Whose hand it it, anyway?
(Please forgive how much of this diary is repetitive and over-explanatory to anyone who knows anything about the financial crisis. I simply wrote it in such a way as to provide the foundations for my critique of the free market all in one place, rather than assuming much knowledge on the part of the reader.)
The great delusion of economic libertarians is that the optimal force to control a market is the action of the free market itself. They believe in the invisible hand, the collective action of the community, and its unerring ability to correct the excesses of the markets and restore equilibrium. The collective actions of individuals, each working in his or her own self-interest, leads to the best possible outcome for society, as society is nothing more than the sum of all these individuals who are seeking the best possible outcome for themselves.
The delusion is not in believing the invisible hand exists--of course it does. The question is what does that invisible hand represent, and what actions will it take?
Free-marketeers seem to believe that the market is derived purely out of the human superego--that the behavior of producers and consumers will be determined by their best assessment of what will be to their greatest overall advantage. Because of this, there is no need to regulate markets or otherwise attempt to influence them. If a particular financial practice is destructive, it will be rejected by the markets because people will avoid destructive practices out of self-interest. The system is self-regulating--the invisible hand will shield us from harm because we'll flee those products and services that cause harm.
I think most people can see the flaw in this line of thinking already, but let me offer an illustrative example. Please be patient with its fanciful nature, but it's an important thought experiment.
Suppose there is a magic ring that brings the bearer magnificent luck for his or her entire life, but also condemns them to hell if they die whilst still in possession of it. The only way to rid yourself of the ring is to sell it--but it must be sold for less than you paid for it yourself, and the buyer must have full knowledge of the rules at the time of purchase. A man comes to you and, having sufficiently proven the wondrous nature of the ring, offers to sell it to you for a hundred thousand dollars. You have a hundred thousand dollars, as it happens, and purchasing the ring will make you a millionaire virtually overnight. Should you buy it?
According to the Free Marketeers--hell no. If everyone acts in their rational best interest, it is never a good idea to buy that ring. Eventually someone, somewhere will be stuck with it and condemned to hell. Eventually there will be a price that no one will pay for it, and whoever has the hot potato at that point is doomed. Lt's say the minimum possible price is a penny--you'd be a fool to buy it for a penny, because you could never unload it. But if no one will buy it for a penny, then you'd be a fool to buy it for two pennies, because you'll have no one foolish enough to buy it from you. And if you'd be a fool to buy it for two pennies, you'd also be a fool to buy it for three, because no one would buy it for two. And if no one will buy it for three pennies... etc. etc. Essentially, there is an unbroken chain of self-interest that extends from a single penny up through an infinite amount of money. If everyone on earth acts in their rational best-interest, that ring will never change hands.
Now who, knowing what they know of human nature, can honestly say that that's how it would pan out Of course not. Selling the thing for a hundred grand would be easy. Selling it for fifty grand would be easy. Selling it for ten bucks would probably be easy. Why? Because humans don't function on rational self-interest, they function on self-interest that overwhelms rationality. It may be perfectly rational to buy the ring for a large amount of money, but only because you know eventually theres someone you can sucker into going to hell for it.
The invisible hand is not the hand of the collective super-ego, it's the hand of the collective id. Why else is legalized gambling a 50-billion dollar industry, despite gambling being illegal in most parts of the country? This doesn't even include local lotteries, only for-profit gambling. Nor does it include the financial tricks that banks and other financial institutions pull which are essentially no more than legal, unregulated gambling, and are an industry that dwarfs traditional gambling.
Let's talk about those financial tricks now--credit default swaps and other derivatives. Credit derivatives are a 60-trillion dollar industry, essentially equal to the GDP of the entire world. And what they are is, essentially, bets that financial institutions place with one another on whether certain financial events will happen. This is usually the cue for free-marketeers to talk about how the government has removed the moral hazard from these activities and banks could never get away with such risky behavior otherwise blah blah blah--but in this case, at least, that's exactly wrong. Derivatives are at heart a form of insurance--a company hedges its bets, as it were, on a loan or other financial product by placing a bet with another company that said product will fail.--in the same manner that every month you essentially place a wager with your car insurance company that your car's going to get wrecked. If you can see how the difference between insurance and gambling is largely contextual, you'll understand how the practice of insuring financial products got so out of hand.
