Why an unregulated free market is unworkable

Once again we get a really good article from Ian Welsh. Let me briefly summarize:

• Everyone knew the current credit crunch and recession was coming years ago


• There a a lot of people who rode the housing bubble and free credit expansion to the top and made out like bandits. They made enough during the boom that they can easily survive the bust.


• From the point of view of individual self-interest the winners (generally top managers) would be fools to not ride the boom and expand it, but leave others to pay the price.


• The people who have created this boom and ridden it up are generally not the same people who will pay the price for it. Investors, consumers and the economy in general will pay the price, and they had almost nothing to do with creating the boom.


• Given this set of individual incentives and no regulations this boom and bust will be followed by another boom and bust.


• [Quote from Welsh.]

  "As a result of this incentive system, if it is possible to have another financial bubble after this one crashes out, there will be one. Guaranteed. There is no way to avoid it unless the economic circumstances are so bad it can't get off the ground (which is possible, if the monetary base starts collapsing.)
  
  The answer is fairly simple, mind you. These sorts of bubbles didn't happen in the post war period. They didn't happen because you couldn't pay enough people enough to make it worth their while. After a certain amount of income, in most western countries, you got taxed at a marginal rate of over 90%. A few CEOs might be able to make it, but most of the executive suite was going to need more than 5 years--they were going to need a career."



• [Further quote from Welsh]

  "At this point to wring the excesses out of the system and to stop the systemic incentives to keep blowing bubbles is going to require doing something to make it so it doesn't pay. [That is, change the incentives so that economically powerful individuals do not gain by creating economic bubbles. This uses the free market rather than abandoning it. It is changing the incentives, nothing more.] There are two parts to any solution.

  The first and simplest way is to put a very progressive tax on all income no matter how or where earned that probably comes in at over 95% of all income over, say, $500,000 or a million at the most. Suddenly, needing to actually keep the companies sound, and knowing that in 7 years when the loans go bad, they'll still be there taking the heat for it, will tend to concentrate the mind not on "can I make enough money to be in a yacht in 3 years" but into "does this deal make sense over the longrun".

  The second thing to do is to stop allowing people to sell risk. For years Greenspan argued that risk markets (the ability to take on, say, default risk in credit or for that matter to sell loans in CDOs) made the system stronger and actually reduced systemic risk by spreading risk around. What it did instead is take the risk away from the people who were able to manage it because they were close enough to the ground to know whether a loan was risky and give it to people who really had no clue and had to rely on bond rating agencies to tell them if the risk was acceptable. [Snip]
  
  So the rule going forward has to be that if you make the loan you keep the risk on your books. You cannot load it off on other people. There are mathematical reasons why in theory it ought to reduce systemic risk to do so, but in the real world they generally don't actually occur because of the problem of incentives--the people with the necessary information to manage the risk have no incentive to do so; the people who wind up with the debt do not have the ability to manage the risk; and the third parties like bond agencies have neither the incentives nor the ability to manage the risk either."

  [Blockquotes mine - Editor WTF-o]

Which leads to Welsh's conclusion

the idea that the financial sector could somehow make far greater returns than GDP growth and do it for decades was always insane and simply could not work. The only way to do it, the only way it has in fact been done, was to cheat and to ignore system risk, use massive leverage, print money and shove it into asset bubbles and so on.

The end result has been two financial bubbles and thirty years in which the average American hasn't had a raise and has taken on debt. A lot of people have gotten rich, mind you, and for them these last thirty years have been great, which is why there's a bipartisan consensus amongst the people who matter in both parties to keep what has been, for them, the best of all possible times, going.

Given a choice, they will keep it going. And there'll be a lot more rich in America, but odds that you'll be one of them are near zero. And when it all comes crashing down, somehow ordinary Americans, despite having never been invited to the party, will be stuck with cleanup duty and the bill.

In hindsight it is obvious. The Economists have created some beautiful mathematical models that explain how everyone can benefit by selling risk from an underlying operation to investors. The investors focus entirely on the risk and ignore the operation that underlies it, depending on their knowledge of the arcane mathematical models which purportedly describe the risk they are trading. But those beautiful models depend on everyone involved having perfect knowledge of the various risk products and applying a strict rigid rule of optimization to the models. That level of knowledge is impossible for anyone not actually involved in the underlying economic activity itself. Herbert A. Simon explained why in his 1950's studies of decision-making (for which he received the Nobel Memorial Prize in Economics "for his pioneering research into the decision-making process within economic organizations" (1978.))

Herbert A. Simon demonstrated that human beings cannot ever have perfect knowledge of any set of circumstances because of the cost (in both time and money) of gathering information. So he presented a model called Bounded Rationality in which actors make their decisions based, not on full knowledge of the situation, but on heuristics or Rule-of-thumb.

As the current mortgage and credit mess clearly demonstrates, any investor who purchases risk from an underlying economic activity with which they are not intimately familiar has no way of establishing effective heuristics as guidelines, and has no way of knowing that they guidelines they are applying aren't working.

Wall Street has been badly served by the genius mathematical whiz kids who have been creating mathematical models of risk to guide them, and the movement conservative free market (and Libertarian) politicians who bought into the apparent certainty described in those models have been lining their pockets as they fooled the public. Sen. Phil Gramm has been a key individual who practiced this deceit.

This is why the Laissez-Faire economics plank of the Reagan revolution has brought us economic stagnation for workers and two economic bubbles in the last decade.

This is why the Reagan Revolution is over.