Monday, November 16, 2009

Free Flow

My friend Janiece just reminded me of one of the reasons I'm a small "L" libertarian: unlike the Ayn Rand fan club, I recognize the limits of the free market.

The free market is the best device ever invented for the fair distribution of goods and services. But the efficiency of the free market depends on several conditions, and one of those is the free flow of information, and relatively equal access of that information to all the players in the market.

I'm not talking about the fact that Proctor and Gamble does not disclose that Joy and Dawn dish detergent are based on the very same patents, and are likely almost identical, save for the price. If you fall for that, you deserve to give P&G a little more of your hard-earned money than would otherwise be the case. Marketers make a lot of money on low-involvement decisions. It's a sort of tax voluntarily paid by the unwary to maintain a free market that is not over-regulated. Not to mention that the law mandates that the patent numbers be printed on the bottle for transparency. What more do you want, someone to read it for you? Read the fine print yourself and caveat emptor.

But we all take a little more care with high involvement purchases, which are de facto the ones that take a significant chunk of cash to make. In those instances, reputable sellers make sure that all the information is available to the buyer. Investing should be one of those high-involvement areas where the market is forced to operate at great transparency. GAAP, fund prospecti, 10Ks and the like keep everyone honest.

Which is why derivatives bother me. I'm a relatively smart guy, I hold an MBA from a top school, and I'm pretty math-savvy. I damn sure don't understand how all the risks in derivatives are accounted for, nor how ownership of that risk is distributed. Given the implosion-prone nature of derivative markets, I'm pretty convinced those people who do say they understand such things really don't.

This is exactly analagous to the illegal practice of buying on margin. In a normal market where people are betting with their own money, prices reflect the wisdom of the crowd on the rational expectation of future cash flows from an investment. Rational people can spot bubbles and avoid them. Although irrational actors can temporarily distort the market, they generally get what they deserve when the market returns to its natural equilibrium.

When people are borrowing to make stock purchases, the information on the crowd's confidence in the solidity of the the investment (reflected in the price) is hidden, distorted, or completely absent. The market breaks down because information is no longer transparent. In a similar way, the inability to track risk and accountability with derivatives distorts the natural feedback mechanisms that allow the market to self-correct.

This is why we need regulators, despite the very real issues of regulatory creep and capture. It is in maintaining the balance of ideals and real-world issues when the system is stressed that one can separate the rational libertarian from, say, Ron Paul.


CW said...

I also think of myself as a "small l libertarian", and I agree that the markets we have today need to have regulation and oversight, because of the huge opportunity for sub rosa manipulation, fraud, and corruption.

The recent financial crisis, however, shows the futility of federal government oversight. We had all the rules and procedures in place and the regulators simply didn't do their jobs. And that's ALWAYS what happens. Government attracts the lazy and corrupt, which undermines most regulatory regimes at the outset. In the case of the world's largest and richest market, the amount of activity, money, and corruption simply overwhelms any possibility of federal government oversight.

Look at who runs the Obama Treasury Department, and the Bush Treasury before, and compare that list to who runs Wall Street.

We have to factor government corruption into any strategy for coping with nontransparent markets. I don't know the solution, but I know you can't trust the government to implement it.

John the Scientist said...

CW, I don't agree that Federal oversight is futile, but it is problematic. I think we need to look to the one piece of Federal regulatory apparatus that works pretty well: the FDA.

Two features work in its favor: open hearings and non-industry / non Federal worker advisory panels made of experts. They make recommendations, and the FDA can follow or not, but if they don't they have some 'splainin' to do.

I think that's a good system of checks and balances.