Wednesday, November 26, 2008

Free Market Utopia

The conventional wisdom on KP seems to be that individuals are better suited to efficiently allocate their wealth than the Federal Government.  I submit that if you goal is to maximize individual utility, KP is right.  If, however, your goals are to help the economy to regain its feet and to foster long-term economic growth, then KP is wrong. 

Maximizing Individual Utility

If there is one thing that Americans do particularly well, it's doing stuff that is going to make them feel good.  Americans are self interested machines, both rapacious and ruthlessly efficient.  We see that in the Country's spending trends.  For example, as the US's coffee pallet has become more refined, our need for fine coffee outlets has increased dramatically.  As a result, we have channeled our dollars and focused our spending to facilitate the creation of a vast, private coffee delivery infrastructure never thought possible in this country.  Our Starbucks-to-consumer ratio that is the envy of the java swilling world. 

Similarly, many Americans are exceptionally good at making money.  Eschewing such antiquated asset valuation models like the CAPM, our brave equity warriors learned that intrinsic asset value is much less important that perceived value.  Of course, the obviously excessive P/E rations of the .com era served to stem some of the irrational exuberance inherent to the greater fool model.  Thus, traders came to rely upon delicate, intricate, and sophisticated computer models put together by some of the best quants money could buy.  The realities of stated income loans, interest-only ARMs, and refinance opportunities without end took a back seat to the highly crafted superior wisdom bestowed upon the few by their eight flat panel monitor arrays: these were worth something and there was money to be made. 

But even those Americans who may not be financial wizards know how to make for a happy holiday.  Both parents and their kids can recite from memory the relative merits of newest generation of ipod nanos when compared to say, the Zune or even the Touch.  Both are probably aware of the new "it" toy, i.e. that toy which is most calculated to bring delight to the kids and make them the envy of their classmates.  Never mind if the kid's 529 hasn't seen a contribution in 18 months.  Never mind if you have to finance the purchase.  It's the holidays: a time during which we are all entitled to a little joy.

Okay, you get the point.  The truth is that people aren't even good at maximizing their own individual long term utility.  If behavioral economics has shown us anything, it's that people will usually take the quick payoff at the expense of greater reward in the future.  CEOs do it.  Traders do it. Everyone does it.  Compounding the issue is that people, at times, don't even know what will make them happy.  They underestimate the utility of future rewards and over estimate the pain of certain trade offs.  Sometimes, it's not their fault - they lack sufficient information about their consequences of their choices. 

The Truth

And here is ugly truth for all of those libertarians who want to live in a country of hundreds of millions: people make bad decisions and do it often.  Efficient market theories assume perfect information and rational actors.  Neither exist nor will they ever exist.  Dreams of unfettered markets self-regulation are as unrealistic and as Utopian as anything dreamt up by the left.

Case in point: civil suits.  Civil litigation is the ultimate in open market, government-free regulation.  Someone rips you off or sells you a bum steer - don't go to government for help!  Rather, settle the matter one-on-one, citizen-to-citizen before a neutral with a jury of your rational-acting, efficiently resource-allocating peers.  Worried that some new food additive might cause cancer?  Why wait for the government to waste millions of taxpayer dollars or burden industry with even more regulations when you can rely upon private individuals using private funds to research the issue and arrive at an answer?  Do you think private corporations have a duty to make their products safer with newfangled improvements like seat belts?  Why wait for government to decide the issue when you can quickly create an economic incentive for companies to behave responsively.

The truth is that every single one of KP's so called free market proponents would love nothing more than use more government regulation to reign in the US plaintiffs' bar.  They would love to rip apart privately-negotiated contingency fee agreements and to prevent average Americans from playing their role in the resolution of private disputes.  Somehow the very same people that libertarians believe should make their own decisions about savings, retirement, insurance, and capital investment become blithering idiots once they step into the jury box.

