Election 2008 The Economy The cost of economic group-think

Author: Robert Prasch, Associate Professor of Economics

As I write this, the major stock market indexes have taken another sharp downturn. Billions more can now be added to the trillions already lost in market capitalization and housing. The only certainty seems to be that before this is over we will have heard a number of accusations and counter-accusations concerning the specific laws or regulations that should, or should not, have been passed to prevent this debacle. In a democracy this is a necessary and important process - one that should be encouraged. Unlike the tepid responses to the collapse of Long-Term Capital Management, the East Asia Crisis, or the Dotcom bust, let us hope that a more responsible, coherent, and effective system of financial regulation will be put in place. The American record between the 1930s and the late 1970s, when we enjoyed rates of economic growth and low rates of bank failure that were the envy of the world, suggests that this can be achieved. So what, then, is the basis of our current failure?

Again we can, and should, look to specific laws or regulations for correction. But before we begin, we should pause to look at the "big picture." If we do, I believe it can be demonstrated that flawed concepts are at the heart of our regulatory problem. These flawed concepts, in turn, supported flawed thinking, and flawed thinking supported flawed regulation. That massive expenditures on public relations and lobbying supported this chain of reasoning is, of course, a point too obvious to mention.

The error to which I refer did not occur at the highest levels of mathematical modeling. On the contrary, it was embedded in our most elementary conception of how markets work. This matters because so much of economic theory has come to be based on a very simple analogy, one that can be useful, but problematic if carelessly deployed. This elementary conception is the simple exchange story that almost all textbooks present as emblematic of "The Theory of the Market." It is almost always some variant of the following: "If Jennifer has cookies and Sammy has lemonade, Jennifer and Sammy could each be better off if they can freely exchange with each other." Much follows from this apparently innocent example. Major public policies such as NAFTA, privatized schools and medical care, and the sweeping deregulation of the U.S. financial sector, can all be traced to this simple, actually simplistic, idea of how markets work. This false analogy is, I submit, at the core of the regulatory problem that America faces today.

Lost in this conception is that both cookies and lemonade are "Inspection Goods." That is to say that almost all of us can readily understand virtually all of the relevant qualities of cookies or lemonade through our innate sense of sight, smell, or taste (We depend, rightly or wrongly, upon the Department of Agriculture to ensure that they are not pesticide-ridden, etc.). Consequently, the market price and quality of inspection goods can be readily, and even ideally, established in the course of the "higgling and bargaining" of the marketplace once so ably described by Adam Smith. The market works well for inspection goods because most consumers are capable of forming reasonably accurate assessments of the underlying qualities of the goods on offer.

By contrast financial assets, and this certainly includes mortgage-backed bonds and credit default swaps, cannot even be remotely thought of as inspection goods. Rather, they are "Experience Goods." That is to say that we will all learn what these instruments are worth at some future date, when we come to find out if they will, or will not, pay out. Yes, we can draw upon some theories and limited historical experience to form estimates of this likelihood, but the fact remains that we do not know. That is to say that we are uncertain. When they are uncertain people tend to follow a "second best" strategy. This is to rely on what they hope, or presume, is the greater wisdom of the crowd. In this case they are acting on the belief that the market, with its aggregation of conventional assessments, is the best available estimator of the "true value" of an unfamiliar asset or financial instrument. Consequently, people buy if others are buying, and sell if others are selling. The problem with a financial strategy based on "following the crowd" is that a period of market tranquility can induce a sense of comfort or assurance that reinforces a tendency to over-invest in risky assets. So long as these "bets" pay off, the underlying strategy appears to have been affirmed, and for that reason is repeated - with ever-larger and more leveraged bets. The consequence is that more and more financial institutions, including many who would never think of themselves as excessive risk-takers, take on what will turn out to have been increasingly dubious financial decisions. After all, they will reason, "everyone" is doing it and "everyone" is making a good deal of money. As the late economist Charles Kindleberger once remarked, "Everyone is a genius in a rising market."

When the market eventually ceases to rise, and it invariably does, everyone discovers - at more or less the same time - that their portfolio of holdings is substantially riskier than they thought, and that they should have sold yesterday. What follows is a "flight to quality" - formerly to gold, and now to U.S. Treasury bonds - and an ensuing crash in the market for the troubled asset in question. The selling pressure soon spreads to related classes of assets and, if not contained, to assets in general. A profound disruption of the "real" economy follows. This is the process we are all witnessing in our morning newspapers. The regulatory solution, as the reader may have by now inferred, is to recognize that assets are not inspection goods, and for that reason need to be regulated if we are to avoid a repeat of this debacle. Finally, let us note invoking the name of "Adam Smith" is inappropriate at this juncture because he also supported the regulation of banks. We could do worse than follow his advice in this matter.