Wednesday, August 22, 2012

The Malign Hand of the Markets

After the near financial meltdown in 2008, many wonder what can be done to stabilize financial markets. Too much government control seems like a bad idea, but letting those who run financial firms continue to enrich themselves at public expense is also a bad idea. In the book, The Malign Hand of the Markets, author John Staddon offers a prescription.

Staddon goes through a number of topics with thoughtful commentary before finishing with his answers to stabilizing financial markets. He begins by explaining various ways that markets can work poorly, which he calls a “malign hand” as opposed to Adam Smith’s invisible hand. One example is problems with the market in scientific research that result from a monopoly buyer, the government. Other examples involve the separation of short-term profits from long-term risks.

Another type of problem that can lead to a malign hand is asymmetric information. Some businesses seek to confuse their customers. When it comes to confusing contracts, Staddon suggests that “If average-IQ citizens cannot understand the contract within a limited study-time related to the amount of money at risk, then the agreement could be declared null and void.”

In explaining why people so frequently make poor financial choices, the author observes that people “live now in environments that have changed drastically in recent centuries—a short time in evolutionary terms. Hence many of their instincts may be poorly adapted to their current environment.”

In his critique of the financial industry, the author observes that agricultural employment shrank from “41 percent of the population in 1900 to 1.9 percent in 2000” not because people eat less now, but because of efficiencies. Despite the advent of computers which should have reduced the size of the financial industry, it has grown and uses “technology to complexify and baffle.” Computers make possible “a swarm of complex new financial products that contribute to systemic instability and whose social value is almost certainly negative.”

Among Staddon’s recommendations for fixing the financial industry, he suggests that only banks that do retail (boring) banking should be allowed to be limited liability companies. Any firms that deal in financial markets should have to be partnerships so that the partners would be responsible for losses beyond the value of their shares.

Recognizing that forcing risky firms to be partnerships is a big change, Staddon suggests a quicker improvement, which would be to tax financial risk progressively. “A common risk management tool is something called value at risk.” This measure could be used for taxation. Small firms would pay very little per unit of risk, but large firms would pay much more per unit of risk. This creates a disincentive to forming too-big-to-fail firms.

Staddon takes on a controversial subject with thoughtful analysis. I recommend this book to anyone wishing to think deeply about the problems in the world’s financial system.

1 comment:

  1. Obligatory LLPs for financial industry sounds like a good idea, but it should be supported by changes in bankruptcy laws. As of now, one who declared insolvent just starts from zero, while general public picks up his bills (companies pass the losses to the public via safety margin on products and services). Instead, an insolvent person must enter into prescriptive work arrangement where most of his income would be directed to repayment of his debts.