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Tuesday, April 21, 2009

I Digress

Taking a break from the somewhat grim global economic news:

Take a look at Shrinkwrapped's post on the current AGW cant. The Shrink is responding to an odd but fashionable behavioral economics post claiming that Adam Smith's theories of a self-regulating marketplace are just all wrong. I always feel embarrassed to use a non-journalist's name when I am pointing out that someone's assertions are lunatic, so I won't cite the author's name. Instead, I will confer a charitable anonymity by using the sobriquet "Wonder Dummy" for the author henceforth.

The basic theme of Wonder Dummy's post:
Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating. The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so. This is a beautiful idea, but the question of course is how closely it represents reality.
Of course the answer to the question is preordained by this careful miscast of Adam Smith's main assertion. That assertion is that economic efficiency is best for the economy, and that economic efficiency can best be attained by not interfering with prices in the marketplace. In fact, I suspect that Wonder Dummy has never read Adam Smith. I prefer to be charitable and assume that Wonder Dummy is not knowingly lying in order to lend credence to a meme that is currently popular, if completely wrong.

If you want to find out what Adam Smith (1723-1790) really said, you can find most of his writing online. Here is the overall page with links to his works online, and I recommend going directly to OnLine Library's Glasgow edition (7 vols). Volume I (link to Table of Contents) contains Smith's "The Theory of Moral Sentiments", which is an extended and realistic contemplation of what really motivates individuals and societal institutions. Adam Smith was no superficial thinker, and his economic musings were not based on an unrealistic view of mankind. Indeed, this quote from Section III, Chapter IV "
Of the Nature of Self–deceit, and of the Origin and Use of general Rules" seems extremely apposite:
In order to pervert the rectitude of our own judgments concerning the propriety of our own conduct, it is not always necessary that the real and impartial spectator should be at a great distance. When he is at hand, when he is present, the violence and injustice of our own selfish passions are sometimes sufficient to induce the man within the breast to make a report very different from what the real circumstances of the case are capable of authorising.
To which I must add, from a different section in context which I will leave the gentle reader to discover, my favorite Adam Smith quote:
What can be added to the happiness of the man who is in health, who is out of debt, and has a clear conscience?
If you have never read Adam Smith's economic musings, I strongly recommend volume I and volume II of "An Inquiry into the Nature and Causes of the Wealth of Nations". But I digress. Coming back to the perturbed conclusions of Wonder Dummy:
In my mind this experience has taught us that Adam Smith ‘s version of invisible hand does not exist, but that a different version of the invisible hand that is very real, very active, and very dangerous if we don’t learn to recognize it. Perhaps a more accurate description of the invisible hand is that it represents human irrationality. In terms of irrationality the hand that guides our behavior is clearly invisible — after all recent events have demonstrated that we are largely blinded to the ways rationality plays in our lives and our institutions. Moreover it is also clear that irrationality does shape our behavior in many ways, pushing and prodding us along a path can lead to destruction. Whether we’re procrastinating on our medical check-ups, letting our emotions get the best of us, or letting conflicts of interest and short term time horizon ruin the financial market, irrationality is certainly involved.
What a surprise. In fact, those who have actually read Adam Smith know that the "invisible hand" is used in the context of government control of trade, specifically, protectionist tariffs against foreign goods. The discussion is found in Chapter 2 of Book IV "Of Systems of Political Economy". Book IV begins with the following paragraph:
Political œconomy, considered as a branch of the science of a statesman or legislator, proposes two distinct objects; first, to provide a plentiful revenue or subsistence for the people, or more properly to enable them to provide such a revenue or subsistence for themselves; and secondly, to supply the state or commonwealth with a revenue sufficient for the publick services. It proposes to enrich both the people and the sovereign.
In short, this is about what governments can and cannot accomplish. Chapter 2 begins as a discussion of government-granted monopolies to domestic industries, and continues as an explication of the harm that such monopolies cause to the general welfare, as in:
By restraining, either by high duties, or by absolute prohibitions, the importation of such goods from foreign countries as can be produced at home, the monopoly of the home–market is more or less secured to the domestick industry employed in producing them. Thus the prohibition1 of importing either live cattle or salt provisions from foreign countries secures to the graziers of Great Britain the monopoly of the home–market for butchers–meat. ...

That this monopoly of the home–market frequently gives great encouragement to that particular species of industry which enjoys it, and frequently turns towards that employment a greater share of both the labour and stock of the society than would otherwise have gone to it, cannot be doubted. But whether it tends either to increase the general industry of the society, or to give it the most advantageous direction, is not, perhaps, altogether so evident.
The invisible hand quote in context:
No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain. It can only divert a part of it into a direction into which it might not otherwise have gone; and it is by no means certain that this artificial direction is likely to be more advantageous to the society than that into which it would have gone of its own accord.
What is the species of domestick industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The stateman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.16 11To give the monopoly of the home–market to the produce of domestick industry, in any particular art or manufacture, is in some measure to direct private people in what manner they ought to employ their capitals, and must, in almost all cases, be either a useless or a hurtful regulation. If the produce of domestick can be brought there as cheap as that of foreign industry, the regulation is evidently useless. If it cannot, it must generally be hurtful.
But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value.12 As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestick industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can.13 He generally, indeed, neither intends to promote the publick interest, nor knows how much he is promoting it. By preferring the support of domestick to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.14 Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the publick good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.
The rest of the chapter is chiefly devoting to explicating when this general rule is false, such as when national defense is involved, or when tariffs are being imposed against your own goods.

