THE BUMBLING COLOSSUS  By Henry F. Field                                              
The Regulatory State vs. the Citizen; How Good Intentions Fail and the Example of Health Care;
                                  A New Progressive's Guide    
  (available at amazon.com)

GOD in Economics Part II -- Of "Systemic Externalities", "Market Failure" and The Nirvana Way of Thinking


Religion and Science Distinguished -- What Each "Knows"

In "GOD in economics Part I" (nearby) we describe the difference between "belief" and "conviction", connecting these to religion and science. Religious belief proceeds on reasoning from untestable assumptions or hypotheses while science rests on reasoning and evidence from testable ones. Each has its limits. Science has its believers, but the nature of the belief differs from religious believers. For the religious, answers -- the key ones at least -- are fixed and immutable. God is. For those who "believe" in science on the other hand, answers are tentative and mutable, subject to further correction or amplification as evidence accumulates or paradigms shift. The belief is in the process, not the answer.

The questions science and religion ask can be quite similar -- what explains the world around us, the skies and ground, why are we here? Each employs reason and logic in their pursuit. But science's first principles are, by their nature, always subject to better or further processing. For example, Newtonian physics was "true" -- until displaced for astro- and atomic physics by E=MC2.

How Science and Religion Can Conflict: "Intelligent Design"

These distinct forms of "knowing"-- the religious and the scientific -- each have their separate domains, which conflict at the margins, but only if efforts to defeat the other are undertaken. An example of a religious effort to "defeat" science is the argument creationists (rebranded as "intelligent design") have with Darwinian natural selection, the foundation of numerous branches of evolutionary science. Philip E. Johnson turned away from a career as No 1 law student, law clerk to U.S. Supreme Court Chief Justice Earl Warren, and long-time Professor at UC Berkeley Law to embark on the lecture circuit attacking Darwin, evolution, and their progeny -- fearing (self-confessedly) that evolutionary science ("Man and monkeys share inheritance") threatens his post-divorce "born again" Christian conversion. He and others at Seattle's Discovery Institute found what they call "irreducible complexities" embedded in life forms which they felt can not be explained by science, therefore beating back the threat to Biblical Christian doctrine.

The point was, "irreducible complexities" were aspects of life forms which could not have evolved and hence showed the "hand of God" in the heart of evolutionary theory. This had an immensely practical and political dimension. If evolution (science) is wrong to present itself as a full explanation of the diversity of life forms, then teachers need to be reeducated and school curricula changed to allow Biblical (revealed) approaches challenging the scientific mind-set to be taught. Grass-roots campaigns were launched, and school boards throughout the country were pressured to alter what is being taught.

Such challenges spurred a few believers in scientific method to check out these "irreducible complexities" by the tools they know. The results are unhappy for those hoping to cage the scientific lion. Jerry A. Coyne's "Why Evolution Is True" (Viking 2009) and Sean Carroll's "The Making of the Fittest" (W.W.Norton 2006), and similar work detail the failure of "irreducible complexity" as a proof of revealed religion and a challenge to science.

It also led to legal conflict -- is "intelligent design" a science or a religious belief masquerading as science and hence requiring its teaching a First Amendment violation of separation of church and state? A most interesting and conclusive decision in this regard was reached in Pennsylvania by federal judge John E. Jones III in Kitzmiller v. Dover, ending (for now) that effort to supplant testable, evidence-based conviction with belief.

So this distinction is no esoteric or academic exercise, but has immensely important practical, everyday significance.

How "Belief" Invades Economics: The Example of "Systemic Negative Externalities"

As noted, the above would be just an exercise in academic musing were it not for the fact that real life practical harms occur every day because of the unseen, unknowing invasion of unfounded or weakly-founded beliefs into main-line popular journalism and political thinking, and worse -- into national legislation. Much of this comes from economists themselves, certain of whom display religious-type belief in their writings and advocacy. The example of "externalities" in economics (sketched in Part I) is a resounding case in point.

Sometimes you have to dig hard for the obvious, and sometimes the obvious just pops into your view. The latter is the case with an article by two Romanian economists, Bogdan Glavan and Flavia Anghel, "We Are Not Macroprudentialist -- A Skeptical View of Prudential Regulation to Deal with Systemic Externalities", (17 The Independent Review n. 3 Winter 2013 at 349-368). For economists, this piece is a must read. For the rest, I will summarize and make relevant to the larger theme here and in "The Bumbling Colossus" -- the harms of intrusive regulation promoted to rectify supposed "market failures". 

