beauty of the free market is that the decisions of isolated individuals (and firms) get reconciled without anybody consciously trying to do so. What makes this possible is that economic actors are rational, in the sense that they know best their own situations and the ways to improve them. It is possible, it is admitted, that certain individuals are irrational or even that a generally rational individual behaves irrationally on occasion. However, in the long run, the market will weed out irrational behaviours by punishing them – for example, investors who ‘irrationally’ invest in over-priced assets will reap low returns, which forces them either to adjust their behaviour or be wiped out. Given this, free-market economists argue, leaving it up to the individuals to decide what to do is the best way to manage the market economy.
Of course, few people would argue that markets are perfect. Even Milton Friedman admitted that there are instances in which markets fail. Pollution is a classic example. People ‘over-produce’ pollution because they are not paying for the costs of dealing with it. So what are optimal levels of pollution for individuals (or individual firms) add up to a sub-optimal level from the social point of view. However, free-market economists are quick to point out that market failures, while theoretically possible, are rare in reality. Moreover, they argue, often the best solution to market failures is to introduce more market forces. For example, they argue that the way to reduce pollution is to create a market for it – by creating ‘tradable emission rights’, which allow people to sell and buy the rights to pollute according to their needs within a socially optimal maximum. On top of that, free-market economists add, governments also fail (
The debate on the relative importance of market failures and government failures still rages on, and I am not going to be able to conclude that debate here. However, in this
In 1997, Robert Merton and Myron Scholes were awarded the Nobel Prize in economics for their ‘new method to determine the value of derivatives’. Incidentally, the prize is not a
In 1998, a huge hedge fund called Long-Term Capital Management (LTCM) was on the verge of bankruptcy, following the Russian financial crisis. The fund was so large that its bankruptcy was expected to bring everyone else down with it. The US financial system avoided a collapse only because the Federal Reserve Board, the US central bank, twisted the arms of the dozen or so creditor banks to inject money into the company and become reluctant shareholders, gaining control over 90 per cent of the shares. LTCM was eventually folded in 2000.
LTCM, founded in 1994 by the famous (now infamous) financier John Merriwether, had on its board of directors – would you believe it? – Merton and Scholes. Merton and Scholes were not just lending their names to the company for a fat cheque: they were working partners and the company was actively using their asset-pricing model.
Undeterred by the LTCM debacle, Scholes went on to set up another hedge fund in 1999, Platinum Grove Asset Management (PGAM). The new backers, one can only surmise, thought that the Merton–Scholes model must have failed back in 1998 due to a totally unpredictable
The investors in PGAM were, unfortunately, proven wrong. In November 2008, it practically went bust, temporarily freezing investor withdrawal. The only comfort they could take was probably that they were not alone in being failed by a Nobel laureate. The Trinsum Group, for which Scholes’s former partner, Merton, was the chief science officer, also went bankrupt in January 2009.
There is a saying in Korea that even a monkey can fall from a tree. Yes, we all make mistakes, and one failure – even if it is a gigantic one like LTCM – we can accept as a mistake. But the same mistake twice? Then you know that the first mistake was not really a mistake. Merton and Scholes did not know what they were doing.
When Nobel Prize-winners in economics, especially those who got the prize for their work on asset pricing, cannot read the financial market, how can we run the world according to an economic principle that assumes people always know what they are doing and therefore should be left alone? As Alan Greenspan, former chairman of the Federal Reserve Board, had to admit in a Congressional hearing, it was a ‘mistake’ to ‘presume that the self- interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms’. Self-interest will protect people only when they know what is going on and how to deal with it.
There are many stories coming out of the 2008 financial crisis that show how the supposedly smartest people did not truly understand what they were doing. We are not talking about the Hollywood big shots, such as Steven Spielberg and John Malkovich, or the legendary baseball pitcher Sandy Koufax, depositing their money with the fraudster Bernie Madoff. While these people are among the world’s best in what they do, they may not necessarily understand finance. We are talking about the expert fund managers, top bankers (including some of the world’s largest banks, such as the British HSBC and the Spanish Santander), and world-class colleges (New York University and Bard College, which had access to some of the world’s most reputed economics faculty members) falling for the same trick by Madoff.
Worse, it isn’t just a matter of being deceived by fraudsters like Madoff or Alan Stanford. The failure by the bankers and other supposed experts in the field to understand what was going on has been pervasive, even when it comes to legitimate finance. One of them apparently shocked Alistair Darling, then British Chancellor of the Exchequer, by telling him in the summer of 2008 that ‘from now on we will only lend when we understand the risks involved’.[1] For another, even more astonishing, example, only six months before the collapse of AIG, the American insurance company bailed out by the US government in the autumn of 2008, its chief financial officer, Joe Cassano, is reported to have said that ‘[i]t is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of the [credit default swap, or CDS] transactions’. Most of you – especially if you are an American taxpayer cleaning up Mr Cassano’s mess – might find that supposed lack of flippancy less than amusing, given that AIG went bust because of its failure in its $441 billion portfolio of CDS, rather than its core insurance business.
When the Nobel Prize-winners in financial economics, top bankers, high-flying fund managers, prestigious colleges and the smartest celebrities have shown that they do not understand what they are doing, how can we accept economic theories that work only because they assume that people are fully rational? The upshot is that we are simply not smart enough to leave the market alone.
But where do we go from there? Is it possible to think about regulating the market when we are not even smart enough to leave it alone? The answer is yes. Actually it is more than that. Very often, we need regulation exactly because we are not smart enough. Let me show why.
Herbert Simon, the winner of the 1978 Nobel Prize in economics, was arguably the last Renaissance Man on earth. He started out as a political scientist and moved on to the study of public administration, writing the classic book in the field,
Simon argued that our rationality is ‘bounded’. He did not believe that we are entirely irrational, although he himself and many other economists of the behaviouralist school (as well as many cognitive psychologists) have convincingly documented how much of our behaviour is irrational.[2] According to Simon, we try to be rational, but our ability to be so is severely limited. The world is too complex,
