Rethinking Markets

I complained last week that Duncan Watts’ editorial was an argument without much substance, effectively an argument based on deep knowledge of networks but shallow knowledge of markets.

At the end of last week, James K. Galbraith testified for the Subcommittee on Domestic Monetary Policy and Technology. And it was pretty awesome. First, it was a takedown of the Fed’s potential role as the main regulatory body in charge of system risk (which he thinks would be a bad idea because it should be the main, not secondary goal of the regulatory body; and because the Fed kind of historically sucks badly at identifying systemic risk). Second, he went on to talk about ‘too big to fail’:

Would the country be worse off with a smaller, simpler financial system, largely operating out of institutions called banks and thrifts, themselves reorganized, downsized, broken up, more competitive and less profitable than the financial sector has been in recent years? I can see no reason to permit the continued existence, let alone to foster the market dominance, of financial institutions so large as to be unmanageable by their own top leadership, let alone efficiently regulated by public authority. Edward Liddy, CEO of AIG, has written that he realized quite early on that the firm was “too complex, too unwieldy and too opaque” to manage as a going concern. In general, “too big to fail” is a synonym for “too big to manage” and “too big to regulate.” Such institutions exist, in part, to help with international tax evasion, to evade regulations, to project political power, to facilitate the kind of “financial innovation” that is the essence of systemic risk. They are intrinsically unsafe. An appropriate goal of public policy would be to shrink them, permitting other institutions of more reasonable size, more conservative practice and greater alignment with public purpose to grow into their market space.

I agree so much with this perspective in general and this statement in particular. It’s worth a longer, more sustained argument to suggest that financial services organizations are not entitled to their business model just because it’s ‘working’ for them. But for now, compare Galbraith to the statement by Robert C. Merton looking for a way to mush-mouth an apology for financial innovation:

You’ll hear in this case as in the past, “Look at all this financial innovation or financial engineering–it’s caused too much complexity, and now the system has run off the tracks.” To that I would say, structurally, one would expect that in the case of a successful innovation, the infrastructure to support it properly will lag behind. Why is that? It’s because if you have 100 innovations, maybe 2 of them will be successful. So it is not practical to build a full infrastructure–regulatory, educational, et cetera–for all 100 innovations. Innovations are going to run ahead of the infrastructure. That, we have to recognize, is structural. It’s not about bad people, it’s not about incompetent people, it’s not about greedy people. It’s not about having a market system or a nonmarket system. Whether the problems are addressed by external regulation or a combination of that along with internal regulation–whatever set of ways, we have to be prepared when innovations come in to have some degree of oversight modulation. If you do too much of that and you stifle innovation, that’s not good. If you do none at all, that’s not good either. So there’s something in between. Sometimes we don’t do enough of it, or the growth of innovation is too quick, but the point is that there is a reason why you will typically find that financial crises are often connected with what are perceived as new things, big changes–innovations.

For Merton, the problem is just that we have so much great innovation and we can’t tell which ones are going to be successful, that we couldn’t possibly have infrastructure and regulation to support them all.

It’s just that Galbraith’s argument is just so much more convincing.