Proceeding onwards to a more close examination of the epically inane quality of Professor Wonder Dummy's post, let us remind ourselves of how this "market failure" occurred.

A. Three US companies were granted a government monopoly on debt rating by being named as NRSRO's. This consolidation of the market occurred in the 1990s by mergers. I have covered this topic before - search for NRSRO. Although, in theory, other such companies could apply to be certified as NRSROs, despite applications, these three had an effective monopoly on the market.

B. In US financial regulation, the importance of being an NRSRO is that only debt certified as being investment grade by an NRSRO may be held for investment. The significance is that lower-graded debt can be held in trading accounts, but it must be revalued based on market value. Some types of financial pools, such as pension funds, shouldn't be in this at all, and other types, such as banks, may hold lower-rated instruments in trading accounts but they will have to reserve against them and constantly revalue them to current market price levels. So an investment designed to return the same value would be far more saleable if it were investment-rated by one of the NRSROs.

C. In the US, until last year there was no NRSRO that was paid by investors. Instead, the financial interests generating the securities paid the NRSROs to rate them. A lot has been written about the opacity of some of these securities, and it has been well-founded.

Now if one had been able to call up Adam Smith on the Way-Back Phone in, say, 2005, the conversation might have gone something like this:

MoM: (Gives above facts, and continues) Sir, do you consider this as a market experiencing perfect liberty?

Adam Smith: My dear lady, that is a government monopoly which must inevitably tend to produce a market price far above the natural price, as I have described in Chapter 7, Book 1 of "An Inquiry into the Nature and Causes of the Wealth of Nations".

MoM: I've read it. Is this the section you mean?
But though the market price of every particular commodity is in this manner continually gravitating, if one may say so, towards the natural price, yet sometimes particular accidents, sometimes natural causes, and sometimes particular regulations of police, may, in many commodities, keep up the market price, for a long time together, a good deal above the natural price.12

21When by an increase in the effectual demand, the market price of some particular commodity happens to rise a good deal above the natural price, those who employ their stocks in supplying that market are generally careful to conceal this change. If it was commonly known, their great profit would tempt so many new rivals to employ their stocks in the same way, that, the effectual demand being fully supplied, the market price would soon be reduced to the natural price, and perhaps for some time even below it. If the market is at a great distance from the residence of those who supply it, they may sometimes be able to keep the secret for several years together, and may so long enjoy their extraordinary profits without any new rivals.13 Secrets of this kind, however, it must be acknowledged, can seldom be long kept; and the extraordinary profit can last very little longer than they are kept.

Adam Smith: Indeed! You seem uncommonly well educated for woman! (Authors always love it when they found out you've actually read their books.)

MoM: My father believed in book-larning. And, in your opinion, does this excess in market price over the natural price result from a particular regulation of the police?

Adam Smith: Exactly. This SEC you describe has a police function. By controlling the cost of holding these commoditized securities, it is controlling the relative price. Since a new ratings firm must be nationally recognized in order to qualify as an NRSRO according to the SEC, and since usage of the firm is dependent upon certification by the SEC, because otherwise the firm's ratings will confer no market advantage and are thus worthless, it would seem that there is an effective monopoly. Nor is it in the interest of the institutions generating the debt to sponsor a new firm even if their prices are lower, as long as the prices of the existing NRSROs can be constrained by such a threat. Thus, it is a closed system and it is to the interest of the participants to keep it that way. Naturally the guild members will impose the most stringent secrecy.

MoM: I see what you mean. In effect, this is another example of merchants and manufacturers lobbying for an effective tariff in order to create an effective monopoly to support their prices, as you describe in chapter 2 of "Of Systems of Political Economy"....

Adam Smith: Correct.

MoM: Well, I really appreciate your time. I think I'll bury some hard money somewhere and just wait for the apocalypse.

Adam Smith: Bury money? That would withdraw it from the true production of the country and cause loss of wealth. That should not be necessary, because the large debt guilds you describe know that they cannot keep selling their debt if the opacity disappears, which it will if those who buy the debt find that it is not repaid. They may sell slightly bad debt, but not very bad debt. Their own self-interest will prevent them from doing so.

MoM: Er... What if I told you that the last three times the debt became very bad, the large guilds went to the king and said that it would be harmful to the national defense and protection if they could not sell debt, so the king took money from the farmers and gave it to the guilds to cover their bad debts?

Adam Smith: Bury such of your specie as you cannot conceal about your person, and flee overseas. Then buy a farm. You can employ a trusted, well-paid messenger to gradually extract your buried gold and silver and bring it to you.

MoM: Thanks, I already have the farm. The kings everywhere are doing the same thing so there is no place left to run. I think I'll just wait it out here. When the peasants get hungry enough, they will rise and I'd like to be next to my ammo stockpiles when that happens.

To regress back to Wonder Dummy's post, if there is one obvious thing, it is that the problem here was created by government interference with free markets. The second salient point is that if human irrationality is a factor in non-governmental pursuits, it surely must be equally so in governmental pursuits. In all things, governments enjoy insulation from the real-world effects of their irrationality. Thus, they may continue in it longer than would be possible for any non-governmental actor.

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