Thursday, February 23, 2012

Too much of a good thing is bad!

Arguably the most famous debate in economics is between those advocating unfettered free markets and those proposing regulatory restraints and proactive government actions to address market failures.

The former claim that free-markets reduce market frictions and promote competition, which in turn generates efficient outcomes. They argue that the ability of markets to lower frictions and promote competition is a function of the degree of its liberalization. Unfettered free markets, they say, produces the most efficient outcomes.

The latter argue that market failures like externalities (both positive and negative), information asymmetry, moral hazard, unequal playing field among market participants etc can be addressed only with government action. Such actions take the shape of regulation, redistribution through taxation and subsidies, and sometimes even direct participation (like running schools and hospitals). In other words, public policies rectify market failures and strengthen free-market.

However, an examination of real world events reveals that markets fail and often fail spectacularly and with devastating consequences. A short history of the past two decades shows numerous examples of greater deregulation, in the direction of unfettered free markets, have failed miserably. Here are six examples of how lowering market frictions results in the reduction of market efficiency or does not lead to the desired outcomes.

1. Free market enthusiasts advocate policies that promote economic growth on the grounds that it can by itself contribute towards increasing incomes and reducing poverty. They see frictions caused by government regulations and restrictions on doing business as being responsible for lower incomes and poverty in many developing countries. However, there is increasing evidence from across the world that poverty and inequality reduction is better achieved by proactive government redistributionary policies and transfers than by mere economic growth.

2. Conventional wisdom would have it that greater choice reduces market frictions and increases efficiency. However, there is ample evidence, from a number of fields, that an excess of choices induce decision paralysis among human decision makers. Human beings are apparently not the objective and rational utility maximizing individuals.

3. Central Banks across the world have been pursuing greater transparency in their communication strategies, so as to bridge the market friction arising from information asymmetry. However the argument that this will promote more efficient shaping of market expectations may not turn out as expected. As I have blogged earlier, extreme transparency in central bank communcation need not always result in efficiency.

4. The wave of financial market deregulation and financial innovation across the world in the second half of nineties and in the last decade were supposed to lower market frictions and thereby increase financial market efficiency. It was believed that the light-touch regulation of financial market participants would facilitate more effective risk diversification and resource allocation and thereby lower both systemic risk and boost economic growth. However, as events of the past five years have shown, it has spawned several market failures - risk mis-pricing, resource mis-allocation, opaque financial instruments, systemic risks like too-big-to-fail and too-interconnected-to-fail, emergence of massive financial behemoths whose activities constrain market competition, and so on.

5. Theoretically atleast, arbitrage opportunities in financial markets arise from the presence of residual market frictions. Therefore, if any privileged information that becomes available were quickly traded away, that would increase the market efficiency. If this logic were correct, high frequency trading (HFT) would have improved market efficiency. However, there is enough evidence that HFT lowers market efficiency, distorts market incentives, and destabilizes markets.

6. Conventional wisdom would have it that completely free trade (which creates frictionless transactions) is the most efficient order. However, as Dani Rodrik has shown in his excellent recent book on globalization, as trade becomes freer and freer, its distributional effects loom larger and larger. In the context of the need to redistribute from the winners to compensate the losers, he shows that at very low tariff levels (as is the case with many countries in the post-WTO era), the marginal gain (say, increase in incomes or GDP) is dwarfed by the degree of redistribution required (from winners to losers). As trade gets more open, the redistribution-to-efficiency gain ratio shoots up. He writes, "It is inherent in the economics of trade that going the last few steps to free trade will be particularly difficult because it generates lots of dislocation but with little overall gain".

In all these cases, from hindsight it is not difficult to rationalize that the incessant pursuit of reduction of frictions contributed significantly to the failures. It removed the systemic checks and balances, institutional and psychological, that aligns incentives among all participants. Further, it also elbowed out the government from stepping in to mitigate markets failures.

Even assuming theoretically that frictionless systems generate efficient outcomes, there is the issue of whether it is possible to reach this state. If left to itself, after an infinite period, any market system may reach its equilibrium when all the ideal conditions hold. However, in the real world, we do not have the luxury of such timeframes and are therefore concerned in dealing with partially distorted markets. As the aforementioned examples illustrate, in such circumstances, there is the need to achieve a delicate balance of frictions.

In fact, Nobel laureate James Tobin, while advocating his famous Tobin Tax on cross-border short-term capital flows, argued about the need "to throw some sand in the wheels of our excessively efficient international money markets". Too little frictions and the resultant excessive efficiency is clearly bad for the system.

In this context, as Barry Schwartz explains in an excellent op-ed in the Times, frictionless free markets are akin to a "too much of a good thing" and they invariably result in sub-optimal outcomes. As the most recent example of reduction in market frictions by way of financial market deregulation and innovation has shown, far from increasing efficiency, such policies are likely to result in market failures and distortions. He writes about the benefits of the less efficient counterfactual,

If loans weren’t securitized, bankers might have taken the time to assess the creditworthiness of each applicant. If homeowners had to apply for loans to improve their houses or buy new cars, instead of writing checks against home equity, they might have thought harder before making weighty financial commitments. If people actually had to go into a bank and stand in line to withdraw cash, they might spend a little less and save a little more. If credit card companies weren’t allowed to charge outrageous interest, perhaps not everyone with a pulse would be offered credit cards. And if people had to pay with cash, rather than plastic, they might keep their hands in their pockets just a little bit longer. These are all situations in which a little friction to slow us down would have enabled both institutions and individuals to make better decisions.

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