Monday, October 27, 2008

Markets are embedded in society

Most of us have been appalled at the economic landscape of the past few months.  For those that are not so financially savvy, but carry-on with their every day lives, there is too much wall-street lingo to grasp. However, reality has begun to reshape the ideas of many economists with respect to regulation and the benevolent role of public institutions that might at least prevent future mishaps. It seems like there will be a new age of economic socialism. Based on my limited experience, I have tried to use simple principles to make sense of the anarchy. My intention here is to is merely to reflect on my understanding.

Many fiscal conservatives that I have argued with seem to believe too strongly in a system where firms and individuals magically interact to give rise to efficient markets.  It seems to me that their assumptions are often rooted in an almost folksy role of markets, and the rationality of economic entities that take part in them.

Much of modern economic thought has been dominated by the notion that people and firms are rational, forward looking, and self-interest seeking entities. Nobel prizes have been won on various propositions and ideas that revolve around these principles - often even testing the boundaries of these assumptions. That, society will be better off overall when each entity seeks to maximize its self-interest has been the fundamental principle that has guided many policy makers.  In principle, the assumptions that govern this idea seem to hold under amany situations and hence the markets work the way they seemed to work.

However, economists have also pointed out firms and people are self-interest seeking with guile (notably Oliver Williamson), and that they are only "boundedly" rational (notably Herbert Simon).  As a result, markets are "inefficient" rather than efficient, but maybe still the only effective tool. The notion of "guile" is important as it imposes a reality-attribute on many economic entities. Both firms and individuals seek self-interest through opportunistic behavior (guile), which imposes costs on the the governance of economic activities (transaction costs).  However as these costs cannot be estimated before beginning economic relationships, contracts are put in place as the tools of governance.  Rationality can only be "bounded" because firms and individuals do not have the tools and information to be perfectly rational ( I haven' even included the role of emotions, yet).

Laying out these simple principles, it becomes apparent that most defenders often forget that self-interest seeking and rationality come with the constraints of "guile" and "boundedness".  Wall Street firms esentially ran amuck with other people's money seeking excessive returns that carried excessive risks (they make money at the expense of their customers). - a classic opportunistic behavior that was simply self-interest seeking with guile.  What was found lacking were proper contracts that would impose restrictions on such behavior.  Absent, some degree of oversight, such behavior cannot be checked.  Governing boards have failed miserably to impose the required checks and balances, probably due to their own involvement with the top management teams or maybe because of golf-game buddiness. Managers who are simply agents acting out their own self-interest have little risk-aversion when playing with shareholder's money.  Markets, absent the regulaiton, let such deviant behavior run amuck and facilitated the collapse. 

Yes, markets are self-correcting.  However, the process is often very slow and when fear dominates greed, ordinary people (not merely investors) face the music.  It is in the self-interest of the tax-payer to impose certain costs on economic entities that have come to cause such pain and suffering to them. Market cannot exist in a rational, self-interest seeking world - but rooted in reality of tha taxpayer's oversight. Not because it is the most efficient way to oversee them, but the most effective. 

Free-market thinkers have had their share of history - their Newtonian world with its limitations has worked with some friction, but reasonable well so far. However, the frame of reference is rapidly changing and it is clear that a new Einsteinian reality is taking hold.  Free-market thought has to learn to operate within this new reference frame, till a new theoretical argument replaces the one that is shaping up now.  The role of the broader society in governing economic activity.  I see it not as socialism but as economic socialism - that all economic activity is embedded in a much broader social context, a notion that has been around for quite some time, but has been ignored so much (see Karl Marx, Mark Granovetter )  

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