October 2008 Archives
I'm not very fond of people who claim that markets can solve all of our problems, but at the same time, I think markets can be very effective at one key economic task: setting prices.
Our current financial problems derive, at their foundation, from private transactions that weren't nearly careful enough about the prices of the goods underneath them. People mistook trends of the present - rising housing prices, the AAA ratings of investment houses, and so on - to be permanent fixtures of the economy. Then they built complex structures on top of opaque and not very stable pricing expectations, adding fuel to the fire by creating compensation structures that rewarded those most willing to misbehave.
There are a few ways to handle these kinds of problems, to ensure that they are at least less likely to occur in the future:
Assume that business folks just needed a reminder about the risks they play with, and trust them to sort it out.
Ban specific practices. No more credit default swaps, NINJA loans, or crazy levels of leverage. Maybe no more short-selling, either, or certain kinds of financial practices.
Require that financial practices be done in the open. Everyone can see your positions and evaluate them, all of the time.
Option #1 would continue and extend the practices of the last thirty years, which I figure reflects the time we've had since the memory of the Great Depression wore off. Usually, once there's a market crisis, people suddenly remember that financiers and businesspeople aren't actually omniscient, or necessarily virtuous.
Option #2 is an obvious choice. If banging your head against a wall hurts, stop doing it. If credit default swaps have damaged companies, industries, and economies, stop doing that. If short selling has results that frighten people when fear is a problem, order it stopped. Unfortunately, this option has some problems of its own. First, there actually are benefits to many of these practices. They facilitate a lot of transactions, and provide critical pricing information. Second, there are many of these things already out there, and unwinding them is not a simple project. That comes with its own costs, which is part of why governments are looking into playing the role of 'patient capital.'
Option #3 is the terrifying choice. Transparency and privacy are more or less opposites, and it seems painfully clear that markets work most efficiently, setting the best prices, when maximum information is available. What's more, we even have the systems we need to manage all of that information today - so in some sense, we're ready to move into the panopticon.
Think, for example, about an investment vehicle composed of a collection of mortgages. No one wants to touch these right now because it's not clear which are suffering and how. (Not only that, but it seems like banks have even misplaced the documentation for them.) Imagine systems which let anyone inspect that collection of mortgages, to see the most recent appraisals on the properties, payment histories, updated credit ratings for the debtors, and information about nearby and comparable properties.
That's a lot of information, a lot of it information people consider to be their business and their business alone - but it would also allow buying and selling of these vehicles with a clear understanding of what's involved. Instead of mixing and matching mortgages to try to create an acceptable aggregate risk, the pieces would explain their own risk.
Scared yet? I'm not sure how comfortable I'd be with such systems, but at the same time that's the primary market-based approach that I can imagine actually fixing these problems. Worried about your bank? Check out its loans and assets. No, really - check out its loans and assets. They'd have to actually list such things. Short selling could still be out there, but there could actually be a market for borrowing the stocks, instead of the quiet arrangements we have today. Folks who want to buy or sell stocks without actually having the money would be noticeable. Crazier yet, contracts might even be public documents rather than secret agreements that only come out in case of a lawsuit. Want to find out what your insurance really covers, and what their payments look like? Want to invest in a company, but find today's SEC filings pretty weak?
I know - it's a lot to think about. It's pretty much an inversion of my expectations growing up. At the same time, though, if we're certain that we want free markets to operate smoothly, it's a terrifying prospect we need to consider.