Wednesday, December 1, 2010


So, Mark Thompson over at LOG linked to the politics versus economics post. A couple of responses popped up that FLG thinks are misreading FLG and attacking points he's not making, but they are assuming he is making.

nadezhda writes:
I’m sorry. This is market fundamentalism at its over-simplifying worst.

FLG’s initial occasion for outlining a “politics vs markets” theory, if I followed his post correctly, was his discussion of capital controls and why he’s opposed to the walk-back by international monetary theorists (including some inside the IMF and World Bank) of the absolutist position against capital controls. Serious economists are starting to acknowledge that an open capital account may not be, in all cases, the optimum policy, especially for emerging markets, which are often victims of the whipsaws of hot money flows. FLG sets up an artificial “economics” vs “politics” opposition, when we’re dealing with an asset (currency) which is created and backed by governments and the value of which is dependent on fiscal and monetary policies of said governments. There ain’t no such a thing as a “free market” in currencies that doesn’t involve government policies and politics. And the global capital markets have a time horizon measured in nano-seconds. So the short-term vs long-term distinction isn’t particularly helpful either.

FLG actually doesn't oppose the walk-back about capital controls. It's a legitimate political decision, especially in conjunction with a fixed exchange rate. FLG just thinks these things cannot be maintained forever. At some point, international financial forces will wash over the bulwark. That being said, FLG thinks they can be helpful at certain stages of development, but only a certain stages, .i.e. not forever. In his write-up at the end of that post FLG fears that democracies try to instate these policies when the trouble is already at hand rather than as part of a long-term strategy. Democracies come under pressure when crises hit, but by then enacting capital controls often makes things worse. The success story, Malaysia, enacted them before they need them, which works, but is also not likely to happen with democratic governments.

On the nano-seconds point, FLG isn't talking about any particular hot money fluctuation. Hot money usually, but not always, reacts to underlying economic problems. Sure, hot money is the proximate cause or exacerbation, but international investors don't just all of a sudden decide to leave a country all at once for no reason. Soros was able to break the pound because the peg was untenable according to fundamentals. Although, in fairness, the Asian financial crisis did see contagion that wasn't exactly tied to fundamentals, but those countries still had issue outside of the hot money.

Now it’s true that attempts to defend an exchange rate that’s likely to depreciate are, in the not-so-long-run almost certain to be costly failures. So to that extent, yes, attempts to cushion fluctuations are eventually going to be overwhelmed by economic “fundamentals”. But what the relaxation of opposition by economists against capital controls is reflecting is the realization that there’s no particularly good reason to exclude any and all capital controls from the toolkit of macro-policy management. So the discussion among economists has moved to what types, in what circumstances, and how do they interact with the other macro tools. Personally, I think they should be limited to a stable regime of Tobinesque “sand in the wheels” controls for small open-economy emerging markets — Chile ran a reasonably successful system for some years that raised the cost, in a predictable fashion, of short-term capital inflows, and which provided some insulation for their exchange rate and interest rate policies. But regardless of where one comes out on the specifics, this is a discussion which is, IMHO, long overdue. The absolutist position so dominated the economics profession for the past few decades that anyone who even modestly questioned the consensus was engaged in a career-limiting gesture.

FLG doesn't disagree with any of that.

But FLG didn’t stop with capital controls in applying his sweeping observations re “anti-market” and “pro-government” “progressive” politics versus the long-run truth of economics. He claims that attempts to interfere with the magic of price formation in the miracle of supply and demand meeting in the free markets are simply doomed to failure (and apparently short-term successes at moderating “fluctuations” will make matters worse in the long-run, though I’m not sure if he’s a pure Austrian liquidationist). Implicit in this formulation is the assumption that prices in asset markets reflect some sort of fundamental “value” that will eventually be reached at some sort of essentialist equilibrium price.

If you really want to know the real fundamental issue here, it's more along the lines of market interactions are mutually beneficial, ceteris paribus. The outcome of political policies and decisions aren't necessarily or often even. It's difficult to stop two people from doing things that are going benefit both of them. And a lot of the time it's also a bad idea.

