Thursday, October 27, 2011

Abolish banks? Maybe, maybe not...

I have little time to post this week as I have to meet several writing deadlines, but I wanted to briefly mention  this wonderful and extremely insightful speech by Adair Turner from last year (there's a link to the video of the speech here). Turner offers so many valuable perspectives that the speech is worth reading and re-reading; here are a few short highlights that caught my attention.

First, Turner mentions that the conventional wisdom about the wonderful self-regulating efficiency of markets is really a caricature of the real economic theory of markets, which notes many possible shortcomings (asymmetric information, incomplete markets, etc.). However, he also notes that this conventional wisdom is still what has been most influential in policy circles:
.. why, we might ask, do we need new economic thinking when old economic thinking has been so varied and fertile? ... Well, we need it because the fact remains that while academic economics included many strains, in the translation of ideas into ideology, and ideology into policy and business practice, it was one oversimplified strain which dominated in the pre-crisis years.
What was that "oversimplified strain"? Turner summarizes it as follows:
For over half a century the dominant strain of academic economics has been concerned with exploring, through complex mathematics, how economically rational human beings interact in markets. And the conclusions reached have appeared optimistic, indeed at times panglossian. Kenneth Arrow and Gerard Debreu illustrated that a competitive market economy with a fully complete set of markets was Pareto efficient. New classical macroeconomists such as Robert Lucas illustrated that if human beings are not only rational in their preferences and choices but also in their expectations, then the macro economy will have a strong tendency towards equilibrium, with sustained involuntary unemployment a non-problem. And tests of the efficient market hypothesis appeared to illustrate that liquid financial markets are not driven by the patterns of chartist fantasy, but by the efficient processing of all available information, making the actual price of a security a good estimate of its intrinsic value.

As a result, a set of policy prescriptions appeared to follow:

· Macroeconomic policy – fiscal and monetary – was best left to simple, constant and clearly communicated rules, with no role for discretionary stabilisation.

· Deregulation was in general beneficial because it completed more markets and created better incentives.

· Financial innovation was beneficial because it completed more markets, and speculative trading was beneficial because it ensured efficient price discovery, offsetting any temporary divergences from rational equilibrium values.

· And complex and active financial markets, and increased financial intensity, not only improved efficiency but also system stability, since rationally self-interested agents would disperse risk into the hands of those best placed to absorb and manage it.
In other words, all the nuances of the economic theories showing the many limitations of markets seem to have made little progress in getting into the minds of policy makers, thwarted by ideology and the very simple story espoused by the conventional wisdom. Insidiously, the vision of efficient markets so transfixed people that it was assumed that the correct policy prescriptions must be those which would take the system closer to the theoretical ideal (even if that ideal was quite possibly a theorist's fantasy having little to do with real markets), rather than further away from it:
What the dominant conventional wisdom of policymakers therefore reflected was not a belief that the market economy was actually at an Arrow-Debreu nirvana – but the belief that the only legitimate interventions were those which sought to identify and correct the very specific market imperfections preventing the attainment of that nirvana. Transparency to reduce the costs of information gathering was essential: but recognising that information imperfections might be so deep as to be unfixable, and that some forms of trading activity might be socially useless, however transparent, was beyond the ideology...
Turner goes on to argue that the more nuanced views of markets as very fallible systems didn't have much influence mostly because of ideology and, in short, power interests on the part of Wall St., corporations and others benefiting from deregulation and similar policies. I think it is also fair to say that economists as a whole haven't done a very good job of shouting loudly that markets cannot be trusted to know best or that they will only give good outcomes in a restricted set of circumstances.Why haven't there been 10 or so books by prominent economists with titles like "markets are often over-rated"?

But perhaps the most important point he makes is that we shouldn't expect a "theory of everything" to emerge from efforts to go beyond the old conventional wisdom of market efficiency: of the key messages we need to get across is that while good economics can help address specific problems and avoid specific risks, and can help us think through appropriate responses to continually changing problems, good economics is never going to provide the apparently certain, simple and complete answers which the pre-crisis conventional wisdom appeared to. But that message is itself valuable, because it will guard against the danger that in the future, as in the recent past, we sweep aside common sense worries about emerging risks with assurances that a theory proves that everything is OK.
That is indeed a very important message.

The speech goes on to touch on many other topics, all with a fresh and imaginative perspective. Abolish banks? That sounds fairly radical, but it's important to realise that things we take for granted aren't fixed in stone, and may well be the source of problems. And abolishing banks as we know them has been suggested before by prominent people:
Larry Kotlikoff indeed, echoing Irving Fisher, believes that a system of leveraged fractional reserve banks is so inherently unstable that we should abolish banks and instead extend credit to the economy via mutual loan funds, which are essentially banks with 100% equity capital requirements.8 For reasons I have set out elsewhere, I’m not convinced by that extremity of radicalism.9 ... But we do need to ensure that debates on capital and liquidity requirements address the fundamental issues rather than simply choices at the margin. And that requires
economic thinking which goes back to basics and which recognises the importance of specific evolved institutional structures (such as fractional reserve banking), rather than treating existing institutional structures either as neutral pass-throughs in economic models or as facts of life which cannot be changed.




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