Wednesday, November 18, 2009

Reds versus blues

(with apologies to Michael Skapinker)

In the blue shirts are Team Markets. The players are Eamonn Butler, Phillip Booth, Marcus Agius, Peter Sands, John Varley and Lloyd Blankfein.

In the red shirts are Team Ethics; Ken Costa, Stephen Green, Adair Turner, Mervyn King, Will Hutton, John Kay, Nick Anstee, John Plender and Gordon Brown.

They are preparing for a match to decide if free financial markets will save or destroy themselves, like a celebrity student seminar on Marx, but with real policy implications.

The day before, angry protesters started targeting bank offices with placards, which should focus the contest nicely on the question of how well today's financial markets fit with common ideas about markets and social justice.

The market ideas are familiar from Adam Smith and David Ricardo. Their application to finance was questioned by Alan Greenspan and will soon be the subject of a TV documentary with Luke Johnson, called “The Flaw”.

The social justice ideas include Rawls notion of equal access to opportunity and a floor under the poorest; Mill's laissez-faire without harming others; and Bentham's greatest good for the greatest number.

So far so theoretical, how does it compare with reality? 

(Referee blows whistle, first half)

First the markets. According to Adam Smith, suppliers produce socially useful goods because that is what people demand. So if cotton is more useful in summer than wool, producers will adapt so buyers are warm in winter and cool in summer, sellers profit all year round and resources are well allocated. I assume this is what Lloyd Blankfein meant with his comment about banks doing God's work (Blankfein shot goes wide, goal kick)

But in finance, buyers and sellers sometimes don't know which product will keep them warm in winter, as evidenced by the way resources were (mis-)allocated across markets meant to serve similar investment purposes, such as high yield, leveraged loans and triple A CDO/CLOs. According to Turner, some may even be socially useless (Turner scores early goal, 0-1)

In theory, suppliers of bad products will lose demand and go out of business. But the reality of finance, as with drugs and airlines, is that mistakes can be too costly to leave matters entirely to the market. No one wants a bail-out any more than a plane crash or a faulty drug, so we can never know if pure free markets will work or not (Butler retires injured).

In market theory, when transaction costs outweigh the benefits, buyers stay away. In finance, it is often hard to know true costs as fees are bundled or paid by agents with little incentive to challenge them. Even open fee structures mask horrible truths about compound costs: John Kay calculates that if Warren Buffet had charged the standard hedge fund 2 and 20 fee to himself over his career as a fund manager, then his USD 62bn fortune would be split USD 5bn to Buffet the investor and USD 57bn for Buffet the fund manager. Yet until recently this was the standard way resources were allocated by the hedge fund industry.

On the other hand, Buffet the investor would still be USD 5bn richer than Buffet the college drop-out (Kay's shot on goal is blocked, end of first half)

(Players given lemons to suck, then return to the pitch after a short break. Second half begins)

How do financial markets compare with the social justice ideas above?

For Mills and Bentham, the appropriation of other people's wealth – otherwise known as rent-seeking – is to be avoided. Yet this happens frequently in normal securities trading. Trading profits are seen as the price society pays for allocative efficiency and a healthy, liquid market. But pro-cyclical, or speculative trading causes volatility and resource misallocation, creating an unknown extra cost to society. The problem is knowing which is which and, as Booth pointed out, an ethically good trade on Monday could be deemed a bad trade on Friday if circumstances change in between (Booth equalises, 1-1)

Short selling raises the same problem. The profits made by short sellers are society's price for an honest market (“A market without bears is like a country without free press,” said Bernard Baruch, cited in John Plender's review of Robert Sloan's book “Don't Blame the Shorts”). But when used speculatively, they can impose even higher costs by transforming a downturn into a panic (Plender passes Varley and Sands, tackled by Agius. Goal kick)

Rawls, Mill and Bentham would dislike the unfairness but it's better than living without markets. The answer may lie in finding a structural balance between different types of trading, such as a variable stamp duty to impede or encourage trading as regulators see fit. An extreme version of this was accepted as necessary during the crisis to ban short selling of financial stocks. The idea lies somewhere between a Tobin tax (Brown scores own-goal, 2-1) and existing taxes such as UK stamp duty and the trading levies imposed by US exchanges.

This solution assumes that we want to influence markets when they fail to fulfill their function. Agreement on what that function is, and what is an acceptable social cost when they deviate from it would provide a common ground on which market purists and ethical interveners could discuss regulatory reforms.

It would make it easier to discuss, for example, changing corporate governance codes to make board members responsible for wider systemic stability, and requiring employers to show that ultra-high remuneration packages are not rent-seeking.

The next problem is agreeing a moral position on market outcomes. For example, Booth says that mortgage securitsation was seen as good in the boom when it extended homeownership to the poor, but bad in the bust when we saw the real impact. These judgments are best left to politicians.

Will Hutton offers an answer based on the obvious outcomes. In a lecture about his upcoming book, Them and Us, he uses anthropological research to argue that humans have an innate sense of due dessert. For rewards to be fair, he says, they should be commensurate with the effort made and the value created. Thus, when money is too easy, the suspicion must be that the market was rigged (Kay passes to Hutton, who beats Blankfein and scores, 2-2)

Both sides ultimately support markets, but as long as there is no consensus on what we want financial markets to do, and no way to measure their overall economic effect, it will be hard to design policies that help. Meanwhile, the global imbalances that created the conditions for the present crisis continue, so perhaps both sides are answering only half the problem.

(Match ends in draw. Teams depart, some by helicopter)

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