Free markets may manipulate our thinking…

Prof. George Akerlof explains his recent book coauthored with Prof Robert Shiller. The book is called Phishing for Phools—The Economics of Manipulation and Deception.

He says free market equilibrium may not be the best thing:

Tong: Phishing for Phools argues that manipulation and trickery play a significant role in free markets. Could you elaborate on that?

George Akerlof: The book is based on conversations with Danny Kahneman [Economics Nobel laureate in 2002] some 25 years ago. In a conversation then, Danny told me that the basis for psychology was that humans are machines that are prone to error. The job of the psychologist is to ferret out that error. In contrast, he said, the basic, fundamental notion of economics is equilibrium. That equilibrium means that if there is a profit left on the table, someone will take up that opportunity for profit.

Danny’s insight says that free markets will not just provide what we really want. That is only the case if those human machines make the right choices. But free markets will also provide us with dysfunctional choices as long as there is a profit to be made.

These principles mean that if we have weaknesses in the equilibrium, the weakness will be exploited if there is a profit to be made. Among all those business people looking around and deciding where to spend their investment dollars, some will look to see if there are unusual profits to be made from our weaknesses. If they see such an opportunity, that will be what they choose.

As a result, economies will have a phishing equilibrium. That is an equilibrium in which every chance for profit more than the ordinary will be taken up. And that will include businesses’ willingness to provide us with the wrong choices.

The problem has been markets are hardly allowed to work for free, There is way too much indirect intervention. The alternative of govt deciding is mostly worse.

He says why each crisis is the same and takes on credit rating agencies:

Tong: According to Phishing for Phools, financial crises are the same each time. Why is that?

Akerlof: “Phishing for phools” in financial markets is the leading cause of financial crises resulting in the deepest recessions. In the 1920s it was Swedish matches (think Ivar Kreuger of Kreuger and Toll); in the 1990s it was the dot.coms; in the 2000s it was subprime mortgages (think Angelo Mozilo of Countrywide).

Every time, the stories are different; the entrepreneurs are different; their offerings are different. But, also, every time it is the same. There are the phishermen; there are the phools. And when the built-up stock of undiscovered phishes (named “the bezzle” by John Kenneth Galbraith) gets discovered, asset prices crash.

As an example of this phenomenon, the book traces the role of poor credit ratings as the epicenter of the financial crisis of 2008. It looks at the history (and economics) of how the ratings agencies built up their reputations over the course of almost a century—until economic incentives changed. In the old days of relational banking, those who sought the ratings wanted them to be accurate; they would not take their business elsewhere if the ratings happened to be low. But when the financial industry became more competitive, low ratings would result in loss of business for the raters (and also for those who sought them). Yet the security-buying public still depended on the ratings for purchasing assets. These dynamics created a phishing equilibrium in which mortgage-backed securities were systematically overrated. When this was discovered, we had the crash.

He does not add why these CRAs remain so prominent? They remain the soothsayers of world economy and keep warning govts to get their act right. Who are the CRAs to tell anyone this after having goofed up and without much apologies.

Phising the Phools is likely to continue as this is how people are. We have really short memories and keep making the same mistakes..

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