Markets and Regulation

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Markets and Regulation

By: Steven Eagle
Posted on November 02, 2011 Bozeman Daily Chronicle

What are the proper functions of markets? In considering this basic question, we often are drawn to the basic paradigm of two individuals, each holding an item, who meet in a town square. Each regards the other’s possession as more desirable, and they agree to swap. They find the exchange mutually beneficial, so we can assume that society benefits, as well.

Adam Smith observed that people have “the disposition to truck and barter.” Those interested in particular types of goods gather in curbside markets that, over time, might become increasingly formal. The New York Stock Exchange followed just this path, starting in 1792.

Barter is inefficient, since the person who owns the things I desire may not be interested in my possessions. The ensuing need for sequential barter transactions is eliminated by the availability of a common medium of exchange, money. Market transactions are epitomized by the exchange of goods or services we produce for money, and the subsequent exchange of money for things we want.

In addition to facilitating higher-value uses of existing things, markets also signal what new things people desire. High prices for certain goods tell producers to divert resources from other uses so as to produce more of them. High salaries in a certain industry signal more students to develop the expertise that industry requires. High prospects for success of a certain corporation result in the stock of that company being more in demand, and the ensuing higher stock price signals the company to issue more shares. The individuals who subscribe to the initial public offering of the new stock thereby fund the company’s expansion.

By signaling increased demand, markets not only facilitate putting existing things to better uses, but also divert human and financial capital from less beneficial endeavors into the expansion of skilled job applicant pools and businesses that better serve society. This account of markets, a highly condensed version of the undergraduate economics principles course, suggests that markets indeed are good things.

Should markets be regulated? Are markets always good things? Note that, in asking these questions, we depart from our original sense of “the market” as the place where individuals with different possessions meet. Now we reify “the market” into a concept, referring to it as an institution in society.

In the most basic forms of market activity, farm produce and crafts of known quality are exchanged for similar items, or for cash. More complex markets, however, work well only in societies that enjoy social trust and the rule of law.

We can assume that transfers of possessions are beneficial only if they are voluntary. We have no reason to belief that thieves value items more than their rightful owners. Fraud vitiates the notion of informed consent. A party’s failure to adhere to contract promises discourages exchanges where goods and money do not change hands simultaneously. For society as a whole, these departures from marketplace ideals are worse than a zero-sum game, in which wrongdoers’ gains equal victims’ losses.

Theft discourages production and trade, since merchants must hire security guards and fortify buildings. Protection against fraud requires investigation and caution, both of which add to the expense of bargaining. The possibility of breach of contract also results in increased contracting costs. Theft, fraud, and breach of promise also lead to larger and more expensive government. Police and detectives must be hired, courts must adjudicate these criminal and civil wrongs, and the criminal justice system, including incarceration, is an expensive burden on society.

Underlying all markets are basic social norms, such as trust, and basic social institutions, such a private property and the rule of law. These are difficult to build and expensive to maintain. But, as was the case in the former Soviet Union, markets cannot function without them.

Can markets be good for their immediate participants, and yet bad for society? Open-air narcotics markets are criminalized, and most people would not want well-functioning markets for contract murder.

More controversially, in “Darwin Economy: Liberty, Competition, and the Common Good” (2011), Cornell economist Robert H. Frank asserts that Adam Smith was “far more circumspect” than to believe that his famous “invisible hand” always leads market actors to benefit society. In particular, Frank’s critique focuses on positional goods. Unlike goods providing absolute value, such as a home furnace in a cold winter, “positional goods” are valuable to their owners primarily because other people do not possess them.

Frank’s principal point is that “One of [Charles Darwin’s] central insights was that natural selection favors traits and behaviors primarily according to their effect on individual organisms, not larger groups.”

As a trivial illustration, stadium spectators rise to their feet during exciting plays on the field, yet do not have a better view than if all were seated. More importantly, people often seek college diplomas and advanced degrees, not because the learning they acquire might be valuable in particular jobs for which they apply, but simply to differentiate themselves from less-well credentialed applicants and thus win favor from employers.

In nature, males with large antlers or massive bodies typically win competitions for females and pass on their genes, thus furthering the species’ tendency to such characteristics. However, large antlers tend to get snared in trees, benefiting wolves and other predators on that species. One could not expect an individual moose or elk to confer benefit on the species by being less well endowed. More on point, one could not expect a motivated young person to benefit society by eschewing the expenditure of time and money pursuing a degree of little intrinsic value, but that would place the individual on the short list for a job interview.

Another illustration of a competition that might provide immense wealth to victors, but little benefit to society, is trading in most derivatives, which are financial instruments that derive their value from other financial instruments or indexes. Commodity futures markets are an exception. They are valuable to society because, for instance, they allow farmers or airlines to lock in the future price of crops they produce or aviation fuel they consume. Initial public offerings of stock, mentioned earlier, also are valuable because they allocate capital to promising businesses. Most derivatives, however, are essentially side bets that do not promote the underlying economy.

One might draw an analogy between financial derivatives and aviation. Pilots define a “hot plane” as a sleek aircraft that achieves peak performance. But there is a tradeoff. Slower, less efficient, planes tend to be more forgiving of pilot error. For pilots of hot planes, pushing the envelop of performance correlates with pushing the edge of disaster. Whatever might be said of a contract between a manufacturer of a single-seat aircraft and its pilot purchaser, the stakes are different for commercial airliners, where government certification demands a certain level of forgivingness. In the world of finance, the derivatives are most profitable when they are most highly leveraged. There are lots of profits in good times, but little margin of safety in bad times.

How strictly should derivatives and similar financial markets be regulated? Here is a recent comment from the blog of Richard A. Posner, who is a founder of the law and economics movement, University of Chicago law professor, and federal appellate judge:

“Most economists did not understand the inherent instability of financial markets (which derives from the basic financial model of borrowing short term and lending long term, which can induce runs, especially when, as in the case of the nonbank banks, the short-term capital—often overnight—is not insured), the vulnerability of housing markets (in which the banking industry was heavily involved) to bubbles, or the potential macroeconomic consequences of a failure of those markets, which made deregulation a riskier policy than in industries such as air and surface transportation, electrical distribution, natural-gas production, oil pipelines, and communications. Because of the potential for catastrophic market failure, regulation should have been much tighter than it was.”

In the same blog post, Posner wrote:

“[T]he fact that there is a great deal of unsound or questionable regulation is not a good argument for leaving all economic activity to the Darwinian processes of the market. Competition forces businesses to ignore external costs and benefits (that is, costs and benefits not borne by the creator of them). If either sort of externality is great enough, there is a strong case for regulation, provided the benefits of regulation can be shown to be highly likely to exceed the costs.”

Markets have led to a vast increase in both productivity and individual freedom in our society, a fact acknowledged by Frank and pervasive in much of Posner’s work. The State, and regulation, although often lending themselves to great abuse, have their necessary place, too. It is crucial to America’s long-term success that we have an intelligent dialogue about the costs and benefits of regulation, as they affect productivity—to be sure—but also as they affect human flourishing, more generally.

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