Sunday, October 5, 2008
But at What Cost?
Yes the markets would eventually sort themselves out but at what cost? In a "Darwinian economic" sense, this is a good thing if it eliminates a weak bank and makes room for better, stronger banks. The big difference that people don't get, and this can not be stressed enough, is that we are not talking about one or two banks. We are talking about entire financial markets. If the markets fail, and again this cannot be stressed enough, everyone, including you and me, suffers greatly. If markets fail, businesses can not function and this means people lose jobs. If markets fail, people lose their economic power and this means people can not buy houses, cars, college educations, etc. If markets fail, people lose retirement plans. If markets fail, everyone suffers direct and devastating economic consequences. This is what people don't get and why it is necessary to take distasteful measures to make sure that does not happen. When the "victory" in letting banks suffer their due consequences and fail means that we lose jobs, houses, retirements, and personal wealth, that is not a Phyrric victory we can afford.
What Is "the Free Market Economy"?
It seems there is some confusion about "free market economics" and the economic rescue plan. Some opponents the the rescue plan oppose it because they believe it to be anti free market. The problem stems from a confusion between what "free market economics" really is and what is an ideology of government non-intervention in economics. These are not one and the same. Government intervention can be anti free market to be sure, but it is not so by definition. The ideology of non-intervention stems from the belief that the free market is the most effective and efficient economy and the concern that government intervention inhibits that by necessity. This is the same as the confusion between democracy and human rights. To be sure, democracy is the best tool to ensure human rights. This does not mean that human rights cannot be had without democracy nor does it mean that democracy is an absolute guarantee of human rights. Similarly, nonintervention is the best tool to enable free markets but it does not mean that free markets cannot exist with intervention nor is it a guarantee that free markets will exist.
The "economy" is what mathematicians and engineers refer to as a "solution space". A solution space is the collection all of the valid states that something can achieve given the governing laws or mathematics. For example, imagine a "fully posable action figure." Any position you can pose the articulated joints, without breaking it, is part of the "solution space" of the posability of the action figure. Each joint has a limited range of motion and therefore the solution space of possible poses is also limited. There are poses that are not part of the solution space that if put into that pose would require breaking one or more joints to do so. Where laws of nature are concerned, the action figure is made out of an indestructible material, meaning that try as you might, some poses, or solutions, are simply not physically possible.
For discussing the economy we'll use another more representative solution space model. Imagine you have something shaped like a soup bowl and in this bowl you have a marble. The bowl represents the solution space for the economy given the laws of economics such as supply and demand. The position of the marble in the bowl represents the state of the economy at any given time. As you can see, the marble will want to roll to the bottom of the bowl. When the marble is in bottom, this is what is called equilibrium. If left alone, the marble will stay at the bottom and if displaced will naturally tend to roll back to the bottom. This is called a "stable" equilibrium. ("Unstable" equilibrium would be something like balancing a broom handle - once balanced it will stay there but if disturbed it will fall.) This type of equilibrium is also what is called a "low energy state". This means that at the bottom of the bowl, the marble is in it's lowest energy state. If you push the marble up the lip of the bowl this will take energy and the marble will be in a higher potential energy location.
So what does this model mean in terms of economics? Consider the real estate market. We have seen two distinct states recently. In one case, prices were so ridiculously high that no one could afford to buy houses anymore. In another, prices have fallen so sharply that a lot of people have lost a lot of money. In both cases, price is determined by the laws of supply and demand. In this example, the laws of economics determine the shape of the bowl. In our bowl model, both of these states are toward the lip of the bowl. The marble was on one side of the bowl with high prices and now is rolling to the other side where prices are falling. Generally speaking, desirable states are at the bottom of the bowl and undesirable states are along the rim and the further up the rim as characterized by an out of balance economy. One aspect of the real economy is that, just like the marble in the bowl, it naturally wants to find the stable equilibrium point of lowest energy and free market economics does this very effectively and efficiently. In economics, this is the most optimal achievable operating state for the economy.
This natural tendency to seek stable equilibrium and the lowest energy state is what people who are "free market" proponents have in mind. The idea being that to leave the market (marble) alone, it will naturally attain the most optimal (lowest energy at the bottom of the bowl) achievable state. Now, before I move on to what this means in terms of the rescue package, let's take some time to look at a couple of concepts this model allows us to play with. Maybe you decide that you want the economy to occupy a state not on the bottom of the bowl? This is the case with things like price controls or other policies that attempt to force the economy into a particular state. Two situations can result. One is that the "desired state" is on the bowl but up on the lip. In order to achieve this state, you must push the marble up the lip and hold it there. This is not an efficient way to have an economy operate and if you drop the marble it's going to go rolling wildly around the bowl before returning to the bottom and we certainly don't want a wildly fluctuating economy. The other case is that the "desired state" is not even located on the bowl. In this case, the desired state in not even achievable within the laws and constraints of economics. You would be left with trying to push the marble around the bowl trying to put the marble some place it simply can't be.
