Politics vs. Economics

nadezhda says:

I’m sorry. This is market fundamentalism at its over-simplifying worst.

FLG’s initial occasion for outlining a “politics vs markets” theory, if I followed his post correctly, was his discussion of capital controls and why he’s opposed to the walk-back by international monetary theorists (including some inside the IMF and World Bank) of the absolutist position against capital controls. Serious economists are starting to acknowledge that an open capital account may not be, in all cases, the optimum policy, especially for emerging markets, which are often victims of the whipsaws of hot money flows. FLG sets up an artificial “economics” vs “politics” opposition, when we’re dealing with an asset (currency) which is created and backed by governments and the value of which is dependent on fiscal and monetary policies of said governments. There ain’t no such a thing as a “free market” in currencies that doesn’t involve government policies and politics. And the global capital markets have a time horizon measured in nano-seconds. So the short-term vs long-term distinction isn’t particularly helpful either.

Now it’s true that attempts to defend an exchange rate that’s likely to depreciate are, in the not-so-long-run almost certain to be costly failures. So to that extent, yes, attempts to cushion fluctuations are eventually going to be overwhelmed by economic “fundamentals”. But what the relaxation of opposition by economists against capital controls is reflecting is the realization that there’s no particularly good reason to exclude any and all capital controls from the toolkit of macro-policy management. So the discussion among economists has moved to what types, in what circumstances, and how do they interact with the other macro tools. Personally, I think they should be limited to a stable regime of Tobinesque “sand in the wheels” controls for small open-economy emerging markets — Chile ran a reasonably successful system for some years that raised the cost, in a predictable fashion, of short-term capital inflows, and which provided some insulation for their exchange rate and interest rate policies. But regardless of where one comes out on the specifics, this is a discussion which is, IMHO, long overdue. The absolutist position so dominated the economics profession for the past few decades that anyone who even modestly questioned the consensus was engaged in a career-limiting gesture.

But FLG didn’t stop with capital controls in applying his sweeping observations re “anti-market” and “pro-government” “progressive” politics versus the long-run truth of economics. He claims that attempts to interfere with the magic of price formation in the miracle of supply and demand meeting in the free markets are simply doomed to failure (and apparently short-term successes at moderating “fluctuations” will make matters worse in the long-run, though I’m not sure if he’s a pure Austrian liquidationist). Implicit in this formulation is the assumption that prices in asset markets reflect some sort of fundamental “value” that will eventually be reached at some sort of essentialist equilibrium price.

Surely the bubbles and collapses of asset markets in the past few years have demonstrated just how distant that model is from the way asset markets really work. You don’t need to adopt Soros’ quite interesting “reflexivity” model in its entirety to have realized that asset markets by their very nature not only overshoot (on both up and down side) — the very fact of their overshooting changes the “fundamentals” on which a hypothetical equilibrium would be based. Market bubbles and crashes aren’t just benign fluctuations. They are crises precisely because they have enormous, and distorting, effects on the real economy, which push the real economy off of any trends consistent with the longer-term “underlying financial and economic forces” on which FLG seems to pin his hopes.

FLG also ignores the fact that asset markets are, by their very nature, in important ways nothing but a set of rules (what constitutes an asset, how is it traded and where and by whom, how is it ‘stored’, how is its value realized, etc.). Those rules aren’t all devised and enforced by governments, but a very substantial portion of them are, starting with laws governing contracts, negotiable instruments, creditor rights, corporate governance, bankruptcy, etc etc. Because the markets depend on the rule sets in order to function, changes in those rules (even a relatively minor court decision among private litigants in Delaware) will change the incentives for market participants, which in turn will affect the operations of the markets, which in turn will affect the real economy. Governments also license financial markets and institutions, which btw is as much for the benefit of market players as to protect those who merely use their services. In the absence of government licensing and regulation, we tend to see the formation of private sector guilds or cartels that perform many of the same (self)-regulatory functions, but with a lot of anti-competitive behavior, barriers to entry, etc. So it’s not as if eliminating government regulation of financial institutions would eliminate “anti-market” rules — it’s just that the rule-making and enforcement would typically benefit, even more than is now the case with government regulation, those institutions with the most economic power, while still leaving the public with a mess to clean up when the inevitable financial crisis occurs.

As we’ve learned to our intense pain over the past several years, the rules that affect market instruments, market structure and market participation produce incentives for practices, for both good and ill, that have a huge impact on where real economic activity is focused as well as on volumes, prices and risks. And it’s not just government rules that can shape incentives in perverse or dangerous ways — those devised by the market participants themselves, such as access by high-frequency traders to exchanges or the standards for collateral for credit derivatives or the “don’t break the buck” practices of money-market fund sponsors — can add gigantic tail risk or push market volumes or prices, both short-term and long-term, far away from anything justifiable in terms of “fundamentals”.

So pace FLG, “anti-market, pro-government, or pro-regulation” aren’t the same things at all. Nor is “pro-market” either “anti-regulation” or “anti-government”. Even the “freest” of markets embody regulation; they depend heavily on government; they can’t function without a set of highly-complex, widely shared rules.

Since we have to have rules, the real issues concern what those rules should be and how and by whom they should be enforced, in order to encourage the financial markets (1) to do a better job at their core economic functions of forming and allocating capital and intermediating savings while (2) reducing the frequency/probability of bubbles and crashes and (3) ensuring that when the inevitable crashes happen, that we won’t once again privatize the profits and socialize the losses. We had a set of rules (both government and private, including both written rules and customs and practices) that demonstrably did a catastrophic job on each of those three objectives. Surely we’re not doomed, in the name of free markets and the holy invisible hand, to having to just suck it up and live with a dysfunctional financial system! That’s theology, not economics.Report