26/06/2009: The invisible hand scores a knockout

An economist I know recently expressed a view that is shared by many people: the financial crisis “simply exposed the stupidity of market participants.” Classical economic theory is based on the notion of homo economicus, a rational being pursuing his or her self-interests. If everyone acts in this manner, so the theory goes, the wisdom inherent in free markets——the invisible hand——assures an optimal outcome.

With personal greed at the core of functioning markets, classical economic theory simply doesn’t allow scope for any irrational behavior by market participants. But after two major asset price bubbles in the past decade, some observers are beginning to think that maybe market participants really are irrational, if not plain stupid. Hence, new disciplines like behavioral economics are aiming to redefine the foundations of economic theory.

While not disputing the merits of the behavioral approach, I think it isn’t needed to explain the current financial meltdown. Rather, in my view the case can be made that each market participant, individual and corporate, probably made quite rational choices leading up to the crisis. In fact, I argue that it is the sum of all these individual rational choices that led to a very suboptimal outcome.

Highlighting the dangers of conflicting self-interests goes back at least to the emergence of game theory in the 1950s and the famous prisoner’s dilemma. The police catch two suspected criminals but don’t have enough evidence for a full conviction. Thus, if both criminals decide not to cooperate with the police, they will each face one-year prison terms. If one criminal decides to talk while the other doesn’t, the talker will go free and his accomplice will get a ten-year sentence. If both decide to cooperate, they will each get five years in jail. Studies show that despite the advantages of stonewalling, each individual sees a decisive incentive to cooperate. Each is acting in an apparently rational, self-interested way but the outcome, a five-year prison term for both, is far from optimal.

I think this story best explains the behavior of the market participants leading up to the crisis. Individual stupidity was not the problem; rather, an aggregation of narrowly defined but rational decisions was the market’s undoing. Homo economicus is still on his feet, but the invisible hand blindsided him.

What does this tell us about the future? If governments want to avoid a replay of this financial crisis, they need to see that aggregated, cumulative individual behavior does not lead to the market as a whole taking on too much risk. This lesson was first learned after 1929. But since the early 1980s, its impact faded as the mantra of the invisible hand’s inevitable wisdom led to the belief that markets themselves have self-interests and would rationally seek their own preservation as an optimal outcome. Alas, when the invisible hand finally showed up, it knocked the wind out of financial markets yet again.

12/06/2009: The MONIAC’s revenge

Browse the webpage of the University of Cambridge and you might stumble upon a video demonstrating the MONIAC. This two-meter tall, rather homemade-looking assemblage of tanks and tubes of colored water could be the work of Rube Goldberg or Jean Tinguely. Amusing but baffling. In fact, it is a computer, the Monetary National Income Analogue Computer, created in the late 1940s by New Zealand economist Bill Phillips to illustrate the dynamics of the UK economy.

Phillips was something of a cross between Crocodile Dundee and MacGyver. In his youth, he hunted alligators in Australia and as a prisoner of war in Indonesia during WWII, he secretly built a miniaturized radio from scratch. After the war he studied at the London School of Economics, where he developed the MONIAC and made several other important contributions to economic science.

While fun to watch, the MONIAC is of course eons away from modern computerized econometric models. Nevertheless we can learn some very useful lessons from it. The water running through the MONIAC’s circuits represents money. If the tubes are clogged, the water cannot flow freely even if more water is added to the tanks. At some point, however, if lots and lots of water is added to the tanks, enough pressure can be created to unclog blocked circuits. But then, if the excess water isn’t removed from the tanks, the pressure it creates can lead to major damage to the whole system.

Sound familiar? Today, money flows worldwide remain subdued, but money stocks have surged in some countries, notably in the US, in an effort to unblock frozen credit markets. Once these channels start to work again, the excess liquidity needs to be removed quickly in order to avoid a flood of inflation.

The MONIAC’s creator is even better known for the Phillips curve, which depicts the negative relationship between unemployment and inflation that he observed in postwar UK. In the 1960s, this relationship was often used by governments as a kind of recipe. Too much unemployment? Just increase inflation. But in the late 1960s US economists Milton Freedman and Edmund Phelps argued that the Phillips curve was fundamentally flawed. And the 1970s proved them right, when many countries across the globe faced both high unemployment and high inflation, the miserable condition we now call “stagflation.”

Interestingly, the Philips curve has enjoyed a bit of a revival lately, though often without citing its origin explicitly. When you hear a statement like, “Inflation isn’t an issue because capacity utilization is low and unemployment is high and rising,” that is recycled Phillips. Capacity utilizations were also low and unemployment high and rising in the 1970s. Nevertheless by the early 1980s, double-digit inflation rates plagued the US and many other countries.

The reemergence of the long-dormant Phillips-curve argument shows that economists are always ready to serve over-aged wine in new-age bottles, or, to use the MONIAC’s imagery, old water in new tubes.