Market Completeness and Financial Regulation

Adair Turner on economic ideology:

The Uses and Abuses of Economic Ideology

...Indeed, at least in the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the International Monetary Fund, in its Global Financial Stability Reviews (GFSR), set out a confident story of a self-equilibrating system...

...So risk managers in banks applied the techniques of probability analysis to “value at risk” calculations, without asking whether samples of recent events really carried strong inferences for the probable distribution of future events. And at regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA.

This belief system did not, of course, exclude the possibility of market intervention. But it did determine assumptions about the appropriate nature and limits of intervention.

For example, regulation to protect retail customers could, sometimes, be appropriate: requirements for information disclosure could help overcome asymmetries of information between businesses and consumers. Similarly, regulation and enforcement to prevent market abuse was justifiable, because rational agents can also be greedy, corrupt, or even criminal. And regulation to increase market transparency was not only acceptable, but a central tenet of the doctrine, since transparency, like financial innovation, was believed to complete markets and help generate increased liquidity and price discovery.

But the belief system of regulators and policymakers in the most financially advanced centers tended to exclude the possibility that rational profit-seeking by professional market participants might generate rent-seeking behavior and financial instability rather than social benefit – even though several economists had clearly shown why that could happen.

Policymakers’ conventional wisdom reflected, therefore, a belief that only interventions aimed at identifying and correcting the very specific imperfections blocking attainment of the nirvana of market equilibrium were legitimate. Transparency was essential in order to reduce information costs, but it was beyond the ideology to recognize that information imperfections might be so deep as to be unfixable, and that some forms of trading activity, however transparent, might be socially useless.

Indeed, the Columbia University economist Jagdish Bhagwati, in a famous essay in Foreign Affairs entitled “Capital Myth,” talked of a “Wall Street/Treasury” complex that fused interests and ideologies. Bhagwati argued that this fusion played a role in turning liberalization of short-term capital flows into an article of faith, despite sound theoretical reasons for caution and slim empirical evidence of benefits. And, in the wider triumph of the precepts of financial deregulation and market completion, both interests and ideology have clearly played a role.

In the Malaysian context, I see this same ideology infecting the Securities Commission and Bursa Malaysia (though thankfully not for the most part Bank Negara) – disclosure based regulation, efforts to broaden and deepen intermediation, and a narrow minded focus on increasing liquidity (including open access for foreign portfolio funds) – all with a view towards completing markets and improving price discovery.

Market completion by the way is defined as having a full set of prices (place, time and specific good) across an entire market.

I don’t generally have a problem with most of these efforts (transparency is all to the good), except disclosure based regulation depends altogether too much on the integrity and faith in the confluence between market interests and agents narrower self-interest, and portfolio capital flows are altogether far more dangerous and destabilising than commonly realised, as I’ve talked about before (here, here and here).

(H/T Mark Thoma)