Prominent Errant Voices Leading Us Astray -- Great Narrative, Wrong Analysis

Glavan and Anghel describe how the 2008 global financial crisis brought a revision of economic ideas, based on a skepticism that financial markets, indeed any free market, can self-correct. Rather, "systemic externalities" cause booms and busts or "market failures", requiring governmental intervention to correct. "Rational" investors and participants view things only from their "private" perspective, so larger "social" benefits and costs are neglected.

As an example of this point of view they quote Alice Rivlin, former Congressional Budget Office head and Vice Chair of the Federal Reserve, and prominent Democrat with the ear of Presidents (she is quoted but the attitude is representative):

"The current financial crisis is a clear example of systemic failure. It illustrates -- once again -- the vulnerability of market capitalism to spectacular boom and bust cycles that can devastate the real economy. After decades of complacency about the ability of markets to correct themselves and the resiliency of the economy to financial and other shocks, we have experienced another spectacle of irrational herd behavior producing rapid increases in asset values, lax lending standards and over-borrowing, excessive risk-taking, and out-sized profits in the financial sector. The boom was followed by a dramatic crash that spread rapidly through world financial markets, causing plummeting asset values, rapid deleveraging, risk aversion, and huge losses."

Pretty convincing, huh? Well, that did happen, but the cause (as explained in "The Bumbling Colossus" at 10-16, 201-208) was not what Alice and her cohorts assert. And their remedy? "Prudential" discretionary authority in a government regulator empowered to intervene in financial (and other) markets with all the tools economists and financial experts can conjure. These include discretion to "prime the pump" of money in the system, suddenly increase federal spending, change bank reserve levels, call bank holidays or government guarantees of debts and deposits -- the list is endless.

Note the hidden assumption -- the government regulator knows more than the market participants, can see events coming before they are visible to anyone else, and has the information needed to foretell just what "tool" will stop the wreckage before anyone knows the wreck is about to happen. This is the Omniscient Administrator, the Government's Omniscient Dictator who governs by omniscient decree (GOD). 

Where in experience on earth has such a creature existed? What example in our governance can these people point to to demonstrate such a facility? The Nirvana approach is at work. Reader, taxpayer and consumer beware.

"Externalities" and "Systemic Externalities" Defined

"The Bumbling Colossus" (at 239-241) defines and describes "externalities" -- the effects on others of transactions. A classic example is a pig farmer who sells his hogs to bacon lovers. But the neighbor annoyed by the stench and noise is not compensated by the price paid. A "systemic" externality is where an entire market or economy is affected although outsiders to any specific transaction. Alice Rivlin's reference to bankers' "herd behavior" is an example. Glavan and Anghel explicate:

"Systemic externalities express the idea that individual behavior often entails a chain reaction or amplification effects that impact, positively or negatively, the whole market. Because of this phenomenon, the economy spirals up or down as investors' buying or selling stimulates third parties to imitate their behavior.  ...."

"In the boom, as asset values rise and mark to market risk is minor, investors underestimate the benefits of liquidity. Profit maximization consequently requires financial institutions to expand their balance sheets and increase leverage, often using short-term funding from the money markets. In the bust, market participants symetrically rush to hoard liquid assets, deleveraging and reducing their exposure to (now overestimated) risky assets. Yet what seems reasonable from a single bank's perspective is bad in the aggregate: if many banks try to deleverage at the same time, they may cause a downward spiral of asset prices and a financial meltdown."

"Theorists of systemic externalities claim that aggregate risk cannot be conceived as the sum of individual risk. Aggregate risk is endogenous, deriving from the banks' individually rational but collectively irrational behavior. Its magnitude depends on the size, degree of leverage, and interconnectedness of financial institutions."

The Illusory and Harmful Alice Rivlin Cure -- GOD
 
These analysts point to the divergence between private and social valuations of risk, and advocate government action to correct this perceived market failure by "prudential discretionary intervention":

"Macroprudential regulation should seek to rein in coordination externalities to moderate lending and leverage during periods of asset-price increases and correspondingly to alleviate pressure to deleverage during recessions. As Frank den Butter puts it, '[T]he main (or even only) aim of regulation, and hence of banking supervision, is to internalize externalities. So in order to become a  trustworthy regulator again, banking supervisors should analyze which externalities were the cause of the systemic crisis.'"