It starts innocuously--Company A has a bundle of loans, and it wants them insured. If those loans go bad, it wants to recoup its money--it wants to reduce its own moral hazard. Another company takes them up on it. Insurance, like gambling, relies on the law of averages--the house can lose big once as long as they win small a hundred times. So this company assesses the risk of the asset and says "we're insuring a thousand of these, and we think 5% will fail; to make a profit, we need to charge at least 6% of the value of the asset." Just like how a house sets the odds on a roulette wheel, and just like your health insurance company decides your premiums.
But here's the problem: What s the self-interest of the people making these loans? They don't own the insurance companies in question so the actual profits of the company don't matter that much to them. All this is theoretical debt based on other theoretical debts--what matters to them is the bonus they get when they bring in business. The people selling these insurance policies actually have an incentive to sell them for less than they're worth, because they will personally benefit from taking those sales away from competitors. If I'm an insurance broker looking at an asset and I say "we have a thousand of these, I think 5% will fail, I need to set premiums at 6% to make a profit" then I'm going to lose that sale to anyone who says "I think only 4% will fail, so I'll set the premium at 5%." Or, even better, I can make myself look good to my boss if I say that the risk is only 4%, because then my 6% premium is twice as profitable! I can play with the numbers in all kinds of ways to make it appear that I, insurance broker, have done a great service for my company (say, AIG), and deserve a raise and a bonus. And my bosses won't complain, because they need their financials to look strong, and because if we don't cook the number someone else will, and then they'll be making all the money.
And as if this doesn't sound bad enough, let's turn this form insurance into true gambling. Doing that is easy--we simply allow people to buy these insurance policies (derivatives) on other people's assets. Imagine if you had a friend who was a terrible driver, and you just knew he was gonna crash into a tree some time soon--and that, moreover, you could take out an insurance policy on his car without actually having to own it. That'd be pretty tempting right? So now when your friend crashes, GEICO has to pay out to you and him. Him because he bought insurancem and you because you speculated (that is, gambled) that he'd need it. That's how credit derivates work these days. It's a totally unregulated industry for gambling on the success of financial institutions and their assets. Banks accepted this situation because each of these banks believed that it knew what it was doing and would come out on top in these bets--and because these derivatives serve to spread risk around. This way, if a bank's assets fail, it recoups a lot of its money from another bank. And then when that bank's stock price dips below a certain level because of that payout, a third bank has to pay them. And so on and so on.
The idea is that these banks support each other and no one actually has to worry about totally melting down. And this is a great system until you have a total meltdown. Then all those walls that are supporting each other become dominoes instead.
And why did this happen? Because nobody thought it would, and they made their decisions about risk accordingly. They allowed their agents to undersell the risk of defaults, they allowed the risk to be spread around without actually decreasing the risk, so that instead of the burden being lightened by many hands, its just crushing all those hands at once.
And, of course, there's the reason that we're blaming this all on mortgages: Related risks. See, in order for the law of averages I talked about earlier to take effect, you need independent variables. The law of averages works great on roulette because every spin of the wheel is independent--spinning a 24 doesn't make it more or less likely you'll spin a 24 again. Similarly, car insurance--just because you crash your car doesn't make it significantly more likely their other customers will crash their cars. You're not going to have a ten-thousand car pile-up, so there's never going to be a time when Progressive suddenly needs to pay out to half of their customers at once.
However, the mortgage crisis was that thousand-car pileup for the financial industry. That's how a couple hundred billion dollars worth of bad mortgages became the detonator for trillions of dollars in debt. Because so many people defaulted on their loans at once, the law of averages didn't have time to catch up and even things out, and so the already stupidly optimistic risk assessments were blown totally out of the water. It was only a matter of time, as derivatives grew and grew, before something like this happened. These financial institutions became too closely linked, and the sums involved became too vast, for actual wealth to keep up..
