Jason, you said: "Conservatives seem to have little trouble admitting that markets involve humans, who are greedy and often make mistakes."
This remark gets us to one part of the financial-crisis debate: are markets "efficient" or not?
The answer may seem academic, but it matters. If people conclude that markets aren't "efficient," they'll demand an even greater role for the government in determining where our money and labor should go. (For an example of this argument, read this Krugman magazine piece.)
Some history: Over the half-century or so up until 2008, academics convinced policy folk that markets were efficient -- that is, that financial markets quickly and accurately reflect all available information.
The theory means, roughly, that you can't win. Say you woke up today and had an epiphany that steel prices would be five times higher in five years. Efficient-markets theory would hold that you can't profit from this realization. The expectation must already be "priced" into the market. Go back to sleep.
The theory also supposedly lulled people-in-charge like Alan Greenspan into doing nothing about the housing market. After all, house prices had to be right -- right?
There are a few problems with the efficient-market theory -- or rather, not with the theory but with how people act upon it (theories don't hurt the economy; people do).
Think about it this way: markets reflect activity in the world. If all human activity is efficient, then why make any decisions about your own activity? Say you're 15, sitting in your room wondering what to do when you grow up. Should you be a doctor? An actress? Should you try for Harvard or for an electrician certification?
Popular interpretation of efficient-market theory would hold that it doesn't matter. Whatever you are going to is already reflected in the future, so don't worry about it.
This conclusion would be crazy. Markets' "efficiency," in finance as in real life, doesn't preclude human agency, but requires it. Markets are efficient because individuals are making millions of active decisions every day, including bad decisions made by, well, "greedy" people who "often make mistakes."
In other words, financial markets wouldn't be efficient if people didn't think that the markets were inefficient -- that is, that they can make money by acting on their own predictions of the future. Many people will be wrong, but that doesn't mean that they should drop out, just as in life.
Markets are handy, then, because they efficiently reflect human beings' inefficiencies -- a useful function.
The housing market circa 2005, for example, was perfectly efficient. It efficiently reflected human beings' propensity to ignore, as Claire puts it, something that should have been "blindingly obvious ... at every stage." It also efficiently reflected, as Claire says, regulators' focus on inflation in goods and services as the key warning sign, a legacy of the Seventies, rather than the nation's vast expansion of outstanding debt, which began in the Eighties and still hasn't stopped.
Financial markets further reflected -- efficiently! -- the government's untenable support of housing, and reflected, too, Americans' refusal to see that house prices would not go up by double-digit percentages year after year after year forever.
When Americans and global investors realized that the housing jig was up, markets efficiently reflected that realization, too -- far too efficiently for the world's western governments.
Efficient markets can't perfectly predict the future, because they reflect human being's collective inability to predict the future. But this fact of life doesn't mean that we should invite government powers to eclipse market signals.
Millions of investors are more likely to correct their own mistakes over time than is one central planning authority who decides, say, that we should treat our largest financial institutions as national champions.
Indeed, when government directs market action, it is other investors in the marketplace that correct that government when it is wrong -- just as happened in 2008, when markets brutally corrected the government's support of housing and finance.
Since then, governments have regained the upper hand. Eventually, though, if the government is wrong in its support of these sectors of the economy -- as I think it is -- markets will win.
**
A final word about Claire's question, which the Queen of England asked, as well: "how could the danger we were running not have been apparent?"
What are the "apparent" dangers today? This year, we could have a blow-out municipal bond crisis. Investors could look 10 years into the future, see that many states and cities won't be able to pay their long-term bonds and their promises to retirees and provide public services by then, and, quite reasonably, desire to sell their holdings now.
In doing so, they could precipitate a panic. Banks' more than $200 billion in municipal-bond assets could plummet in value, forcing them to sell off other financial assets like stocks, forcing stock markets down and thus pushing down the value of states' pension funds, which the states need, of course, to pay off the retiree liabilities that everyone is worried about, triggering further municipal bond panic, and so on and so on.
Money-market funds, too, could ditch their own more than $300 billion in municipal bond holdings, forcing the values of their own funds down and forcing yet another government bailout so that the "hot money" -- that is, money that investors can take out of the system at any time -- doesn't flee as it did in 2008.
If this scenario were to play out, it, too, would look unavoidable in retrospect.
