I recently read a book called The Soros Lectures, which is a compilation of a series of lectures given by George Soros at the Central European University.
In short –
Individuals are boundedly rational (we are insufficiently equipped to deal with the complexity around us). The decisions we make are in the background of this bounded rationality. He calls it Fallibility.
The actions of individuals have consequences. Since these actions are based on imperfect information (bounded rationality) the outcomes are divergent from what we hoped. These outcomes further complicate the environment we make decisions in. He calls it Reflexivity.
The collection of these sub-optimal decisions and their consequences are in essence the market.
“Individuals are boundedly rational and the collective representation of their bad decisions is the market.”
So essentially he talks about how the efficient market hypothesis is flawed because it assumes players to have perfect information and making decisions that will converge to a consistent equilibrium.
I am inclined to share his skepticism. The markets have time and again displayed that they are not the best judges of value creation. To rephrase, the markets are blind to bubbles and other inefficient allocations of resources.
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Does that mean I support a state controlled economy? Not yet. The way the crisis of my age has played out, it has become evident that the Markets and Governments are constituted by the same set of imperfect (boundedly rational) participants. Neither is able to identify and channel resources towards areas of long term value creation (neither am I but at least I don’t feign competence).
Long term value creation: this phrase has a bad rep. It has been abused in too many “strategic” presentations. I want to clarify – If you invest 100 Rs in a venture that can give you returns over 5 years to increase the value of your investment to 120 Rs (in real terms) we call it an investment with a ROI of 20%. Now when this ROI is sustainable – i.e. not generated by artificially inflated asset prices, artificially generated demand etc… I call it long term value creation.
Long term value provides real utility for the producer and the consumer. A house sold to an unfit consumer during a real-estate bubble creates dis utility when the fairy-tale is over and is not characteristic of value creation.
A market participant will characteristically look to invest resources that give him an ROI. A regulator should ideally be able to create a structure where the market participants automatically use their energies towards activities that create sustainable ROI (Long term value).For example banks will lend against a house as collateral because they see a tangible ROI based on rising prices. Governments need to mandate 40% home-owner equity to prevent irrational lending practices.
In Tarzan speak – “Markets for ROI, Governments for Sustainability”
So to get to my point – A free-market system with minimal regulation is the lesser of the 2 evils.
Market participants take a personal risk in the generation of ROI and hence will be as efficient as possible. They may falter when it comes to sustainability which is why we need a government for gentle course corrections. The government does not seem capable of anticipating sustainability and can only provide remedial recourse when it is violated. Eg: ‘Quantitative Easing’
Government agencies are essentially promising to create an environment that fosters sustainable ROI .
- There is a principal–agent problem. The money they are experimenting with is public money. So even if ‘quantitative easing’ does not work, there is no skin lost for the government machinery. The public is saddled with higher taxes.
- There is no objective mechanism to measure the performance of the government (long term value creation is admittedly a little abstruse). Obama can promise that ‘quantitative easing ‘is the better option (versus austerity) and there would be no way to test his hunch.
- There are no incentives for our leaders to truly worry about the value creation in the long term. How does it matter to Bush or his predecessors today, that the US is plunged into a recession because of financial regulations during their regime?
While governments are not bad, it is essential to recognize that they are as fallible as markets and are probably not equipped for a task as complex and ambiguous as Long term Value creation. Therefore my skepticism towards a purely state-controlled economy.
To rephrase an article I read – government debts are a ponzi scheme which allows present governments to lend with the promise of greater value tomorrow. The ponzi hopes to expand at best till we actually make a breakthrough (technological/economic) or at least till the next political successor.
“When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having being fairly and completely paid.” – Adam Smith from the Wealth of Nations