We now have, as one economist put it, an endless black hole of debt , trillions of dollars of it, sucking up the capital of the financial industry and subsequently freezing the credit markets. Banks view each other as too risky to work with, thanks to the notable collapses. Further, the massive numbers of derivatives traded between these institutions are so convoluted and complex that it's impossible to tell exactly who is in a position of strength and who's on the verge of collapse.
And the reason for all of this is the invisible hand. This entire industry, like the gambling industry, exists as a result of people risking their long-term self-interest on the prospect of immediate benefit and/or the chance to beat the odds. This is not rational behavior, but it is inescapable human nature.
There's another argument that the free marketeers may yet use to justify their delusion that the market can handle these problems--an evolutionary one, one might say. That is: Yes, many people will do irrational and stupid things, and everything won't always be perfect. But those irrational people and bad companies will be eliminated by the market, and so better, healthier ones will take their place in the long run.
Now, aside from Keynes's notable quip that "in the long run, we're all dead," there is an obvious problem with this theory: the inadequacies of a species don't always lead to genetic variation and further adaptation, sometimes they lead to a sustainable harm, and other times they simply lead to extinction..
As to the first, the upright stance humans adopt is a prime example. The benefits of the upright stance seem to be sufficient that we put up with the innumerable problems it causes. Humans are much less stable than virtually any other animal, much more prone to tripping and falling. We're relatively slow, and we suffer from chronic back injuries that other animals don't. Being bipedal is literally a pain in the ass--but it doesn't stop us from surviving, it just makes us a bit less happy and successful than we otherwise would be. The negative affects of the free market can be similar--not enough to destroy an industry, just enough to make life a little worse for everyone. Look at the atrocious state of US healthcare, or even the abundance of unused exercise equipment scattered across suburbia. And, of course, the far worse outcome is that these corrections of the market lag so badly behind their negative affects that they actively destroy a nation's prosperity. Maybe the market will correct for the financial crisis in time, but how many years of recession and depression should we put up with before we admit the market has failed us? And where is our assurance that those bankers who came out on the winning side of all these debts won't pull the same tricks a few years down the road?
Gambling, of both the traditional kind and the innovative new form practiced by the financial industry, is only one aspect of what is a general rule of human behavior--you cannot trust people as a group to act in a rational way. Individuals may act rationally, but rational individual behavior by many people does not translate into rational group behavior. And many times even individuals don't act in a rational manner.
Here's where it comes down to id, ego, and superego again. Humans are unified by id. Almost everyone's id wants almost exactly the same things--food, sex, safety, love, whatever. Those are just the things that humans want, that's our nature. However, we are emphatically not unified by ego or superego. This is why the lowest common denominator is always so base--sex, violence, whatever. Those are common desires or urges, while in more advanced thought we disagree. We don't all share the same moral values, and we don't all share the same rational appraisals of how to accomplish our goals. You can demonstrate this at any time right here on the board--every American here, for instance, will be eager to prevent a terror attack on US soil, but you'll probably see several different opinions as to why.
And what is the result? As a society even more than as individuals, our unthinking impulses become more powerful than our rational behavior. Our thoughts and values work against each other, while our short-term desires coalesce. You can see this in our national addiction to oil--we all have our ideas about how to fix the problem, but we don't agree on them and in the meantime we all just keep buying it because its much easier than trying to change the world on your own.
And that's the invisible hand again; it's a solid, unyielding hand composed of our collective id, that trails off into a whispy, ineffectual arm as it extends back toward our superego. It has no real rational guidance.
And this is why, for all the faults of government, government must fix significant problems in the market. Government sis the mechanism by which we turn our various conflicting ideas into a cohesive force. Instead of individuals with ideas conflicting with each other canceling each other's efforts out (or preventing the consensus that would produce those efforts), we select leaders who impose their ideas upon us. We need that--we need to be forced to work in unison. We can't all row in different directions and expect to get anywhere. And we need to get over the national delusion that millions of good, smart, rational people can act as a good, smart, rational group without some measure of tyranny from the majority. And that is doubly true when so many people are not naturally good, smart, and rational to begin with.