As much fun as the other reply is, the real defense against your point is that "efficient" doesn't mean what you think it does. Efficiency in a market means that there exist no long-term arbitrage opportunities, because they will be exploited and thus cause prices to shift until those no longer exist. It emphatically DOES NOT mean "good" or "desirable" or anything like that. The market very efficiently went over a cliff, efficiently responding to incentive misalignments created by government regulation and efficiently ensuring that you had no significant arbitrage opportunities in the meantime.
The free market is more force of nature than construct of man, like gravity or a huge river. It can be harnessed, but it will efficiently crush you if you get in its way. It is also like the forces of nature in that it is extremely difficult to successfully harness it when one willfully chooses to not understand it because one does not "like" it, which is why the track record of social systems that start out with "Let's pretend the market isn't a force of nature but that we can will it into compliance with our ideology" tend to fare so poorly in practice; it's hardly any different than assuming gravity won't actually hurt you if you just love hard enough, then trying to get into rocket design. (The problem isn't that you won't get a rocket off the ground with such a plan, the problem is that you will....)
Well, I certainly can get behind your definition more.. but a gigantic 10 year bubble sticking out to the side and then bursting doesn't seem efficient by that definition. You'd think the wizards of the market, with the billions of dollars in pay they're collectively bringing home, would've corrected for that sooner, no?
This concept that in 2008 the market was responding to incentive misalignments created by government regulation.. what regulation? All we did was deregulate from 92 onwards. Are you gonna claim that a billion in fannie/freddie loans to minorities caused the problem? What about the overleveraging, the AAA credit ratings? Those were government problems?
It seems like a whole bunch of individuals played the "greater fool" theory as long as they could, and what we wound up with was the opposite of efficient, by your definition. I'm not necessarily saying more regulation would've prevented that, aside from generally being a brake on everything, but it's a hell of a bad case for the wisdom of markets.
This concept that in 2008 the market was responding to incentive misalignments created by government regulation.. what regulation? All we did was deregulate from 92 onwards.
This is false. The Community Reinvestment Act, passed in '92 and periodically ratcheted upwards thereafter, forced banks to increase loans to minority groups. It issued guidelines on how lenders should evaluate borrowers for these purposes:
Affirmative-action policies trumped sound business practices. A manual issued by the Federal Reserve Bank of Boston advised mortgage lenders to disregard financial common sense. "Lack of credit history should not be seen as a negative factor," the Fed's guidelines instructed. Lenders were directed to accept welfare payments and unemployment benefits as "valid income sources" to qualify for a mortgage. [1]
While not a regulation issue as such, it's also true that attempts to rein in Freddie Mac and Sallie Mae (semi-governmental entities both) were rebuffed by Congress; even when we knew there was potential trouble, the regulators wouldn't allow market concerns to dictate to their beast.
The Big Short tells us "In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000." Nothing in the CRA ever demanded that obvious inability to pay be disregarded. Once Wall St. started believing bogus CDO ratings and it became possible for mortgage banks to unload 100% of the risk, they weren't being pressured into writing stupid loans, they were eager to stuff the channel by writing as many as they possibly could before the music stopped, and used every trick they could think of (teaser rates, negative amortization) to get each buyer out the door and through the first months of a loan they knew was doomed.
"but a gigantic 10 year bubble sticking out to the side and then bursting doesn't seem efficient by that definition."
Where was the enormous arbitrage opportunity left behind, and why didn't you (or anybody else) exploit it?
Maybe you can answer that, but if you can't, you're not arguing for "inefficiency", you're still arguing "not good".
You also appear to be conceiving of regulations as something you simply have "more" or "less" of, which is not a useful mental model. What matters about regulations is their content, not their quantity. And what the content of our regulations created was A: mandating that banks make loans they would not have made without them and B: an implicit government backing for those bad loans.
Have you looked at the balance sheets for Fannie & Freddie lately? They're not bleeding a billion here or there.
Also, yes, the credit rating agencies are government creations as well. There are regulations (ahem) that require certain entities to take certain actions based on the word of the rating agencies, causing them to no longer just be groups of people stating their opinion, skewing their own incentives and raising the incentives others have to game them.