But stepping beyond that into a less philosophical and more tangible issue is that my point is that governments simply cannot make economic and financial guarantees that last forever.

Surely the bubbles and collapses of asset markets in the past few years have demonstrated just how distant that model is from the way asset markets really work. You don’t need to adopt Soros’ quite interesting “reflexivity” model in its entirety to have realized that asset markets by their very nature not only overshoot (on both up and down side) — the very fact of their overshooting changes the “fundamentals” on which a hypothetical equilibrium would be based. Market bubbles and crashes aren’t just benign fluctuations. They are crises precisely because they have enormous, and distorting, effects on the real economy, which push the real economy off of any trends consistent with the longer-term “underlying financial and economic forces” on which FLG seems to pin his hopes.

FLG has no hopes to pin on economic and financial fundamentals. He doesn't worship at that altar because he thinks it's good, but simply trying to state that it is more powerful than politics over the long run. Moreover, FLG doesn't deny that the strict efficient market hypothesis holds, but he does contend that prices fluctuate within a range of their real value.

FLG also ignores the fact that asset markets are, by their very nature, in important ways nothing but a set of rules (what constitutes an asset, how is it traded and where and by whom, how is it ‘stored’, how is its value realized, etc.). Those rules aren’t all devised and enforced by governments, but a very substantial portion of them are, starting with laws governing contracts, negotiable instruments, creditor rights, corporate governance, bankruptcy, etc etc. Because the markets depend on the rule sets in order to function, changes in those rules (even a relatively minor court decision among private litigants in Delaware) will change the incentives for market participants, which in turn will affect the operations of the markets, which in turn will affect the real economy. Governments also license financial markets and institutions, which btw is as much for the benefit of market players as to protect those who merely use their services. In the absence of government licensing and regulation, we tend to see the formation of private sector guilds or cartels that perform many of the same (self)-regulatory functions, but with a lot of anti-competitive behavior, barriers to entry, etc. So it’s not as if eliminating government regulation of financial institutions would eliminate “anti-market” rules — it’s just that the rule-making and enforcement would typically benefit, even more than is now the case with government regulation, those institutions with the most economic power, while still leaving the public with a mess to clean up when the inevitable financial crisis occurs.

FLG needs to be clear here. He is in favor of regulating leverage, through capital requirements, collateral requirement on exchanges, etc, to mitigate against systematic risk. He's less impressed with calls for regulation that are only tangentially related to the cause of the systematic crisis. But nor is he a no regulation is good regulation type guy.

As we’ve learned to our intense pain over the past several years, the rules that affect market instruments, market structure and market participation produce incentives for practices, for both good and ill, that have a huge impact on where real economic activity is focused as well as on volumes, prices and risks. And it’s not just government rules that can shape incentives in perverse or dangerous ways — those devised by the market participants themselves, such as access by high-frequency traders to exchanges or the standards for collateral for credit derivatives or the “don’t break the buck” practices of money-market fund sponsors — can add gigantic tail risk or push market volumes or prices, both short-term and long-term, far away from anything justifiable in terms of “fundamentals”.

Again, FLG is worried about leverage. Further, he isn't arguing that incumbent or powerful firms, .i.e market participants, don't try to set the rules and practices according to their preferences. So, FLG does see a role for government intervention that is pro-market rather than pro-specific firm or pro-industry. He also gets a little concerned when with the supposedly pro-consumer regulation, but he doesn't want to get into that now.

So pace FLG, “anti-market, pro-government, or pro-regulation” aren’t the same things at all. Nor is “pro-market” either “anti-regulation” or “anti-government”. Even the “freest” of markets embody regulation; they depend heavily on government; they can’t function without a set of highly-complex, widely shared rules.

FLG isn't saying no, zero regulation. But he is saying that those rules won't last forever. And the more they fight against economic fundamentals, the more likely they'll fail. Put simply -- it's better to try to shape incentives rather than try to stop people from doing things.