Fine. But the history of the most recent financial crisis, including the President's Commission to investigate its causes and Dodd-Frank, shows only that determining the "cause of the systemic crisis" is hardly child's play, and largely escaped the green-eyeshades of our "best and brightest" in government. ("The Bumbling Colossus" at 201-208). It was also highly politicized.

So just who is going to be making this call?  Our governmental omniscient director (GOD) . Again. The theory is a lot like the notion that a butterfly beating its wings in Australia affects the weather in France. There is a lot of interconnectedness in the world. But is the answer to have government find the butterfly and stop its beating? What does intervention itself entail?

What the GOD People Miss

Glavan and Anghel sum it up well:

"Market-failure models are biased in their analysis of systemic externalities because they consider problematic only private -  not public -- borrowing. ... What is of interest to the advocates of regulation is not systemic risk in general, but only private systemic risk -- and for purely ideological reasons. [Governmental failures] in promoting financial instability are completely overlooked. ... [Witness] historical experience with sovereign serial defaults." 

"From a historical perspective, countercyclical macroeconomics ("stop and go") policy ... shows that it is very difficult for a social planner to refrain from increasing public expenditures during booms.... Governments usually keep expanding public works and social programs both in good times and bad times."

"Interconnectedness is considered a latent source of systemic risk in modern finance. But this view of systemic risk may be considered simply a truism. ... [I]nterconnections are all the result of mutually agreed-upon contracts. Creditors have... no inherent reason to neglect the implied exposure to their counterparties' counterparties. ... Interconnectedness, by itself, is not a market failure."

"Given that a certain correlation among investors' balance sheets is a natural outcome of the operation of the principle of division of labor and specialization, it follows that only in a free market with internalization of costs and benefits would it be possible to discover the optimal interconnectedness among firms or assets. There is no way to discover an optimal level of exposure or interlinkages other than to observe that level arising spontaneously from investor's plans."

How GOD is the Real "Devil"

Now comes the good part. Let's stop focusing just on the so-called negative systemic effects of private transactions, and take a look at what government adds to the equation when it intercedes. This is where the rubber hits the road.The authors begin with the following shocking but tantalizing observation:

"Systemic risk is to a large extent the result of antirisk policies that regulators implement worldwide under the umbrella of poorly defined prudential reasons. A host of regulations issued by the national and international agreements -- such as Basel I, II, and III -- have constrained banks to abandon their independent policies and adopt the same standardized quantitative models of risk assessment."

"After the Asian crisis of 1997, it became noticeable that the homogenization of risk assessment leads to a homogenization of portfolios and further, to similar trading acts -- that is, to herd behavior. The cause of herd behavior is not bounded rationality, stupidity, ignorance, informational asymmetry, or imitation, but 'identical knowledge': the fact that all market participants assess the risk of various investments similarly because of the uniform regulation. As Avinash Persaud concludes, '[A]ny system in which market participants have the same tastes (to reduce risks and regulatory capital) and use the same information (publicly available ratings, prices, and price-driven models) will lead banks to herd into and out of markets and will eventually cause systemic collapse.""

So herd behavior derives not from the free market, where everyone seeks competitive advantage by ferreting out better information and speculating. It comes from government efforts to restrict this process, through regulation. Banks share strong similarity to other businesses, including health care providers (doctors, hospitals, drug and device companies); they are inherently entrepreneurial. This means:

"Banks try to discover and how to use their own and attracted capital to achieve the highest profit possible. [Like any other enterprise] they know they can survive in the market only if they identify untapped business opportunities, innovate, and accurately anticipate market developments."

"In recent decades, as a direct consequence of regulatory policy, the entrepreneurial dimension of banking has been replaced more and more with typical bureaucratic work. Mandatory procedures, state-imposed risk-assessment models, and technical standards issued by the banking supervisory authority have left less room for the exercise of productive entrepreneurial abilities and channeled banking activity into predetermined patterns."

