[OPE] Flaw in Free Markets: Humans

From: Jurriaan Bendien <adsl675281@telfort.nl>
Date: Sun Sep 13 2009 - 06:03:44 EDT

Flaw in Free Markets: Humans
Published: NYT September 12, 2009

THERE is broad agreement that Alan Greenspan, the former Fed chairman, was
wrong to have believed that market forces alone would insulate society from
excessive financial risk. But Mr. Greenspan was wrong for reasons very
different from those offered by his most vocal critics. Those critics fault
Mr. Greenspan for having overestimated the strength of competitive forces, a
point he essentially conceded in Congressional testimony last fall. But the
financial crisis was not caused by a shortfall in competition. On the
contrary, it was fueled by competition's growing strength.

Adam Smith's theory of the invisible hand, which says that market forces
harness self-serving behavior for the common good, assumes that markets are
competitive, and most markets have in fact become more competitive over
time. Today, if an opportunity exists anywhere in the world, information-age
entrepreneurs can seize it more quickly than ever. The invisible hand,
however, requires not just strong competition but also two other
preconditions. The economic models that spawned Mr. Greenspan's former
optimism simply assume those conditions, despite compelling evidence of
their absence. First, those models assume that rewards depend only on
absolute performance, but in the real world, payoffs are often tightly
linked to relative performance. When a valuable new piece of information
becomes available to the investment community, for example, the lion's share
of the gain goes to whoever trades on it first. For an individual firm like
Goldman Sachs, it is thus completely rational to invest millions of dollars
in computer systems that can execute stock trades even a few seconds faster
than others. But rivals inevitably respond with similar investments. Taken
together, these expenditures are wasteful in the same way that military arms
races are.

A second problematic assumption of standard economic models is that people
are properly attentive to all relevant costs and benefits, even those that
are uncertain, or that occur in the distant future. In fact, most people
focus on penalties and rewards that are both immediate and certain. Delayed
or uncertain payoffs often get short shrift. (...) Many experienced analysts
had warned for years that those derivative securities were vastly
overpriced, but Mr. Greenspan assumed that prudent concerns about the future
would prevent investors from taking foolish risks. Real investors faced a
tough choice: continue earning high returns from mortgage-backed securities,
or move their money to safer vehicles and watch their friends and neighbors
pass them by.

Full: http://www.nytimes.com/2009/09/13/business/economy/13view.html?hpw

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