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The Invisible Hand is Neither “No Hands” Nor “Firm Hands”

Posted by Bob Warfield on November 11, 2008

It’s a great pity the world’s economy lays in tatters from the perspective of people’s perceptions of the efficiency of Free Markets (as well as many other more tangible and immediate tragedies).  The tragedy is that the financial ruin that surrounds our economy is being shackled to the notion that Free Markets have failed.  The conclusion being pushed is that this disaster is as a result that the markets were in fact too free.

I’m inspired to write this both after numerous lunchtime conversations and after reading Dale Dougherty’s piece, “The Visible Hand.”  While we’re on the subject of hands, my title comes from Adam Smith’s notion of the Invisible Hand that guides Free Markets to do the right thing.  Hard core capitalists and entrepreneurs are often proponents of Free Markets, but its hard to be excited about them at the moment.  The trouble is there are some subtleties at work here that are being lost.

Is this disaster really a result of too much market freedom?  I don’t think of it that way, but perhaps it is because I have an odd view of what it means to be a Free Market.  Smith’s notion of a Free Market was that individuals acting in their own enlightened self-interest would produce behavior that collectively results in the greatest good for their community.  This collective result is that “invisible hand.”  Milton Freedman calls this “cooperation without coercion”, an expression I love, because it speaks to the idea that everyone can benefit through natural cooperation that is not forced.

That’s all well and fine, but there was a tendency to assert that a Free Market meant one free of any regulation. That’s the “No Hands” reference in the title of this piece, and it is where my own peculiar view perks up, because I don’t believe a Free Market implies no regulations.  In fact I think that is categorically wrong and that’s where the real blame lies for our current circumstances.  A Free Market requires effective competition and a relatively level playing field.  Based on that, for example, I would argue that there is a real need for anti-trust regulation.  Too much monopolization eliminates the “Free” and “competitive” aspects of a Free Market, and so inhibits the action of the Invisible Hand to produce much collective good.

I look at this as being similar to physics, where scale matters.  When there is enough competition, the markets behave smoothly and positively deliver the benefits commonly ascribed to Free Markets.  This is a competitive scale where Newtonian physics work.  When there is too little compeition, we see quantum effects trickle in and life is suddenly much harder.  Newtonian physics no long works, and we see completely unintuitive results where very sudden and drastic changes an occur, often to the worse.

It is no surprise to me that Free Markets keep failing catastrophically around financial markets, and in particular, that it keeps happening around financial markest where accurately predicting the future matters.  Take the 1987 Black Monday crash.  Experts are still arguing about it, but two of the leading cause contenders are Program Trading and Illiquidity,  Both are cases where was appeared to be an efficient free market was in fact not.  WIth program trading, if too many of the algorithms become too similar and are executed in rigid lock step by computers, suddenly what appear to be independent operators are all acting as one single large entity.  Illiquidity is simply an example of a market that such large transaction volumes going on that it outstripped the liquidity, another non-Free Market scenario.  The Long Term Capital fiasco is very similar in scope, and I will argue so too is the current crisis around mortgages.

What keeps happening is we allow relatively few people to get too much of the market.  For the manufacturing world we largely cured this through anti-monopoly means.  But, the financial world allows iceberg-like behavior where much of the danger lies beneath the surface and invisible.  it is as a result of allowing too much leverage. 

I read somewhere that the mortgage brokerage industry had access to 40:1 leverage.  If you had $1M, you could write mortgages to the tune of $40M.  Isn’t that absurd?  I recall well my father explaining to me the evils of trading on the margin for stocks.  As he put it, if you borrow to the full margin amount, not only are your gains doubled, but so too are your losses.  If a stock goes down by half, you’ll be wiped out with a margin call.  Most people in my generation regard margin like this as evil, but now imagine that 40:1 advantage mortgage lenders enjoyed.  It took comparatively little swing in housing prices before everyone was incented to default on the mortages and wealth started evaporating like cool water on a hot summer sidewalk.

We’ve built up in modern times a series of financial markets that encourage this kind of leverage.  Look at energy prices.  Look at the swing in gasoline prices we’ve seen just in the last 12 months.  Isn’t it hard to believe that much swing was due to demand?  Do you believe enough people are driving less than half as many miles to change demand so much?  Me neither.  I wonder how much gasoline one can control with $1M properly deployed in the futures markets?  Is it the 40:1 mortage brokers enjoy?  More?  Less?

All of this contributes to the erosion of competition because relatively few people in very specialized businesses gain control over extremely large markets.  They can make a lot of money if things go as they plan (there’s that dependence on predicting the future that I mentioned), or they can leave the rest of us holding the bag if things don’t go so well.

Can it be as simple as tightening the “margin requirements” on some of these financial instruments?  Maybe so.  I’m sure there will be those that argue this leverage is needed to allow legitimate businesses to hedge risks cheaply, but if they had to build more of that risk into their prices wouldn’t it be better than the cost this latest finanical disaster has placed on us?

Let’s make sure we don’t throw the Free Markets baby out with the bath water.  The Invisible Hand means neither Free Hands nor Firm Hands.  it means hands focused on maximizing competition and ensuring a truly free market.

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Great post in ongoing about this tawdry business.

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