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.