Even with government assistance, the markets failed to allocate sufficient investment in infrastructure and growth to tackle issues such as energy independence, math & science education, and basic road maintenance.  Take energy independence for example.  The markets failed us in the 1970's.  After the embargo and after the Reagan administration took Jimmy Carter's solar panels off the White House's roof, the private failed to allocate sufficient resources to prevent future shocks.  Even after 9/11, SUV sales continued to rise in the US.  Neither the public nor US industry were committed to doing what needed to be done in order to properly tackle the issues. 

I will acknowledge that a number of externatilites may distort the energy markets, so it's not a "pure" example.  But we have one example of a regulation-free market: CDSs.  The government was actually prohibited from regulating this market.  Look where that got us.



4 comments:

Restless Native said...

Whoa there, Aztec. I am for free trade and generally for free markets but I don't disagree with you at all. Your points are very much in line with the book I suggested be required reading for the SP, Nudge. They talk about Humans v "Econs", Humans frequently making bad choices while mythical beings called "Econs" could actually function well in a Friedmanite (Milton, that is) environment.

friedmanite said...

Interesting post. I have a couple comments.

First, you're saying that humans acting in their own self-interest don't always make good decisions. So we should replace some of their decision-making power with central government decision-making power. Yet the central government doesn't have a good record of making sound decisions either.

At least with individuals, they have to account for their own decisions, pay the consequences, and normally learn to perform better in the future. I can guarantee you a lot of people will be looking at their house purchases a lot closer the next time around. On the other hand, central government continues to fund and expand Fannie and Freddie.

As for your examples of infrastructure and education, those are both controlled by the government, so I don't see how free markets can be blamed for their lack of performance.

Aztec Tomb said...

RN: Nudge is an important book and has informed a number of Obama's policy proposals. For example, Obama wants to make 401k contribution the default for employees. That means that employees would have to specifically opt out rather than specifically opt in. The result is greater savings.

It's no secret that Sunstein is an Obama adviser and supporter. If you dig into Obama's policy papers, you will see Sunstein's fingerprints all over them.

Fried: I should have noted that this is part 1 of a series of posts. Having concluded that unfettered markets are not the solution, the next post will be an argument for why government spending tax dollars is better for the economy than if individuals had spent the same bucks.

While people by in large should live with the consequences of their actions, there are things that government can do to encourage people to make better decisions. This circles back to the research being done in behavioral economics and the 401k contribution proposal outlined above. The key is that people still have the ability to make a choice, but they should be encouraged to make the correct choice.

I thought KP had finally stopped the Freddie and Fannie bashing, but I guess not. The government is currently their conservator, but gained an equity stake in these publicly traded companies. This is absolutely necessary considering that we are in the middle of a credit crisis. If there is no liquidity in the secondary mortgage markets, no one is going to be able to get a loan. Now that the Feds have agreed to back Citi, you are finally seeing interest rates decline and money being pumped back into the economy.

Finally, your last paragraph emphasizes my main point. The government has no monopoly on either education or infrastructure. Anyone can open a private school, charter school, or university. Heck, you can home school your kids. Education is very much a private market. Yet this private market has failed to produce a sufficient number of qualified graduates to meet the current demands in engineering, research, and medicine.

The same is true for infrastructure. There is private ownership of railways, pipelines, refineries, electrical transmission lines, ports, ferries, and toll roads. A huge part of our infrastructure consists of common carriers, which are open to all, but privately owned.

The nation's entire oil and gas infrastructure is privately owned. And due to consumer demand, energy companies have built massive, but efficient distribution systems with private dollars and lapdog Federal oversight.

But the same market forces have failed to sufficiently meet the challenges of energy independence. And where the markets have failed, there is a substantial case for the government to step in and help solve the problem.

Restless Native said...

This is shaping up to be a battle royale in the very best sense of the idea. The whole raisin del tree of the KP is to foster this kind of dialogue. Friedmanite is a thoughtful voice of reason on that end of the spectrum, and Aztec is bringing a unique perspective that is also well thought out and cogent. How nice for someone in the middle to hear both sides presented in a civil forum and just think about the issue.

Delightful.