I have been posting the highlights of my forthcoming presentation at the AALS Annual Meeting for the Section on Socio Economics. This is the third post, and it will focus on the usefulness of the neoclassical paradigm as a foundation for legal policy analysis.
I define the neoclassical model of law and economics to entail recognition that if we assume perfect information, zero transaction costs, property rights and contract law, perfectly rational market actors, and perfect mobility of resources, then free markets unfettered by government intervention will allocate all resources within an economy to their highest and best use. That can be theoretically helpful, but is very limited in determining policy and law.
For example, we cannot even be sure that move towards the basic assumptions of the model is effective. Suppose increased transaction costs actually enhanced efficiency and lower transaction costs created inefficiency? A recent study shows just that:
Previous research suggests that a decline in transactions costs leads to improved economic efficiency. In this paper, we show that such a decline will introduce increasingly uninformed consumers into established markets. Using a model of financial market inefficiency, we show that this increase in uninformed individuals can increase market risk (volatility), can decrease efficiency, and may reduce social welfare even when market participants are perfectly rational. We then test the predictions of our model using data on the retail equities market. Our results suggest that securities that have a large proportion of small trades (presumably isproportionately from small, online retail investors) tend to be less efficient by conventional measures, consistent with our model predictions.
Even prior to this study there were manifold problems with the market fundamentalist approach to law and economics, and its excessive emphasis on efficiency. For example, the Grossman-Stiglitz paradox demonstrates that the attainment of perfect information is impossible, as any market with perfect information would create disincentives for participants to seek information.
The inescapable conclusion is simply that efficiency (the foundation of market fundamentalism) functions only as a theoretical construct to highlight the strengths of market economics, but with only limited practical application. Unregulated markets will never achieve optimal resource allocation, and by extension optimal macroeconomic outcomes.
The subprime mortgage crisis teaches more about the shortcomings of efficiency. Efficiency fails to account for any transaction tail. If transactions are interconnected in a way that one transaction may in the future influence future transactions with macroeconomic effect then efficiency will fail to encompass all the means by which a transaction interacts economically. For example, financial innovation may create vehicles that could increase the flow of capital to residential housing, a historically safe place for credit. Meanwhile globalization, including the mass migration of jobs, may impair consumer buying power. Historically low interest rates may invite lenders to search for yield by extending credits to otherwise questionable credit risks. All of these transactions satisfy efficiency requirements, and all seemingly contribute to growth. Yet, the tail of the transactions led to a severe credit contraction that operated to shut down transactions across the economy. Efficiency analysis looks at all transactions in isolation and simply assumes that transactions are always economically beneficial. It fails to account for any transactional tail.
Probably there are massive economic tails. It depends on the context of the economy. Transaction interconnectedness is dynamic not static. In my view, George Soros and his theory of reflexivity and Hyman Minsky's theory of credit cycles, begin the analysis of transactional tails. There is much more work to be done on this issue. Every transaction interacts with a complex of economic webs, sometimes beneficially and sometimes negatively. Transaction interconnectedness is different from spillovers in that spillovers are static. Pollution is pollution.
Subprime loans can be economically disastrous or economically beneficial, as the subprime lending probably was through 2003 or so.
Legal infrastructure is the only means of controlling negative economic tails.
Until efficiency reckons with such tails it deserves to be treated as a mere theoretical construct.
The subprime mortgage debacle was significantly enabled by the government. See Freddie Mac, Fannie Mae, and Barney Frank. Politicians, federal agencies, and academics have a hard time acknowleding that home ownership is not a right and that lending to those who cannot financially afford a mortgage loan does more harm than good.
ReplyDeleteUsing a model of financial market inefficiency, we show that this increase in uninformed individuals can increase market risk (volatility), can decrease efficiency, and may reduce social welfare even when market participants are perfectly rational.
ReplyDeleteSo, the idiots are screwing things up and need their betters in academia to ride to the rescue, saving them and the whole system from those evil market fundamentalists. What did Hayek call this? Oh, that's right, the "fatal conceit".
Uninformed players entering into the markets and temporarily increasing volatility does not alter the markets long term efficiency. Nor does there being winners and losers, even when both act rationally, impact social welfare.
Of course the attainment of "perfect information" is impossible. (I hope the taxpayer didn't spend too much for the study that led to this insightful jewel of wisdom) Information changes in real time. As market participants react to it - regardless of whether it is widely disseminated - the market reflects the value of that information. What is completely and indisputably certain is that no bureaucrat can ever have enough information to dictate efficient outcomes. That is also true of politicians who seek to impose regulatory "cures" for perceived market inefficiencies.
The inescapable conclusion is simply that efficiency (the foundation of market fundamentalism) functions only as a theoretical construct to highlight the strengths of market economics, but with only limited practical application. Unregulated markets will never achieve optimal resource allocation, and by extension optimal macroeconomic outcomes.
Wow, and I suppose that only truly gifted regulators are capable of leading us to the promised land of "optimal resource allocation". Psychologists refer to this condition as "delusions of grandeur".
Free markets are the most efficient allocators of resources, not in theory, but in fact. If this were not true, the Soviet Union would still be in existence and people would not be forced to use ration cards in Cuba. It is socialism that works only as a "theoretical construct" and fails, each and every time, to efficiently allocate resources.
For example, financial innovation may create vehicles that could increase the flow of capital to residential housing, a historically safe place for credit.
You've got the cart before the horse. The financial vehicles created during the subprime crisis were created in response to a government policy that knowingly and deliberately misallocated resources. Far from being "bit players", the GSE's that were at the very center of this crisis were the primary purchasers of subprime debt, driving financial "innovation" and speculation, and creating the transactional tail that you describe.
The losses to the taxpayer as a result of this government interference in the market continue to mount. The Obama administration has just given the GSE's a blank check - to be paid by our children and grandchildren - to cover these losses. "Legal infrastructure" resulting in inefficiency and a true reduction of social welfare.