Or ... nothing at all could happen. Investors could go on funding municipalities as they have for decades, ignoring the long-term problems of states and cities. Investors could figure, quite reasonably, too, that those problems are the same problems that the country as a whole must deal with: expensive healthcare and pension costs. The states are us. If we're not worried about "us" now, then why worry about the states? This outcome, too, would seem inevitable in retrospect.
It all depends on messy human interactions, just like in life.
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Jun '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Markets efficiently reflect mass intoxication, and they just as efficiently reflect the hangover.
Sep '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
As a long only money manager I do not believe that markets are perfectly efficient but I am absolutely certain that they are more efficient than politicians. Let's not forget public choice theory.
May '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Thanks, Nicole. Too often it seems like this debate involves one side saying, "Markets aren't perfect, but government rarely helps," and the other side saying, "Markets aren't perfect! Government! MORE GOVERNMENT!"
Case in point: Krugman, whose work generally boils down to an assumption that the rest of us are so stupid we need bureaucrats guiding our every move.
Nov '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Yes markets can be inefficient but it takes government intervention to make them really, really inefficient.
Much of the current situation has its genesis in the financial engineering of the likes of Barney Frank who thought it good that folks with little or no capital nor secure cash flows (i.e. a paying job) should have easy access to the American dream of home ownership.
Hence the development of CDOs and such to facilitate the easy passing around of the risk involved until the proverbial music stopped.
May '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Does scale make a big difference? Does an economy of 300+ million people respond slower or less efficiently to market changes than an economy of 13 million?
In other words, independent of emerging technologies (telephones, airplanes, internet -- a whole other question), have changes in population and trade diversity since the time of America's founding greatly affected the efficiency with which citizens respond to the market?
As much as I respect America's early years, I often wonder how well systems designed for the original 13 colonies would stand up against the expanse and complications of modern America. Temporarily set aside freedom and acceptable risk. Just think of the logistics.
Edited on Jan 15, 2011 at 7:27pmJun '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Nicole, your initial definition of efficiency is too aggressive to be realistic. Markets as you put it later in the article cannot possibly discount for “all” information affecting an asset’s value. The reality is that efficiency should be limited to one measure, and that is the investor’s ability to convert an asset to cash as quickly as possible with as little sacrifice in value as possible. Hence, the stock and bond markets, which quote asset prices on a minute-by-minute basis, are way more efficient than the real estate market. Where you can sell a stock by calling your right now, you can’t do that with your house. Also a stock or bond has a “universal’ value where your house has a local, which is to say idiosyncratic, value. If you want to sell your house quickly you have to sacrifice a good deal of its real value, assuming it has a real value. Lastly, if markets were “efficient” in the truest sense of the word no one could earn a disproportionate return based on material changes in the condition of the entities whose earnings or interest payment underpin their assets’ values.
Sep '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
one would think that more information faster would make for more efficiency but it appears to me that the existence of the 24hr news cycle could be making markets somewhat more over-reactive in the short run
Oct '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Markets and economics are merely an exercise attempting to understand how people function in the financial realm. Perhaps the missing element in the equation is how a truly free people, exercising their own choices, will behave. The moment we accept into the marketplace the factor of coercion, whether the mob or the feral government, or even the state governments, we are no longer looking at the natural workings of man in his environment, we are now looking at one more contrivance of the power structure.
Can we never get back to the idea that God has endowed man with certain inalienable rights? Does life, liberty and the pursuit of happiness require so many qualifiers? Is man the simple creation of God truly capable of freedom, or have we replaced the black person, evidently incapable of rising to human status, with any person with a mental limitation placing him short of a graduate education.
Thanks, but I prefer living in a world where the economic dynamic is determined by free men of any color pursuing their own happiness, without the harness of their betters steering them on the route to "prosperity".
I am uncomfortable wearing a saddle.
Jun '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
As for government’s role in markets, that should be limited to prosecuting and punishing crooks. All else should be left to the market players to adjudicate, the most important of these would be the establishment of market rules such as reporting requirements. As it turns out governments by their nature serve to influence markets by means of their daily activities, which take the form of the issuance of bonds, granting of contracts, and the issuance of currency. These government actions or influences are in the nature of the beast and can in themselves be considered disruptive of efficiency. They are disruptive because by their conduct governments pick winners and losers, and thereby distribute massive favour or otherwise affect market asset values. To suggest that government should take on the additional role of balancing for perceived inequality is to argue that there is a balance that can be set by fiat that would not only be perceived but actually be more equitable than money could buy, which, of course, is to deny the fairness of the best measure of equality ever invented by man: money.