I slogged through much of the Financial Crisis Inquiry Report (http://fcic.law.stanford.edu/). One of the conclusions was that while mandating loans didn't help, they weren't numerous enough to be a major cause. Once the mortgage-backed securities engine got churning, there was an enormous demand for more loans to feed it. That provided most of the incentive for the bad loans, not government mandate.
The original contention was "extremely close" to optimal. I'm merely contending that the markets fuck it up big occasionally here, pretty low hanging fruit for me. As for why I didn't exploit it? I don't know, I don't work on Wall Street, don't play that game? I could've told you that the mortgage thing was a problem long before the ratings agencies, apparently, but everyone knew in hindsight.
Anyways, 10 years is pretty darn not good in my opinion. I'd call it inefficient, as far as pricing is concerned.
Agree on "more or less" regulations being a not-useful mental model. It seems to follow from that contention that "regulations!" isn't a one-word answer to any question of who to blame for anything, or how to solve anything.
RE: Fannie and Freddie I have not looked at their balance sheets. I'm under the impression that whatever the problem is with them, it's dwarfed by the size of the financial crisis, ergo they're not primarily at fault for the crisis. Moreover, the program to lend to minorities had been in place for decades. Seems hard to blame it for the 2008 meltdown, why not sooner?
It does seem that any regulations putting institutional faith in the ratings agencies are wrong-headed.
jbooth, if you're going to accuse others of ignorance and "turning off their brain", you should probably educate yourself about the issues you are talking about. The size of Fannie and Freddie's balance sheets were around $500 billion and taxpayers have so far lost about $300 billion on the bailouts of the GSEs. So, they were not insignificant contributors to the crisis, and reasonable economists disagree about the share of blame that the GSEs own. The mortgage interest tax deduction is about another $100 billion of subsidy to the mortgage market annually. Some people question the wisdom of these measures and the government's role in propping up the bubble.
Housing subsidies directed at minorities were increased over time in the Clinton and Bush administrations, but weren't large compared to the massive overall portfolio.
Jerf, this is a surprisingly insightful and concise statement--one that I largely agree with. I'm curious, though, and want to ask CWuestefeld as well:
If we accept that the free market can act in ways which are detrimental to the global objective function (without loss of generality, let's pick your favorite, e.g., "Everyone gets food", "Individuals have class mobility", "I can shoot and eat the homeless for sport" etc.), do we as a society have a moral obligation to adjust market behavior via regulation or incentives? How does one reconcile a desire for free markets with a desire to satisfy other human goals?
It's why I'm a little-L libertarian; free markets can and will efficiently price and trade in evil. Slaves were once traded on the open market, after all, and they were probably efficiently priced, but that certainly doesn't make it a good thing. (Just to hit the point again, efficiency has very little to do with "good".)
I think it's possible to regulate effectively, but the problem is that it requires an engineer's approach, not a government's approach. One must be able to adapt, admit one is wrong, and generally regulate at the incentives, instead of being required to stay politically viable and only then regulate, be politically unable to admit error (and via the mechanisms of politics, become insulated from the facts that would show error), and be continuously stuck in the regulation of the effects instead of the incentives that got us there. Oh, and as I alluded to previously, being regulated by people who won't even look at the mechanics of the market squarely because they think they're intrinsically evil because sometimes they make bad things happen (which they definitely do!) isn't a great start to engineering success.
Yes. The market can be evil by human standards, just as gravity feels pretty evil when you're in a crashing plane. But you gotta deal with what really exists, not what you wish existed, and when harnessed properly it's one of the bigger forces for good we've ever discovered.
That's a fair question, but don't let it suck you into a "false choice" fallacy.
There are plenty of real-world examples of this. In all cases, free trade will make all parties better off on the whole. However, the effect of doing so may be that individuals at the margin lose out, e.g., an unskilled factory worker may find that someone in China is doing what used to be his job. It's pretty well decided now (although not without any controversy) that, at the margin, minimum wage laws increase unemployment in the lowest-paid workers.