So voices urging more regulation as the cure-all for financial and other market distress completely miss the point and lead us down the path to increased harm:

"Far from saving us from alleged externalities that create instability, regulatory policy has itself created instability. State policy has exacerbated the coordination problem in the private sector, stimulating herd behavior through regulation."

This analysis, although clarifying, is not new. More than a decade before the recent financial crisis, George Kaufman observed:

"The bulk of the evidence suggests that the greatest danger of systemic risk comes not from the damage that may be imposed on the economy from a series of bank failures, but from the damage that is imposed on the economy from the adverse effects of poor public policies adopted to prevent systemic risk. As a result, it can be argued that the poor performance of banking experienced in almost all countries in the last two decades reflects primarily regulatory or government failures, rather than market failures."

Omniscience (GOD) should be Replaced by Many Voices - the Market

Friedrich Hayek pointed out in "The Use of Knowledge in Society" (35 American Economic Review 519 (1945)) and earlier, that knowledge of production methods and requirements is widely dispersed among individuals and companies. This means individuals act differently, based upon different information sources, so "herd behavior" has a natural corrective force. When all rush off in one direction, much money is to be made by one who sees that the king has no clothes and puts his bet elsewhere. Smart players throughout time have done just this.

Where government enhances a competitive free market instead of hostility to it, all these forces are embodied in one simple piece of information -- price. whether of goods, services or credit. Only the price system coordinates these fractionalized pieces of knowledge into a useful, single tool. Interfering with free pricing (by regulation, control, mandates and the like) reduces the net social product (ordinary people are poorer) by replacing a highly efficient mechanism with a less efficient one. 

No one, especially not a public central authority, possesses a clear picture of the overall picture. As Glavan and Anghel point out: 

"Given that policy makers are not omniscient, they cannot know ex ante the optimal pattern of investments and consequently cannot improve on the market outcome."

The history of policymakers' failure to see bubbles and properly know what to do undermines the Alice Rivlin Nirvana approach. So to with the "riskless" weighting of euro-zone sovereign bonds -- which the private market will not touch with a 10-foot pole but European Central bank decrees their regulated banks buy and hold. The "crony capitalism" or Crony Socialism we see with banks currying favor with U.S. regulators -- Citibank, Goldman Sachs, Countrywide are notorious examples -- suggests they spend far too much time trying to be seen as "too big to fail" so as to capture public benefits. Taxpayers and creditors beware!

The bottom line -- interfering with free prices and competitive independent private actors, and installing an intrusive regulatory hand instead, brings economic decline. The assumed regulatory task for the Omniscient Administrator is unrealistic, indeed:

"it is impossible [for the regulator] to determine the relative profitability of different productive processes, and so there is no guide for determining a superior pattern of resource allocation.... At the limit, in a socialist commonwealth the central planner has no rational way to decide whether to shift resources from project A to project B."

The same is true for the price of credit (risk). There is no way for a regulator to assess whether credit A is better or worse in its total economic setting than credit B.

Glavan and Anghel wrap it up this way:

"The systemic externality argument does not provide a solid theoretical foundation for a rehabilitation of prudential policy. It does not deal with the critical issue of systemic externalities in policymaking, and it overlooks the fact that what is seen as herd behavior in private markets is often a reflection of the unseen consequences of prudential regulation. The absence of a realistic account of government behavior means that the case for macroprudential government regulations rests not on comparing real markets and real governments, but only on finding that the real market's outcome falls short of a 'Nirvana' standard of perfection. The mere existence of financial networks and linkages cannot ipso facto be a good reason for imposing a macroprudential [regulatory] policy because the (supposedly vicious) existing pattern of exchanges is itself the result of political institutions and previous interventions. ... Thus, economists need to revise their perspective on regulation and deal with the fundamental institutional factors that affect economic calculation and risk assessment leading to boom and bust cycles."

Good call. Those seeking to increase regulation via the "systemic negative externality" argument display all the earmarks of "belief" akin to religion, not "conviction" based upon solid reason and testable evidence. Its proponents do us a great disservice.