Jun '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
No one ever made money with more information. They made money by having the specific information needed to make them money.
Jun '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
RAYCON: Thanks, but I prefer living in a world where the economic dynamic is determined by free men of any color pursuing their own happiness, without the harness of their betters steering them on the route to "prosperity".
I am uncomfortable wearing a saddle. · Jan 15 at 7:23pm
It can be argued that the freest among us are those with the most money. They certainly are free from material want, which can truly be enslaving.
Dec '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Another way of looking at what's already been said...
As a whole, free markets produce the purest scientific understanding about the world. Or if you don't like the word scientific, how about empiricism, in the broadest of forms. A scientist looking to get grants is biased toward the grant. But an entrepreneur looking for profitable markets has put his money where his mouth is. As a whole, throughout an entire economy, owners of capital make DARN SURE they're making the right decision based on speculative market prices and consumer preference. The scientist is not subject to this level of scrutiny.
Nov '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
The Chairman of the Federal Reserve ought to have no authority to do anything about the housing market. It should not be part of his job.
Aug '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Pardon me if someone's asked this already, but...
Why should it be necessary for markets to be perfectly efficient? Why wouldn't it suffice for markets to be more efficient than the alternatives?
Edited on Jan 15, 2011 at 11:17pmDec '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
The magic of the market is not that some people get rich, or that it seems to work most of the time. The magic is how it deals with bad ideas. Or put differently, imperfect humans.
If I miss something in business, or make a mistake, what happens? I disappear, or if I have deep pockets, lose some of it and correct my way. The constant fine grained feedback cycle at the level where decisions are made and information can be recognized and processed is the invisible hand.
If failure is not allowed, it is not a market. There hasn't been a real market in the financial world for many years, and the current crisis is largely a result of that. Almost every aspect of the crisis had caused a failure in the past that led to crisis action by the Fed and other institutions to prevent the damage from having any correcting influence. Eventually the stupidity gets stacked so deep there is almost nothing left.
Aug '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Derek's argument seems entirely plausible to me.
How would you go about poking holes in this argument?
May '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Nicole Gelinas: Jason, you said: "Conservatives seem to have little trouble admitting that markets involve humans, who are greedy and often make mistakes."
This remark gets us to one part of the financial-crisis debate: are markets "efficient" or not?
Markets may be composed of human beings, but so are governments. Behavioral characteristics that plague the humans who participate in markets plague those who participate in government as well.
Dec '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Michael Labeit Markets may be composed of human beings, but so are governments. Behavioral characteristics that plague the humans who participate in markets plague those who participate in government as well. · Jan 15 at 10:55pm
Larry Miller on economics and government spending
"Economists are the only people who say things like 'it's too soon to adopt a wait and see attitude'...aww that's quite a science you have going there"
Edited on Jan 15, 2011 at 11:52pmRe: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
Midget Faded Rattlesnake: Pardon me if someone's asked this already, but...
Why should it be necessary for markets to be perfectly efficient? Why wouldn't it suffice for markets to be more efficient than the alternatives? · Jan 15 at 9:34pm
Edited on Jan 15 at 11:17 pm
Midge has, I think, elegantly summed up the point of confusion--the (good) argument that markets are more efficient resource-allocators than governments was somehow perverted into the (ridiculous) argument that markets are perfect--and instantaneous-- resource-allocators. Then, to wade further into logical folly, you get critics noting that the second argument appears to be false, therefore the first must also be false and its inverse true.
Jul '10
Re: Book Club cont'd: "Conservatives seem to have little trouble admitting that markets involve humans"
I'll be a brat.
Who want's a market to be efficient?
I would rather a Market be Flexible and Fluid. I like the concept of Creative Destruction in Markets. I also like the concept of Winners and Loosers.
Efficiency tends to breed Homoginization, a flattening out of the normal distribution.
It is Fluidity that allows an insurance company to suddenly spring up in a dry goods store. That really wasn't an efficiency, when it first happened.
You want efficiency in a production line, not in the Economy.