But free market proponents sometimes have it wrong too. The idea that the market attains the most optimal state when left alone, when taken as ideology, can lead one to actions or inaction that are unwarranted. This is what caused many "free market" republicans to vote against the rescue bill. Their ideology is to allow the market to freely correct itself. Strictly speaking as mentioned above, this is a "nonintervention" ideology and not "free market economics." And this is where many "free market" proponents can go wrong. Just because the marble will eventually land at the bottom of the bowl does not meant that we should just sit by and allow the marble to follow any trajectory to achieve that. Certainly we do not want to obstruct that, but neither should we necessarily allow a fate determined by a "random" trajectory. As you can imagine, the marble can roll in many different directions and paths. These are all valid "free market" solutions as the marble is allowed to freely roll toward the bottom of the bowl. The thing is, not all of the possible trajectories are equivalent and we can and should influence what trajectory the marble takes. If one trajectory would produce a great deal of devastation and another less so, then by all means we should do what we can to influence the trajectory toward the less destructive path. This satisfies free market principles so long as we do not attempt to force the trajectory to follow any specific unnatural path. And this is what the rescue plan does. The likely trajectory if we did nothing would be to result in devastating consequences resulting in massive collateral damage to you and me and everyone else. The rescue plan simply attempts to influence the trajectory to take a less catastrophic path. The financial markets are still free to be priced according to "free market" economic principles such as supply and demand. What the rescue plan does is to remove some of the toxic product from the market in order to eliminate the negative effect that has on supply. As supply increases as a result of removing the "toxins", demand and pricing are free to adjust in response according to free market economic principles.
So now you might ask, if the marble wants to stay at the bottom of the bowl, how does it end up somewhere else on the bowl in the first place? The economy is not a static thing. Circumstances can and do change over time in response to changes in prevailing conditions. The most accurate answer in terms of the bowl analogy would be that the shape of the bowl is always changing. A simpler analogy would be if the bowl got bumped or tilted or something knocked the marble to thrust it away from the bottom of the bowl. In the real thing, this could be anything that alters supply and demand or resources. Examples are things like the dwindling supply of oil, a natural disaster such as a hurricane, new technology, changing cultural or social preferences. In the real estate market as well as the dot com boom and bust, one of the greatest disruptive influences was speculation. This was a sudden influx of large amounts of money into the real estate market that temporarily skewed the apparent demand in the market. This had the effect of a sharp whack on the marble that sent it spinning off wildly. And the availability of "easy money" (all of the "creative" loan products made available that enabled the ease with which money could be poured into the market) simply added fuel to the fire.
What "free market" economics is all about is this "equilibrium seeking" and allowing the economy to seek the path of lowest energy. However, just because it is most efficient to rely on the natural equilibrium seeking nature of free market economics, that doesn't mean we should allow the economy to pass along any trajectory from a disturbance back to equilibrium. We can, and often times should, act to nudge the trajectory toward one path and away from another. As long as we don't try to force it along a "higher energy" trajectory, this is still a valid free market solution. What we have to evaluate pragmatically is which possible paths incur more or less devastation along the way and how can we nudge the marble toward the least destructive path. The rescue plan is simply a very elegant nudge that allows the free market "marble" to do the rest. The rescue plan is consistent with free market economic principles. Rather than controlling the market by decree, the rescue plan puts the government in the role of participatory agent in the free market. The buying as an agent in the free market is strategised in such a way as to influence the free market trajectory on a more favorable and less destructive path.
The "economy" is what mathematicians and engineers refer to as a "solution space". A solution space is the collection all of the valid states that something can achieve given the governing laws or mathematics. For example, imagine a "fully posable action figure." Any position you can pose the articulated joints, without breaking it, is part of the "solution space" of the posability of the action figure. Each joint has a limited range of motion and therefore the solution space of possible poses is also limited. There are poses that are not part of the solution space that if put into that pose would require breaking one or more joints to do so. Where laws of nature are concerned, the action figure is made out of an indestructible material, meaning that try as you might, some poses, or solutions, are simply not physically possible.
For discussing the economy we'll use another more representative solution space model. Imagine you have something shaped like a soup bowl and in this bowl you have a marble. The bowl represents the solution space for the economy given the laws of economics such as supply and demand. The position of the marble in the bowl represents the state of the economy at any given time. As you can see, the marble will want to roll to the bottom of the bowl. When the marble is in bottom, this is what is called equilibrium. If left alone, the marble will stay at the bottom and if displaced will naturally tend to roll back to the bottom. This is called a "stable" equilibrium. ("Unstable" equilibrium would be something like balancing a broom handle - once balanced it will stay there but if disturbed it will fall.) This type of equilibrium is also what is called a "low energy state". This means that at the bottom of the bowl, the marble is in it's lowest energy state. If you push the marble up the lip of the bowl this will take energy and the marble will be in a higher potential energy location.