Since we have to have rules, the real issues concern what those rules should be and how and by whom they should be enforced, in order to encourage the financial markets (1) to do a better job at their core economic functions of forming and allocating capital and intermediating savings while (2) reducing the frequency/probability of bubbles and crashes and (3) ensuring that when the inevitable crashes happen, that we won’t once again privatize the profits and socialize the losses. We had a set of rules (both government and private, including both written rules and customs and practices) that demonstrably did a catastrophic job on each of those three objectives. Surely we’re not doomed, in the name of free markets and the holy invisible hand, to having to just suck it up and live with a dysfunctional financial system! That’s theology, not economics.

FLG actually agrees with most of that. He's not saying that we ought to live with the financial system because IT IS GOOD without reservation. He's saying that it is more powerful. As in James Carville wants to come back in his next life as the bond market because then he could scare the shit out of everybody.

So, we need to realize that the way in which we accomplish those goals needs to be adaptable to changing circumstances. For example, capital requirements that automatically shift higher in good times.

So, FLG thinks you misunderstood him.

Second up is gregiank:
I think Nade. has a fair point regarding seeing the separation between market and politics as oversold and artificial. Markets only exist in the context of laws, courts and regulations. Whatever gov there is always part of and influenced by the market.

FLG doesn't really buy into the whole markets need regulation to work. Markets exist whenever and where ever people who want to buy and sell thing get together. Perhaps that requires very basic rules, but those can arise organically and spontaneously. However, he does think modern markets, which are very complex, can be improved by good regulation, but that more often than not they are hurt by what is bad regulation. Nevertheless, he's not entirely anti-regulation as he made clear above.
I think you are hacking away at a bit of strawman regarding the goals of liberal econ. Liberal policies are focused on a social safety net to protect people from the worst effects of market swings, not to protect them. Outside of that regulations are focused not on controlling the market but on trying to create a fair open market or on basic safety kinds of issues. Whats left is basically things like health care where many of feel has failed and will never work. There is no liberal push to control the market, just to soften the worst effects, especially on the most vulnerable.

Okay, that's a fair point. It's not protecting people from market swings, but the effects.

That kind of reminds me of this passage from Machiavelli:
Fortune is the arbiter of one-half of our actions, but that she still leaves us to direct the other half, or perhaps a little less.

I compare her to one of those raging rivers, which when in flood overflows the plains, sweeping away trees and buildings, bearing away the soil from place to place; everything flies before it, all yield to its violence, without being able in any way to withstand it; and yet, though its nature be such, it does not follow therefore that men, when the weather becomes fair, shall not make provision, both with defences and barriers, in such a manner that, rising again, the waters may pass away by canal, and their force be neither so unrestrained nor so dangerous. So it happens with fortune, who shows her power where valour has not prepared to resist her, and thither she turns her forces where she knows that barriers and defences have not been raised to constrain her.

And so liberal politics, of which FLG would argue Machiavelli is the fount but that's another post entirely, is concerned only with managing the effects. But to continue Machiavelli's analogy, FLG thinks at some point those canals will overflow and the defences be overrun. Yet, the people who built the canals will say how great the canals are and the people will, after several years of no floods, make decisions based upon those floods not happening any more. Until such time that the dam that held back the waters breaks, and the flood is worse then ever.

So, if you really want to boil the main point of my previous post down, it's that government tries to make guarantees with no expiration when it can't. Eventually, the forces of the market will overcome the government's ability to deliver.

I suppose this is also the place to note the observation that in the long term we all die.

It's actually funny you say that because FLG has another time horizons theory that says liberals are focused on the short-term. He has a bunch of quotes that he uses to support that, including the King's "fierce urgency of now," Paine's "eternal now," and Keynes' "in the long run we're all dead."

But that focused on an individual. FLG is talking about government policies. Governments are supposed to last forever and so are the policies FLG is most concerned about.

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