.  Thus, even the idea of "value added" profits quickly fall apart when we consider the impact of deception and manipulation.

Finance has taken deception and manipulation to an extreme through multifarious versions of fraud, shrouding risk in complexity, and subverting the government.  Willful deception was at the heart of every piece of the mortgage crisis - appraisal fraud, liar's loans, deceptive selling of toxic CDOs, deceptive AAA ratings.  Financial firms and markets compel the government to intervene aggressively by holding the economy hostage, making campaign contributions, and exerting ideological influence.  In finance, the "freer" the market has become, the further it's moved from fair competition.

Deception undermines markets. Manipulation undermines markets.  Both lead to economic inefficiency.  Yet deception and manipulation are also incredibly lucrative investment opportunities.  Because economists have no uniform framework to address these distortions, we focus on attacking government as a source of inefficiency.  This in turn breaks down the rules that limit deception and manipulation.

Competition works when there are rules.  Rule-governed competition in sports promotes the development of extraordinary physical ability.  If we eliminated rules in sports, people wouldn't get faster or stronger.  Sports stars would just be the psychopaths willing to go the furthest to undermine their opponents.  This is what has happened in finance and other industries where we've embraced the ideology of unfettered self-interest.

While sweeping (e.g. government) reform is crucial, I think that moral and cultural reform are essential as well.  Given the gridlock in our political system, I think that moral clarity is necessary to build the political will to pass meaningful regulatory reform in any case.  In the financial industry, I'm convinced that no regulation can be effective without changing the moral framework.  Bankers will always be wilier and more voracious than the regulators, so unless they themselves change, they'll always find ways to subvert the rules (not to mention rule-making!).  True reform has to come from within.

We as a society seem to have given up the fight on moral grounds - we've accepted the ugliness of finance and consumerism as necessary for America to function.  I argue that we can't give up.  Unfettered greed (with emphasis on unfettered) is the cause of our problems, not a necessary evil.  From a scientific standpoint, simplistic, Randian notions about the efficiency of the free market are simply wrong.


sabre51 said...

You are absolutely right, people are greedy. Extremely greedy. I agree that, if you could chnge bankers to feel a moral calling to be honest to stockholders and home-borrowers, the world would be a better place. I agree that preferences are malleable and that this can cause difficulties in welfare analysis.

However, desire for utility is not malleable. People are greedy because it brings them rewards, and convincing them not to be will not succeed. Intellectuals have been calling for reform since the days of JP Morgan, but bankers are still extremely greedy. Change from within is not going to happen. Society has not "given up the moral fight," as you put it- we still impose status penalties on bankers because of their overriding greed (of course, this has the side effect of making banking relatively more attractive to people whose greed overwhelms their desire to feel good about their behavior). I strongly disagree, though, with your phrasing that unfettered greed is the cause of our problems.

Firstly, rent-seeking is not really related to efficiency (it is certainly important, I'll get to it) in terms of total productivity, which is the most important factor in standard of living. The more there is, the more each person can have. Free markets are efficient because they drive producers to be more productive, and they drive consumers to choose those products they want most strongly (whether influenced by marketing or not). In the free market rent-seeking is checked naturally by competition, so that any move to drive prices above costs is an opportunity for a competitor to beat you. Helping consumers protect against rent-seeking is itself a valuable service, and firms can profit by doing it well. The only reliable way to profit in a true free market is to provide things which consumers value.

The main way in which firms seek rents in our economy is through government action, which is immune to competition. The mortage crisis is a perfect example. Banks were willing to lend to creditors that they knew were risky because Fannie and Freddie virtually guaranteed them in case of default. The AAA ratings were inaccurate because financial regulation required banks to use the ratings by the big three (government protected oligopoly), so the banks had a reason to influence those ratings. In a free market, the banks would be able to gain only for a very short time by influencing those ratings, since any deterioration in the accuracy of ratings would damage reputation and lose profits for the raters. Indeed, if you look at market measures of risk, like credit default swaps, mortage backed securities were accurately gauged despite the AAAs.

I'm writing all this because I really do think this is a defining issue for our time. You are clearly very smart, much smarter than me (your post on Benford's Law was fascinating, despite your later comments, and that was what got me hooked on this blog). But everyone has to be willing to put their feelings aside and focus on outcomes. Reading this, it sounds like your feelings for those who were hurt are informing your arguments, as they do for almost everyone. But our current economy with further government intervention to address these problems will not achieve the same results as a free market. If we want to address inequality (which I do, and it sounds like you do to) we can tax and transfer afterward, in a much more efficient way than our current hodgepodge of Medicaid, welfare, housing, etc. I'm also writing because we need to have the smart people on our side, because most people will never be able to understand the complex arguments that go with a problem like this.

You said it yourself, "Bankers will always be wilier and more voracious than the regulators... they'll always find ways to subvert the rules." Many people make similar comments, about businesses using the government's power to abuse consumers. Be the person who takes the next logical step: "Well, what if we just took away that power?"

Jesse B said...

I think we need to place distributional outcomes on par with efficiency outcomes. Economics has long worshipped the idea of maximizing efficiency while ignoring the distribution. Many economists recognize this, but it is hard to address it. I would like to see some sort of "dual mandate" situation where both efficiency and distribution are considered and we consider something to be "better" if efficiency is lowered somewhat with a more equal distribution of resources. I'm being intentionally fuzzy there because I'm not sure myself of the answer. But I know that we all have ingrained ideas of equality, which says to me they are an important concept to be included in our analysis.

I think Jialan is on to something in calling for more morality. Acquiescing to greed as "simple human nature" and consumerism as part of our 'culture' is a cop out.

Jialan Wang said...

Dear Sabre51,

Thanks for your comments.

1. When I talk about the detrimental effects of greed, I'm not just talking about rent-seeking. In the current financial system, greed actually destroys value in myriad ways (see the current Libor scandal for a case in point). So my call for a reigning in of greed are very much directed at economic inefficiency.

2. Most economists share your belief that it is simply not possible to curb greed and malfeasance. I demand proof, and I suggest we at least experiment a little instead of dismissing notions of cultural change out of hand.

In fact, a growing body of work shows that cultural norms and peer effects make a great deal of difference on economic behavior. Another reason to consider cultural change is that self-regulation is more efficient than government regulation. No one can monitor an individual like herself, and no one can monitor a firm like its own employees. Furthermore, there are no regulators to be co-opted, and no subsidies to be used for political purposes. I think free-market types will actually like my solution if it's given a fair shake.

3. I think it's naive to think that free markets always lead to the best outcomes. This is one of the most pernicious legacies of neoclassical economics, and is refuted by myriad evidence of market failure (not to mention a basic concept called externalities).

The free market works best in cases of undifferentiated commodities, like copper and steel. But the free market does not work well in service markets (e.g. banking), where information and reputation become critical factors. If economics is to become a science, we cannot blindly assert that competition will magically solve everything. This has to be proven by empirical evidence on a case by case basis.

If you want me to believe that eliminating all social services and taxing and transferring will decrease inequality, show me a country that has done it.

I'm not a pro-government-interventionist. But I do believe that there is a role for regulation in ensuring fair competition.

As Misha Glenny put it in his enlightening book McMafia that documents wholescale larceny by Russian oligarchs after the fall of the Soviet Union:
"The whole process was dramatic testimony to how venality and myopic stupidity are always likely to triumph in the absense of regulatory institutions."