Finance and the perversion of the principles of economics

A recent exchange over at Felix Salmon’s blog made me realize that a large segment of the financial industry has no idea what economists mean when they say that a market is “efficient”.

So let me start with some Econ 101:  Trade improves welfare because both traders are made better off.  That is, when a farmer pays in wheat to the blacksmith who shoes his horse, both the blacksmith who needs wheat and the farmer who needs a healthy draft horse are better off.

In order for both traders to be better off the terms of the exchange must be completely understood by both parties to the transaction.  If the wheat is the rotten, or the blacksmith is putting the shoe on in a way that will fall off immediately, the trade does not contribute to social welfare because one party has given value without receiving value in exchange.

So economics claims that trade and markets and profit-seeking activity are all socially beneficial only when all participants have a full understanding of the nature of the market and given that understanding believe that prices were fair.  This is econ 101.  This principle is embodied in contract law as “the meeting of minds”.

The question raised on Felix’s blog was whether a transaction where an intelligent trader makes money off of the stupidity of an investor can be held to contribute positively to economic efficiency.  Given that the intelligent vs stupid framework is a strong indicator that the investor does not understand that he is not getting fair value for the asset, the answer to the question is obvious.  One party is being made worse off, so we know that social welfare did not improve — it may have stayed the same, or it may have fallen — but the trade cannot possibly have added to social welfare as long as the standard being used is economic (or Pareto) efficiency.

Some things that should be obvious to anyone who has taken Econ 101 apparently need to be explained to members of the financial industry:

(i) The fact that trade takes place on a market does not make trade efficient.  Only if prices represent fundamental value (more or less) — or if some version of the efficient markets hypothesis holds — do we have reason to believe that market trade is socially beneficial.

(ii) The fact that somebody makes profits is not evidence that that individual contributed to society.  In fact, Adam Smith would probably laugh out loud if he heard that claim.  Only in circumstances where prices reflect fundamental values (approximately) are profits evidence of socially improving trade.

So if you ever hear some financier claim that when he gets rich off of some sucker’s stupidity the trade was efficient and the profits he made represent a positive gain to society, please tell him to enroll in Econ 101.

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