Monday, October 15, 2012

Branches of economics do create more value than the ATM

This year's Nobel Prize winning economists confirm that there are branches of economics that actually create more value than Paul Volcker's famous standard of the automated teller machine.

Alvin Roth and Lloyd Shapley did research into how to efficiently and most beneficially match different actors in a given market to areas like organ donation and transplant.  The result of their research has been improved market performance.

Some readers might be shocked by your humble blogger having anything nice to say about the economics profession.  They shouldn't be.  I actually think that all branches of the economics profession could create a lot of value.

Unfortunately, there are some very prominent branches of the economics profession that not only do not create value, but actually promote destructive behavior.

It is no surprise that the branches of economics I think promote destructive behavior focus on the financial system and monetary policy.  I have been documenting this fact on this blog.


Gary said...

A great many economists are doing good work, especially in areas that are untainted by the interests of The Blob (The Payoff: Why Wall Street Always Wins, Connaughton). The area of Health Care economics is especially important as we tackle this critical component of GDP, seeking to make it more efficient with better delivery of services to the population.

While I would like to lay the entire blame for the poor showing of the economics profession before and during this financial crisis (as represented by the Queen and her Question)on The Blob and its influence in regulatory and academic circles, such a move would not explain the mistakes made by those who have a solid history of standing up to the financial elite.

Something more is at work here, and I suspect that Ms. Stewart is onto something as it echoes the writing of William White in the Dallas Federal Reserve paper recently published, in which he makes the comment about the inability of economic models to accurately capture the workings of financial markets.

Yes, there are examples of assymetrical information operating in markets quite well . . . for a while. One could say that we built a $15-$20 trillion market on a foundation of opacity (structured finance) and that it operated for some time in a symbiotic relationship, with buyers and sellers doing well.

However, something happened on August 9, 2007 that changed the relationship. Buyers got slapped in the face in a way that was impossible to ignore. Of course, I am referring to the actions of BNP Paribas in freezing three funds because it could no longer believe in the credibility of the prices it received from Wall Street for some structured finance securities.

As soon as the validity of the pricing models came into question in such a public manner, the basis of trust in opaque markets shattered. At that point in time, the true basis for the Invisible Hand to operate, the ability to obtain a credible valuation and determination of risk vs. reward, was inexorably changed. Buyers realized that they did not have the information required to make fundamantal investment decisions for structured finance securities and so,they walked away from the market and went on strike.

In my opinion, there are three types of assymetrical information. The first comes from trading knowledge, the ability to see more of the market than others. Buyers have always been willing to give Wall Street this advantage in small quantities, because it did not disturb the basic tenets of valuation and risk vs. reward.

The second form of assymetrical information came from Wall Street's connections in the political, regulatory and academic worlds. This type of networking information was also permitted by the buy side because once again, it did not by itself change the fundamental nature of the investment decision making process.

However, the third type of assymetrical information, the equivalent of inside information, presented a different problem. If Wall Street knew the valuation of scecurities because it owned sub-prime mortgage lenders and could study the books and gain color while viewing loans, then it had an enormous advantage over the buy side. Initially, the buy side acceeded to this difference in information, but the opaque nature of the securities brought home by the BNP Paribas actions in 2007 meant that they were essentially in the dark on valuation ability while Wall Street was not. This set up an intolerable disparity and led to the buyers' strike.

Along these lines, another important point needs to be understood in my opinion and it draws significantly on your hammering on the pre-requisite of the Invisible Hand.

The Invisible Hand works as long as the buyers perceive that they have all of the information needed to make an investment decision. However, once that perception is destroyed, the basis of the Invisible Hand is removed and the market no longer functions properly, almost regardless of price. At that point, price transparency is greatly subordinate to valuation transparency.

Nice work.

Richard Field said...

Thanks for the excellent comment.

Clearly, health care is one of the major areas where economists have tended to add value.

As you point out, we cannot get the frozen segments of the financial system functioning again until we require these segments to provide all the information necessary so the buy side perceives it can value the related securities without Wall Street having the equivalent of inside information.