The fact that some deregulation may have (localized) negative consequences shouldn't automatically disqualify them: there are more choices than just "let the market run free" vs "continue the regulation". We can, for example, get the benefits of that free trade, and use a portion of the economic gains to finance job retraining programs.
However, I'd also like to point out an implicit assumption in your question that may be problematic. You refer to "the global objective function". Part of our difficulty is that there isn't such a global function that all can agree on. Indeed, it may be that some of our utility functions are mutually exclusive. Many people would say that we should optimize for full employment, but I personally think that's bunk: there are plenty of people who don't want to work, but do so because they need to buy food; they'd rather take care of the kids while the spouse works. The adoption of a single utility function to govern the country (something, it seems to me, that both Conservatives and Liberals would like to see) sells out American individualism, and the diverse lifestyles and values of our people.
Perhaps we misunderstood one another. When I said "without loss of generality", I meant that for almost any conceivable objective function, free markets may not maximize that function. For a social objective like "the weighted average of the self-actualization of all people in their individual ways", a market may be non-optimal. I hesitate to construct an example for fear of getting bogged down in one particular case, but Jerf's efficient pricing of slavery comes to mind. Another might be the well-being of nonparticipants; for instance, habitat preservation for wildlife.
I argue that the only function that a free market can optimize for is the market itself; all other consequences such as happiness, fulfillment, distribution of experiences etc., are side effects which arise from coupling the market to the world via the decisions of participants, regulations, etc. Only if you assume perfect coupling of the market to the global objective is the system morally optimal.
In all cases, free trade will make all parties better off on the whole
This, however, makes it sound like you are assuming perfect coupling in the absence of any regulation, or that your objective function is the execution of the free market itself, and not, say, the well-being of the individuals and societies participating in it. I must not understand you correctly.
Actually, I rather like your proposed objective. Except I'm not sure what you mean by "weighted average": what would be the weighting factor? I realize you said that you didn't want to get bogged down in the function itself, but I think it may be important.
If we can agree that capital is the means by which a person can achieve fulfillment (I don't just mean by "being rich", obviously. It may enable the person to donate to charity; or that person's labor, which which has a monetary value, may achieve some end; or to obtain medical care to cure an ailment; etc.), then I can see an answer.
In the free trade example, opening borders to trade expands the economies of both nations. That's pretty much the same as saying that more capital is available within both nations, which means that -- across the whole population -- people are better able to move up their utility function (i.e., achieve self-actualization). In other words, because money -- capital -- has the power to buy or enable other things, then our positions may be compatible.
Of course, some individuals may benefit more than others, and indeed, some may find themselves worse off. That's where some would claim that we as a society owe compensation to some, to pay for our own gains.
Looking back at what I just wrote, it seems the crux of the argument, then, is the degree to which you can believe that capital can provide the answer to whatever your objective function is.
I'm going to reject the example of a market in slavery. This is the very epitome of a non free market. The slaves themselves are being forced into the transaction, and since a free market, by definition, requires rational actors entering the transaction of their own free will (because they all expect to be better off in the end), it cannot be considered free.
The classic examples of market failure are "tragedy of the commons" problems due to externalized costs, and public goods that would suffer "free rider" problems, like national defense. The externalization problems are due to our legal framework for property rights; a system that fully allocates property rights (e.g., some person owns this river; some person owns the air) would fix this, as demonstrated by the Coase Theorem. The free rider problem is stickier. They do turn out to be much rarer than people believe (e.g., the classic example is the lighthouse, but historical research shows that in the past, these have been provided by markets), but they're not entirely fictional, and I don't have a good answer to the overall question at the moment.
The free market is more force of nature than construct of man, like gravity or a huge river. It can be harnessed, but it will efficiently crush you if you get in its way. It is also like the forces of nature in that it is extremely difficult to successfully harness it when one willfully chooses to not understand it because one does not "like" it, which is why the track record of social systems that start out with "Let's pretend the market isn't a force of nature but that we can will it into compliance with our ideology" tend to fare so poorly in practice; it's hardly any different than assuming gravity won't actually hurt you if you just love hard enough, then trying to get into rocket design. (The problem isn't that you won't get a rocket off the ground with such a plan, the problem is that you will....)