The power of financial markets

You might imagine that the global financial crisis had reduced the power and influence of finance and those involved in financial markets. After all, the excesses shown by participants in those markets had caused the largest recession since WWII. (Not to mention a constant stream of cases of illegality and mis-selling.) However I wondered yesterday if the opposite might be true.

This was during a debate at the Houses of Parliament, in which Jonathan Portes and I were debating austerity with Roger Bootle and Doug McWilliams. A constant refrain from our opponents was that (a) the stock of government debt was very large, (b) you needed the confidence of markets to be able to maintain this level of debt, (c) markets were fragile beasts, so best take no chances, and (d) therefore we needed austerity to reassure those markets.

I immediately thought of one of my better posts, where I suggest too many people view markets like a vengeful god, and those that are ‘close to the markets’ like high priests. (I couldn’t quite believe it when a member of the audience asked our opponents about whether they thought some proposal would ‘pass muster with the markets’.) Now Roger, who is a sensible guy, did agree that default was not really an issue for the UK, but the danger was rather inflation, if the deficit or debt became ‘too large’ and markets refused to fund it, so it had to be monetised. If it seems odd to you that the markets would start worrying about the monetisation of debt because a large recession increased deficits, but be quite unconcerned today about the central bank creating money to buy huge quantities of government debt as part of Quantitative Easing, then your mistake is to think that the markets are always rational. If they are both fragile and febrile, as our opponents and others close to the markets often suggest, it could happen.

Before the financial crisis, it was in the interests of those involved with financial markets to emphasise how rational they were. No need for regulation - these are clever people who knew what they are doing. The crisis blew that argument apart, but instead it created the idea that the markets could be dangerously irrational: irrationally exuberant at one point, and irrationally risk averse the next. It also showed how dependent on these markets the economy had become. Hence the idea of a vengeful god that could suddenly turn on you for no good reason and who therefore had to be appeased at every turn.

This kind of argument has a strong emotional appeal, particularly when the financial crisis is fresh in peoples’ minds. I suspect that attempts to show that markets are actually pretty rational most of the time will not work. Instead I’m afraid we have to focus on the high priests. A truly irrational market could do anything. The problem comes when the high priests declare that, by being close to the markets, they can discern some logic to its tantrums. And by a divine coincidence, this logic just happens to fit macro view of the world that the high priests hold.

For example, we are told that markets worry about large deficits and require austerity immediately. Never mind that there is no sign of worry, and that interest rates are falling: markets are fragile and febrile and could turn at any moment. The high priests, being close to the markets, understand that. Strangely the high priests never detect any concern that a persistent recession brought about by austerity might - through hysteresis effects - permanently damage productive potential, with potentially greater impacts on the tax base and long term solvency. I guess the high priests markets had not read that paper.

We are told that Osborne needed to give a clear demonstration to the markets that he had the political will to bring the deficit under control, which is why deficit reduction had to be front loaded. It does not seemed to have occurred to the high priests markets that, given his desire to reduce the size of the state and win the next election, front loading austerity is exactly what he wanted to do, even if he had no particular concern about the deficit. To show a clear conviction to give top priority to reducing the deficit required him to do something that was politically costly, like raising inheritance tax.

And do not forget that Ireland and Portugal were constantly told by those close to the markets that they needed to embark on acute austerity to ‘regain the trust of the markets’, when in fact what the markets were looking for all the time was for the ECB to act as a lender of last resort. I could see that from my academic ivory tower, but most of those ‘close to the markets’ did not.

The financial crisis may have told us about the power that financial markets have, and how it is important to understand how they behave. But the way to do that and to make good policy in the meanwhile is through economic science, and not to rely on the wisdom of priests. As I said in my little speech at the debate, the cost of UK austerity in 2010 and 2011 was at least 5% and probably more like 10% of GDP, numbers which neither of our opponents challenged. The gods it seems require big sacrifices nowadays. But if the only reason for making this sacrifice is that the high priests tell us that this is what the gods require, then I think the time for enlightenment is well overdue. 

Paternalism and Irrationality

I have talked before about how most economists have an instinctive dislike of paternalism: a dislike of the idea that someone (usually someone in authority) knows better what is good for people than people themselves. I think this is a very good instinct to have, but sometimes it has to be set to one side. Economists should know this, because they often use economic theory in a paternalistic fashion.

How can I write this last sentence? After all, are economists not very careful to focus on agent’s revealed preferences, rather than any objective model of what is good for people? They prefer what people actually choose as measures of well being (like consumption), rather than some scheme of what is involved in the good life dreamed up by some philosopher.  

However, as Daniel Hausman discusses in a recent book, the idea that a preference based measure of individual welfare can ever be a completely adequate measure of individual well-being is deeply problematic. There are many reasons for this, but the one most economists recognise is where individuals clearly act in ways that are not in their own self interest (or in the interest of others). The example I used before is seat belts.  But behavioural economics and experimental data are giving us many more. For example, an individual’s choice may be influenced by the presence of irrelevant alternatives: the choice between A and B may be influenced by whether C is an option, even though A and B are both preferred over C.

These features of behaviour pose an obvious problem for any preference based measure of well being. What economists typically do, faced with this dilemma, is one of two things. The first may be to deny the premise that agent’s choices in these cases are inconsistent with their own self interest. Failing that, the second response is to try and correct the preference measure of welfare to get round the problem. For example, if someone’s preference for not wearing seat belts is due to ignorance about the statistics, then we might be justified in imagining what their views would be if they did have this information. We can talk about welfare as involving maximising preferences that are not based on false beliefs. The idea is that maximising these purified preferences then maximises individual well-being.

There are a lot of problems with this approach, which Hausman discusses in detail. However, it strikes me that once this attempt is made, economists themselves tend to be paternalistic. Because how do we judge whether preferences need correcting? Often we simply ask whether choices are consistent with rational choice theory i.e. the basic axioms of much of microeconomics. If they are not, then any preferences that violate these axioms need correcting. What we are doing here is elevating rational choice theory, or more generally the micro theory we typically use, to an objective theory of well being.

Let me give one final, and rather more complex, example. There is a lot of evidence (and has been for some time e.g. Ainslie (1992), Picoeconomics, CUP.) that individuals discount over time in a hyperbolic way, rather than in the simple exponential manner which captures impatience as a constant discount factor. Hyperbolic preferences mean that if the choice is between A now and B in x periods time, we may choose A, but if it is between A in y periods time, and B in y+x periods, we choose B. Now hyperbolic preferences cause problems because they are clearly time inconsistent. From a welfare point of view, we have to ask who is the individual whose welfare we are maximising: the individual today with one set of preferences, or the individual tomorrow with different preferences. Faced with this dilemma, economists and governments typically ignore the preferences agents actually have, and carry on using a constant discount rate. Yet if this is not what people actually do, does it make sense to discount at all?    

In this and many other ways, economists appear quite happy to ‘correct’ the preferences people have, and instead make judgements on the basis of the preferences they should have. That may be the sensible thing to do, but it seems pretty paternalistic to me.