Tuesday, 28 July 2009

Twenty years of economics

Robert Peston's article today isn't a bad summary of the last twenty years of economic theory.

Information asymmetry is the term for markets that don't work because proper information is not available to both parties - e.g. the broadband speed example that Robert gives.

Adverse selection is a related problem which causes credit to be mispriced. It works like this: companies know more about their business prospects than banks, thus banks will charge a premium on loans to account for the risk they run. This premium puts off creditworthy businesses, whose owners will prefer to invest their own money or raise it in the markets. This leaves only businesses which are middling or downright bad risks still willing to borrow. As the best businesses have left the market, this affects the average risk profile for the banks, who put the rates up again... discouraging the borderline cases and leaving only the really bad risks. Rates then go up again, and... you can see where this leads. This is classically called "the market for lemons" and can lead to a whole market ceasing to operate properly.

Cognitive biases are the specific aspects of psychology where we depart from making rational choices in a predictable way.

All of these problems, which are inherent in unregulated markets, lead to market failure. The discovery and analysis of these issues have been among the main outcomes of economic research in the last two decades.

This is a politically significant debate. The reason is that, unlike most of the earlier debates about free markets versus intervention, none of these problems arise from government action. Traditionally, government action would usually reduce the efficiency of markets; and the debate was about whether this was a worthwhile sacrifice.

In the case of the three items above, the market has a built-in inefficiency. Government regulation therefore may be a way of improving how the market works rather than replacing it.

In this respect the Conservatives' proposals about increasing information about financial products are useful; but it does not address the issue of cognitive bias, which can in fact be worsened by the availability of too much unfiltered information.

No party has a concerted programme to understand cognitive bias on a large scale and how it affects economic outcomes, although there are a few individual programmes - for instance Lord Darzi's recent report on health services includes some discussion of behavioural economics. I would encourage all the parties to give this some detailed thought, as it is becoming clearer and clearer that it's a critical aspect of how the economy works.

Update: Chris Dillow makes some good points in dissent.

1 comment:

Tim said...

I fail to see how governments and regulation can prevent irrational behaviour, for the simple reason that politicians and regulators are no more likely to behave rationally than are market participants!

The best we can hope for from such sources is a level playing field. An efficient market does require effective regulation, as Robert Peston suggests, but then he and you both get into the area of tactics. Is it possible to construct or regulate a market in such a way that all participants only ever behave rationally? Surely the best way of correcting irrational behaviour is an efficient market, one that punishes poor tacics and rewards astute ones, in a manner that is both proportionate and timely?

You mention 3 distorting elements. Information assymetry can rightly be regulated out of the system. Adverse selection is a disaster for the market concerned, but it presupposes an alternative one, so perhaps it's not such a major problem? Cognitive bias (i.e. people are irrational) can only be reduced by the workings of an efficient market. I defy you to propose an alternative method short of eugenics!

The problems in markets in the last ten years have been down to market abuse. Let's not throw out the baby with the bathwater. Yes there was irrational exuberance, but this was a symptom of the abuse. The protection that had served us so well for nearly 70 years was swept away and the vultures descended. This is the issue that needs to be addressed. Next to that, a bit of under- and over-valuation of assets is small beer.