Imperfect Financial Markets

The NewScientist in its July 25,2009 issue has an essay by Dr. Terence Kealey, Falling out of love with market myths. The essay advances the argument that conservative Economic theories are derelict. These theories were barely tenable originally, have dwindled in efficacy with the emergence of huge secret/shadow and non-transparent financial markets from derivatives through insurance to massive private equity and hedge fund transactions, yet continue to to be used to this day in defense of the Finance Industry after the Meltdown. Perfect and Efficient [or nearly so] markets are claimed for financial affairs . “So just let the markets work” is the plaintive cry from diverse conservative pundits as Jim Kramer through Charles Krauthammer to George Will. [for a more extended list of those who said the markets were working and there is no Housing Bubble , see here]. So let me quote verbatim what Dr. Kealey has to say:

My story starts with a theory that Ronald Reagan  and Margaret Thatcher sold us. It is called “supply side economics”, and it claims that economic growth depends, first, on the rich[not the poor] being rewarded with tax cuts; and second, on markets being freed from regulation.

Clearly the theory is flawed. The rush by bankers to pay themselves large bonuses, even as their failing banks were being nationalised, reveals the true function of this bloated remuneration – to benefit only its recipients while the banks failed precisely because their regulation was too lax.

Supply-side economics was buttressed by two futher theories: “rational expectations” and “efficient markets”. As their names imply, these assume that traders do not make systematic errors when predicting the future, and that the price of financial products such as shares, bonds, and property accurtately reflect all relevant information.

Yet traders do make systematic errors of prediction, and the prices of financial products can actually reflect misinformation. The rel function of these economic theories was manifestly to help the rich justify the methods by which they grew even richer…. The economists’ most bizarre theorey is that of  “perfect markets”. It is also their most important theory: the authoritative New Palgrave Dictionary of Economics states that “no set of ideas is so widely and successfully used by economists as is the logic of perfectly competitive markets”.

What Dr. Kealey is saying is that the Economic Emperor has been undressed because efficient markets [let alone perfect ones] are a fiction. Clearly the definition of perfection is not true of Financial Markets which have produced two huge bubbles within the span of ten years – first the DOT.COM Bust and more recently the worldwide Housing Bubble.  What is worse is that Obama Administration’s Financial advisers have continued to defer and postpone addressing this issue. In fact, they have let the major banks of the TARP leash and capable of restoring the massive bonuses [which they have all quickly done] that were part and parcel to the adverse risk taking and systematic errors that engendered much of  the financial mismanagement that aided and then triggered the Financial Meltdown of 2007-2009.  The esence of the piece can be found here.