So what does this model mean in terms of economics? Consider the real estate market. We have seen two distinct states recently. In one case, prices were so ridiculously high that no one could afford to buy houses anymore. In another, prices have fallen so sharply that a lot of people have lost a lot of money. In both cases, price is determined by the laws of supply and demand. In this example, the laws of economics determine the shape of the bowl. In our bowl model, both of these states are toward the lip of the bowl. The marble was on one side of the bowl with high prices and now is rolling to the other side where prices are falling. Generally speaking, desirable states are at the bottom of the bowl and undesirable states are along the rim and the further up the rim as characterized by an out of balance economy. One aspect of the real economy is that, just like the marble in the bowl, it naturally wants to find the stable equilibrium point of lowest energy and free market economics does this very effectively and efficiently. In economics, this is the most optimal achievable operating state for the economy.
This natural tendency to seek stable equilibrium and the lowest energy state is what people who are "free market" proponents have in mind. The idea being that to leave the market (marble) alone, it will naturally attain the most optimal (lowest energy at the bottom of the bowl) achievable state. Now, before I move on to what this means in terms of the rescue package, let's take some time to look at a couple of concepts this model allows us to play with. Maybe you decide that you want the economy to occupy a state not on the bottom of the bowl? This is the case with things like price controls or other policies that attempt to force the economy into a particular state. Two situations can result. One is that the "desired state" is on the bowl but up on the lip. In order to achieve this state, you must push the marble up the lip and hold it there. This is not an efficient way to have an economy operate and if you drop the marble it's going to go rolling wildly around the bowl before returning to the bottom and we certainly don't want a wildly fluctuating economy. The other case is that the "desired state" is not even located on the bowl. In this case, the desired state in not even achievable within the laws and constraints of economics. You would be left with trying to push the marble around the bowl trying to put the marble some place it simply can't be.
But free market proponents sometimes have it wrong too. The idea that the market attains the most optimal state when left alone, when taken as ideology, can lead one to actions or inaction that are unwarranted. This is what caused many "free market" republicans to vote against the rescue bill. Their ideology is to allow the market to freely correct itself. Strictly speaking as mentioned above, this is a "nonintervention" ideology and not "free market economics." And this is where many "free market" proponents can go wrong. Just because the marble will eventually land at the bottom of the bowl does not meant that we should just sit by and allow the marble to follow any trajectory to achieve that. Certainly we do not want to obstruct that, but neither should we necessarily allow a fate determined by a "random" trajectory. As you can imagine, the marble can roll in many different directions and paths. These are all valid "free market" solutions as the marble is allowed to freely roll toward the bottom of the bowl. The thing is, not all of the possible trajectories are equivalent and we can and should influence what trajectory the marble takes. If one trajectory would produce a great deal of devastation and another less so, then by all means we should do what we can to influence the trajectory toward the less destructive path. This satisfies free market principles so long as we do not attempt to force the trajectory to follow any specific unnatural path. And this is what the rescue plan does. The likely trajectory if we did nothing would be to result in devastating consequences resulting in massive collateral damage to you and me and everyone else. The rescue plan simply attempts to influence the trajectory to take a less catastrophic path. The financial markets are still free to be priced according to "free market" economic principles such as supply and demand. What the rescue plan does is to remove some of the toxic product from the market in order to eliminate the negative effect that has on supply. As supply increases as a result of removing the "toxins", demand and pricing are free to adjust in response according to free market economic principles.
So now you might ask, if the marble wants to stay at the bottom of the bowl, how does it end up somewhere else on the bowl in the first place? The economy is not a static thing. Circumstances can and do change over time in response to changes in prevailing conditions. The most accurate answer in terms of the bowl analogy would be that the shape of the bowl is always changing. A simpler analogy would be if the bowl got bumped or tilted or something knocked the marble to thrust it away from the bottom of the bowl. In the real thing, this could be anything that alters supply and demand or resources. Examples are things like the dwindling supply of oil, a natural disaster such as a hurricane, new technology, changing cultural or social preferences. In the real estate market as well as the dot com boom and bust, one of the greatest disruptive influences was speculation. This was a sudden influx of large amounts of money into the real estate market that temporarily skewed the apparent demand in the market. This had the effect of a sharp whack on the marble that sent it spinning off wildly. And the availability of "easy money" (all of the "creative" loan products made available that enabled the ease with which money could be poured into the market) simply added fuel to the fire.
What "free market" economics is all about is this "equilibrium seeking" and allowing the economy to seek the path of lowest energy. However, just because it is most efficient to rely on the natural equilibrium seeking nature of free market economics, that doesn't mean we should allow the economy to pass along any trajectory from a disturbance back to equilibrium. We can, and often times should, act to nudge the trajectory toward one path and away from another. As long as we don't try to force it along a "higher energy" trajectory, this is still a valid free market solution. What we have to evaluate pragmatically is which possible paths incur more or less devastation along the way and how can we nudge the marble toward the least destructive path. The rescue plan is simply a very elegant nudge that allows the free market "marble" to do the rest. The rescue plan is consistent with free market economic principles. Rather than controlling the market by decree, the rescue plan puts the government in the role of participatory agent in the free market. The buying as an agent in the free market is strategised in such a way as to influence the free market trajectory on a more favorable and less destructive path.
Subscribe to:
Posts (Atom)