Saturday, 28 June 2008

More from Stiglitz and Soros: Asymetric information and reflexivity

The argument of Adam Smith [1776], the
founder of modern economics, that free markets led to efficient outcomes,
“as if by an invisible hand” has played a central role in these debates: it suggested
that we could, by and large, rely on markets without government intervention.
There was, at best, a limited role for government. The set of ideas that
I will present here undermined Smith’s theory and the view of government
that rested on it. They have suggested that the reason that the hand may be
invisible is that it is simply not there – or at least that if is there, it is palsied.

While a number of critics wish to maintain a reformed capitalism Soros and Stiglitz are particularly interesting because they challenge not just the excesses of global neo-liberalism but also some of the foundations of economics. Economists, even many Keynesians, assume that markets generally work, with the actions of consumers and producers leading to efficient outcomes at a micro level. Stiglitz and Soros accept the principle of a market-based society but doubt that the market automatically delivers efficiency. Their critique based on notions of reflexivity and asymmetric information is similar to that of Keynes.
Economists since Alfred Marshall, in the nineteenth century, have argued that human beings are ‘rational’ in that they seek to maximise their personal benefits and minimise the costs of any transaction. Consumers aim to maximise ‘utility’ and producers profit. Both groups calculate the best course of action during millions of transactions. The actions of millions of producers and consumers functions as an invisible hand creating choice, prosperity and even justice. The liberalisation suggested by the Washington consensus is founded on Marshall and Smith’s assumptions of rationality, calculation and maximising behaviour. Given these foundations it is safe to assume that the market should be extended as far as possible because it generates efficient outcomes.
Typically we might argue that if a country removes capital controls, its entry into a global money market will bring benefits. If a country has sound economic policies, money will flow in as investors ‘buy’ its currency so as to make gains. If a country is running a trade deficit, demand for its currency will fall, because foreigners will demand less of it to buy the country’s goods and services. Because demand falls the value of the currency will fall, in turn its exports will become cheaper and its imports more expensive. As more of its exports are sold and fewer imports are bought the deficit will be magicked away. The market is a structural device, a mechanism, for restoring ‘equilibrium’ or balance.
Yet, as Soros and Stiglitz argue, this notion of the market bears little resemblance to the conditions and complexities of modern economic reality. The money traded for goods is a tiny percentage of speculative currency flows, meaning that currencies are little affected by trade balances and therefore unlikely to float downwards to restore imbalance. With capital liberalisation billions of dollars’ worth of currencies flow in and out of economies in seconds. Such flows create waves of chaos rather than restoring equilibrium.
Shares, it is assumed, are bought for profit, so potentially profitable, well-managed companies will enjoy increased demand followed by rising share values. Rising share values will make it easier for such companies to expand. In reality share values can reach mountainous heights before crashing back, as the dot com bubble of the 1990s illustrated. Share values are often unrelated to company performance. Soros, who has made a billion dollar fortune from such movements, particularly currency movements, argues that the market is shaped by reflexivity. Economic rationality increasingly depends on our ability to successfully guess the behaviour of other economic actors. Such reflexivity, where individuals reflect on what they think will happen in markets and change their behaviour in response, leads to an increasingly abstract and exaggerated economic system. If share holders think others are likely to sell their stocks, shareholders sell anticipating that prices will fall, such action leads to a stampede to sell and market instability. Even if dot coms have little value the belief that others will buy pushes up share values into a bubble of inflated stock market value. Soros’s appreciation of the potentially negative consequences of a market based not on rationality but predictions of mass and often hysterical behaviour is profound:
The prevailing doctrine on how financial markets operate has not changed. It is assumed that with perfect information markets can take care of themselves; therefore the main task is to make the necessary information available and to avoid any interference with the market mechanism. Imposing market discipline remains the goal.

We need to broaden the debate. It is time to recognize that financial markets are inherently unstable. Imposing market discipline means imposing instability, and how much instability can society take? (Soros 1998: 175-176)

To understand such instability Soros uses the concept of reflexivity which he traces from Greek drama to the introduction of intersubjectivity into sociology by Alfred Schutz:

The concept of reflexivity is so basic that it would be hard to believe that I was the first to discover it. The fact is, I am not. Reflexivity is merely a new label for the two-way interaction between thinking and reality that is deeply ingrained in our common sense. (Soros 1998: 10)

Keynes was one of the few academic economists to make large amounts of money from commodity markets! The fact that he, like Soros, had a sharp understanding of reflexivity should be instructive to those who seek to play the markets. Keynes put the concept at the centre of his theoretical system:

[economics] deals with motives, expectations, psychological uncertainties. One has to be constantly on one’s guard against treating the material as constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worthwhile falling to the ground, and whether the ground wants the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth. (quoted in Moggridge 1976: 27)

Keynes feared the effect of capital liberalisation as a means of shifting investment from productive activity to a form of gambling:
The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow. (Keynes 1960: 155)
Keynes while no anti-capitalist believed that extending the market meant extending uncertainties to new areas of human existence with destabilising and potentially damaging consequences. In the third millenium see-sawing currency and share values mean that jobs may be swept away with one spin of the economic roulette wheel.
Stiglitz specifically examines asymmetric information as a form of market failure. He suggests that in the real world information is always imperfect to a lesser or greater extent. Such asymmetry means that markets may not work efficiently and if some actors have access to greater information than others there is potential for injustice. Assumptions of reflexivity and asymmetric information, ignored by the Washington consensus, powerfully shape the operation of real markets and have important consequences.

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