Note (7-26-10): In this post I’m just using Adair Turner’s Project Syndicate piece as a means to critique the argument that financial innovation “completes markets” and therefore contributes to efficiency of our financial markets. Lord Turner is definitely not one of the “captive minds” of finance. He’s one of the people who’s working to reform the system. However, I think the fact that he’s doing so from within the system means that he’s sometimes a little too soft spoken. I’m just trying to point out how utterly ridiculous the ideology underlying deregulation really was.
In a critique of the economic ideology of the past era, Adair Turner writes:
Indeed, at least in the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the International Monetary Fund, in its Global Financial Stability Reviews (GFSR), set out a confident story of a self-equilibrating system.
Thus, only 18 months before the crisis erupted, the April 2006 GFSR approvingly recorded “a growing recognition that the dispersion of credit risks to a broader and more diverse group of investors… has helped make the banking and wider financial system more resilient. The improved resilience may be seen in fewer bank failures and more consistent credit provision.” Market completion, in other words, was the key to a safer system. …
[A]t regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA.
This talk of market completion makes it sound as if there is some formal economic theory that supports the view that incremental “market completion [is] the key to a safer system”. The point needs to be made that only people who don’t actually understand economic theory could possibly make this argument. Unfortunately if Adair Turner’s description of the culture at the FSA is correct, then the problem that he is describing is not one of the dominance of a specific school of economic thought, but instead the complete failure to use the tools of economic analysis.
The concept of market completeness comes from the Arrow-Debreu model, which is itself the modern apotheosis of classical economic theory as it was first posited by Adam Smith and then developed formally by Leon Walras. In the Arrow-Debreu model every member of the economy can buy insurance against any possible eventuality in that economy. There is no such thing as bankruptcy, but only entities that (i) understand what they will and will not own in every possible future eventuality and (ii) make perfectly credible promises to share what wealth they have in “tail risk” settings as long as they are paid a fair premium to do so beforehand. Anybody who has studied this model understands that “complete markets” refers to an idealized world that does not, and indeed, cannot ever exist.
The Arrow-Debreu model was developed more than half a century ago, so economists have had plenty of time to study the question of whether in an economy with incomplete markets (that is, in an economy with some missing insurance markets) the addition of another insurance contract is necessarily welfare improving. The answer to this theoretical question is incontrovertibly no (as Lord Turner acknowledges in a middle paragraph). While there may be some special circumstances where increasing market completeness may enhance economic efficiency, in the general case, there is no reason to expect an increase in economic efficiency.
Furthermore, even before the work on incomplete markets was written, it would have been an obvious logical fallacy to jump from the observation that an economy with complete markets is efficient to the assertion that as markets become more complete, they become more efficient. Thus the failure of the culture at the IMF and the FSA that is described by Adair Turner is a failure to apply basic economic theory to the problems they faced. And Adair Turner is far too kind to both members of the financial industry and to his colleagues at the FSA:
Market efficiency and market completion theories can help reassure major financial institutions’ top executives that they must in some subtle way be doing God’s work, even when it looks at first sight as if some of their trading is simply speculation. Regulators need to hire industry experts to regulate effectively; but industry experts are almost bound to share the industry’s implicit assumptions. Understanding these social and cultural processes could itself be an important focus of new research.
But we should not underplay the importance of ideology. Sophisticated human institutions – such as those that form the policymaking and regulatory system – are impossible to manage without a set of ideas that are sufficiently complex and internally consistent to be intellectually credible, but simple enough to provide a workable basis for day-to-day decision-making.
If financiers and regulators relied on theories of “market efficiency and market completeness” to support their activities, then that is prima facie evidence that they did not understand these theories. There was nothing “internally consistent” or “intellectually credible” about the claim that the assets the financiers were creating and the regulators were failing to regulate were efficiency enhancing for the economy as whole.
I can certainly agree with Adair Turner that social and cultural processes that drive people to share an ideology and make common assumptions have played a huge role in this crisis, but I think it is a mistake to dignify the process of rationalization that took place as “internally consistent” or “intellectually credible”. There was an ideology and there was a pseudo-logical foundation to that ideology; these foundations crack easily, however, as soon as they are subject to careful analysis. It is important to recognize that while ideology likely played a large role in the crisis, logical coherence did not.
Synthetic Assets 
Agreed. I read that article and also found it disappointing. Not only disappointing, but kind of surprising.
It’s essentially a brief take from the middle section of a speech he gave back in April this year, and a very poor and often misleading one. Perhaps he didn’t do the editing himself. Who knows?
In any case, at least some of the wholly justified concerns you raise are directly and indirectly answered in the longer version. For example, the last paragraph you quote looked like this in the original:
“But we should also not underplay the importance of an ideology in itself – of a set of ideas complex and internally consistent enough to have intellectual credibility, but simple enough to provide a workable basis for day to day decision-making. Complex human institutions – such as those which together form the policymaking and regulatory system – are difficult to manage without guiding philosophies – and guiding philosophies are most compelling when they provide clear answers. And a philosophy which asserts that financial innovation, market completion and increased market liquidity are always and axiomatically beneficial, provides a clearer basis for the decentralisation of regulatory decisionmaking [than] one which teaches that innovation is sometimes valuable and sometimes not, depending on the market and depending on the circumstances.”
Here I think his view of why and how these (nominally intellectually credible) orthodoxies came to so dominate things is clearer, and I think much more defensible.
A little later, after a brief look at how individually rational activities can easily produce harmful systemic effects, some comments on animal spirits, irrationality and behavioural economics and, finally, a few words on irreducible uncertainty, he goes on to ask:
“So, should new economic thinking explore the implications which would follow even if people were fully rational but operating within real world constraints? Or should it explore the role of instinct and emotion? Or recognize Keynesian inherent irreducible uncertainty and, as a result, be deeply sceptical of any attempt to achieve in economics the precise conclusions of the physical sciences?
The answer is all three. [ . . . . . . ]”
I’m not suggesting any of this is new to you, Carolyn (I’m sure you’re a great deal more familiar with it all than I am) but instead hoping to establish that Turner’s Project Syndicate piece didn’t do him much justice.
P.S. As an extra inducement to look at the original, he also questions the benefits of fractional reserve banking.
It can be found here:
Click to access INET%20Turner%20%20Cambridge%2020100409.pdf
Now that you post the link I do recall reading Turner’s INET piece and mostly agreeing with it.
I hope this post doesn’t come off as being particularly critical of Turner himself. It isn’t meant too. The British regulators are definitely much more willing to call a spade a spade and that is an admirable — and necessary — trait.
On the other hand, I think it is dangerous to be too deferential to the rationalizations that financiers have come up with to justify their actions — and that many regulators have chosen to buy into. The difference between rationalization and sound logical foundations should always be recognized.
My goal here is to pick apart the “completion of markets” nonsense, and Turner’s piece was a convenient means of doing so. I’m very much impressed that the head of a regulatory agency came out as forcefully as Lord Turner has in criticism of his agency’s past actions.