The Malign Hand
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Staddon Preface The Malign Hand McGraw-Hill – 2012 (draft) i Staddon Preface To Lucinda ii Staddon Preface Acknowledgements I thank first, Duke University, for research support and for providing an atmosphere conducive to interdisciplinary research over many years. I am also grateful to York University, UK, for a research home during several summers. I thank libraries – The British Library, the University of York library, the City of York Public Library and, especially, the libraries of Duke University. The internet has been indispensable. Without it, getting up to speed in many areas of knowledge novel to me five years ago would have been nearly impossible. For comments on the manuscript and on talks I have given about this topic I thank Jérémie Jozefowiez, Armando Machado, Jessica Staddon and Knox Huston. I thank my agent, Don Fehr, for cutting my original draft down to a more focused form. I am grateful to NSF and NIH for research support over many years. As this book was going to press, I became aware of a couple of others, by writers more expert than I in the arcana of finance, making very many of the same points: British finance experts Kevin Dowd and Martin Hutchinson’s “Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System” (Wiley, 2010) and Australian economist Steve Keen’s “Debunking Economics - Revised and Expanded Edition: The Naked Emperor Dethroned?” (Zed Books, 2011). We differ to some extent on the cures, but the diagnoses are similar. iii Staddon Preface Table of Contents PREFACE INTRODUCTION Part One CHAPTER 1 The Malign Hand CHAPTER 2 Democracy, Fairness and the Tytler Dilemma CHAPTER 3 Value and Reason CHAPTER 4 Efficiency and Unpredictability CHAPTER 5 The Housing Bubble CHAPTER 6 Market Instability and the Myth of Comparative Statics CHAPTER 7 Growth and the Conservation of Money CHAPTER 8 Debt, Inflation and the Central Bank CHAPTER 9 J. M. Keynes and the Macroeconomy Part Two CHAPTER 10 Financial Markets are Different, I: Problems and Some Solutions CHAPTER 11 Financial Markets are Different, II: Risk and Competition CHAPTER 12 Financial Markets are Different, III: Regulation by Rule iv Staddon Preface The Malign Hand PREFACE A runner-up for the title of this book was “Alice in Finance-Land.” I’m not a financial professional or an academic economist. When I came to look at how modern finance is organized, I felt more than a little like Alice, encountering alien structures, strange ‘products’ and disturbing belief systems. But, “Veeery interesting…” as the old Laugh-In guy used to say. He would usually add “…but stupid!” which echoes my own puzzlement: Why are they doing this? Why is it legal? What on earth do they think will happen in the long term? To a financial innocent, financial markets look more than a little crazy. Perhaps it’s just ignorance? I have a background in experimental psychology, behavioral economics and in the concepts and mathematics of dynamical systems – like markets. But I have never traded financial products for a living nor published much in economics or at all in finance journals. I do have some relevant technical knowledge. Still, does that really qualify me to write a book centered on the economics of financial markets? Well, as Ms. Palin might say, “How’s conventional economics doin’ for ya?” The answer, of course, is “not very well.” Most professional economists failed to predict the ‘dislocation’ (as it is now euphemized) of 2008-9 and don’t agree now on the best way to deal with it. There is, in the words of my high-school reports, room for improvement. Unlike physicists or engineers, economists can’t afford to be too snooty about interlopers. Polls show that most Americans feel that something is wrong with the country, that the system is broken, or at least damaged. Best-sellers with names like ‘Broke,’ ‘House of Cards,’ ‘Crisis Economics,’ ‘Meltdown’ and ‘Freefall’ proliferate. These books are often riveting blow- by-blow accounts of an unfolding financial crisis involving powerful people and large sums of money – fun to read but not always helpful in understanding problems or finding solutions. Something is wrong, but a page-turner may not provide the answer. This book is not about people, although a few strong characters cannot be avoided. It isn’t really a page-turner. It is as close as I can make it to a readable and disinterested scientific analysis of a set of economic problems that are complex but more comprehensible than you might think. The book ends with suggestions for reform. People usually react to any such suggestion in two ways. First, they look at where it comes from: is it from my guys (left vs. right, Democrat vs. Republican) or the other guys? If it’s from their team they are likely to support it, if from the other, not. After a little thought, they may actually look at the proposal to see if it supports their values or not: is it for ‘working families’, or against big government, or ‘green’, or whatever? They rarely ask about the long-term effects of a proposal, how will it actually work out? British economist John Maynard Keynes, quotable as always, had something to say about this issue. Fanning the flames of short-termism, although such was not his intention, he famously wrote : “The long run is a misleading guide to current affairs. In the long run we are all dead.”1 Well, 1 A Tract on Monetary Reform (1923) Ch. 3. v Staddon Preface yes, but if the survival of the American experiment in anything like its present form is important, the long run is in fact all that matters. In this book I look at long-run effects, on whether the current system, or proposed fixes for it, can yield a sustainable outcome. How do financial markets actually work? How and why do they break down? And what might be done to remedy these problems? A realistic account must involve not just economics but psychology, evolutionary biology, philosophy, both moral and conceptual, and some understanding of dynamical systems. Experiment – the only valid way to identify cause and effect in science – is for the most part impossible. The government can’t mess about with fiscal and monetary policy in a controlled way to look at their effects on employment and national wealth. Even if it could, an uncontrolled world environment means that the effects of an experiment at one period might not hold for a later period. No one is smart and knowledgeable enough to study and understand every aspect of a modern society in depth. My excuses for taking another bite at the apple are two: the current crop of experts have not done well; and I have a sufficiently odd mix of interests and expertise that something new may emerge from my own efforts to understand what has been happening. You can judge whether or not I have succeeded. vi Staddon Introduction INTRODUCTION The idea of the efficient free market dominates modern economic thought. The free market is a kind of Platonic arrangement where traders buy and sell subject only to the most minimal rules. ‘Efficiency’ is an idea I will look at in much more detail later. Suffice it to say now that many believe this ideal market always tends to the common good. But this idea is utterly false, as recent events attest and the arguments of this book will show. The ideal free market supposedly has only two rules: the right to property and the sanctity of contracts. Wikipedia describes it as “a market in which there is no economic intervention and regulation by the state, except to enforce private contracts and the ownership of property. It is the opposite of a controlled market, in which the state directly regulates how goods, services and labor may be used, priced, or distributed, rather than relying on the mechanism of private ownership.” A naïve student might be forgiven for answering on the exam “There are two kinds of market, free and controlled.” False, of course: all markets must follow some rules if they are not to degenerate into a Hobbesian war of all against all. The differences are the amount and type of regulation, not its presence or absence. There is nothing magical about just these two rules. There is no perfect “free” market. I will show in a moment that rules in addition to contracts and property are essential if financial markets are to work as advertised. If our student wants a good grade, he might go on to laud the free market and perhaps even quote Scottish Enlightenment psychologist, philosopher, and father of modern economics Adam Smith. When the merchant sells you something, said Smith, in the most famous line in the credo of capitalism, “he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention” – that end being, of course, the public good. The baker hopes to make a profit, but in the course of that pursuit, you get bread. This is the magic of the free market. But Smith was no dope. He knew that the pursuit of self-interest did not always lead to good results for the community. He pointed out that “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Smith would certainly have agreed that to make a market work for the common good, some regulations against monopoly and price fixing are necessary.