The Citizen's Task -- Keep the "Noise" at Bay
 
These proponents are legion and have enormous amplitude, since media such as the N.Y. Times, The New Yorker, and Charlie Rose -- interesting and widely seen as credible sources read or seen by the intelligentsia -- promote them endlessly. You see the effects of "belief" in government omniscience passing as verifiable economics in the advocacy and journalism of popular highly visible public intellectuals like Paul Krugman, Atul Gawande, Steve Brill, Alice Rivlin, Larry Summers, and most recently, the President of the United States. More importantly, it has led to such significant broad-scale enactments as ObamaCare, Dodd-Frank, and the Stimulus, which clog and continue to drag down American GDP, stifle job creation, and make most of us poorer in the name of improving our lot. 


GOD in ObamaCare, Dodd-Frank & Stimulus

As explained in "The Bumbing Colossus", these enactments reflect the intrusion of "belief" into policy, deflecting us from better paths and trapping us in what the book calls the "Regulatory Illusion" -- the belief that intrusive regulation is the answer to perceived "market failures". Instead of capturing the most efficient vehicle available to advance the common good -- markets-- proponents of acts such as ObamaCare, Dodd-Frank, and the Stimulus rely upon a hopelessly inadequate and inefficient replacement -- a government bureaucrat. What problem can't be solved by the creation of GOD -- a governmental omniscient dictator -- tasked with the impossible -- perfect information allowing discretionary prudential adjustments correcting the miscues of the unwashed multitude herding about in markets?

ObamaCare does this by putting all hope for cost control and the power to impose limits on people's health options in the hands of committees of "wise men (and women)" empowered to "say no" to treatments. Dodd-Frank does this the same way -- supercommittees of top level government officials empowered to throw monkey wrenches into banking and finance as they see fit.

The 2009 $825 +/- billion "Stimulus" was GOD by Congress. It was predicated on the discredited Keynesian idea that any form of spending regardless of productivity creates a multiplier effect enhancing the private economy. Proponents' econometric models showed unemployment would fall from over 9% to under 6% in a year. Instead, the needle failed to budge. No multiplier effect ensued (see "The Bumbling Colossus" at 42-43, 250-252).


One would think this utter failure of the greatest stimulus in history would give pause to those (many seemingly from the Princeton Economics Department) promising great effects. But no. As recently as March 2013 Paul Krugman was heard on Charlie Rose to complain "it wasn't big enough"!! Talk about a true believer. No amount of evidence is enough to turn such minds from their rigid beliefs.

How About One Enormous Systematic Positive Externality -- the Free Market?

It is also remarkable that the proponents of "systemic negative externalities" never stop to consider what Adam Smith divined over two centuries ago, the "invisible hand". For what is the invisible hand -- that individual transactions in self-interest combine systemically to increase the welfare of the whole -- but an enormous systemic POSITIVE externality? One that government can not improve upon except by regulations (the right kind) promoting free transactions and reducing barriers to competitive entry. Key among these of course are laws recognizing private property rights, creating an impartial judicial system, and protecting from theft, predation and war.

The observation that discussing "systemic externalities" without recognizing the importance of the enormous power for good in the "invisible hand" suggests that the entire hulabaloo over systemic externalities is a restatement of the obvious, but its use to increase governmental interference in markets is highly ideological and pernicious.


Free markets need better press and bolder advocates. The 2008 financial crisis muted these because most people blamed things on the wrong culprit, markets instead of government. The Bumbling Colossus grew larger instead of smaller.

This does not mean eliminating government just for the sake of it. There are enormous benefits in the right kind of regulation -- that supports individuals' choice and consumer/taxpayer welfare instead of undermining it. This is explained in The Bumbling Colossus at 218-223 "How Do You Tell What Regulation to Avoid and What to Keep?"

In fact, the role of government needs to be shifted -- to directly supporting the poor instead of treating them like thieves-in-waiting incompetent and unable to act for themselves. In health care, everyone should be encouraged to have catastrophic-coverage linked health savings accounts, funded with vouchers for the poor. Along with that, government can help ensure needed information is out there, enabling market players to be free and independent actors. This encourages entrepreneurs and producers (drug companies for example) to innovate methods, products and services to capture consumer attention (and dollars). Prices will no longer be "rip-off" but will find constant reduction as competition returns.

For finance, reduction of the regulatory GOD allows incentives to return so that individuals and companies can watch their own hen-houses (banks) for solvency and risk-taking. Spring flowers bloom.


And we return to a rational and sane, sound, evidence-based world.


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