Friday, September 24, 2010

Economists stunned

(Translated from "Les économistes atterrés")

Some French economists published recently a very interesting manifesto ("Economistes atterrés"). I signed it.

The crux of their argument is as follow: while the market for consumption and investment products converges towards their equilibrium prices due to the interplay of supply and demand, conversely prices of patrimonial assets (financial products, buildings, stocks of raw materials) diverge.

On this latter market, a price increase fuels the anticipation of a higher price in the future ("it goes up, so it will continue to rise"). The hope of a capital gain causes an increase in demand that still increases the price, until the anticipation turns ("it has risen too far, it's not going to continue"). Then the price collapses, crosses the equilibrium price without stopping and decreases until a new turn of anticipations ("it has dropped too much, this decline will not continue").

Hence the price for patrimonial assets undergoes large oscillations, while for consumption or investment products an increase of the price is moderated by a decline in demand (except perhaps for luxury goods).

*     *

Therefore it was insanely dangerous to let go of the reins of the financial market and to entrust the de facto financial institutions (banks, insurance companies, pension funds, investment funds, rating agencies etc.) to manage the economy. Yet this has perseveringly been done for several decades.

The "économistes atterrés" describe the consequences of this policy and offer a healthy alternative.

But they do not answer an obvious question: why the hell was this policy implemented ? Everyone knows that financial markets are very volatile. In a famous passage in the General Theory, Keynes explains how to make a fortune playing the stock market: one has to observe the behavior of other players and to anticipate their decisions, regardless of the "true value" of the stocks.

Why on earth did one accept some dogmas which were obviously false: "markets are always right", "information is perfect", "finance controls the risks" and so on ?

*     *

I will advance an argument which is familiar to the readers of this site: I think that this blindness was a corollary of the computerization of the economy.

Some explanations. In 1975 the economy was destabilized by the oil shock. Oil has so far provided a convenient and cheap energy which promoted economic growth, and suddenly the price of this essential ingredient of prosperity became high and, worse, its volatility made all forecast uncertain.

In order to overcome this difficulty, one had to find a new resource, and precisely at this time was information technology ready. While PCs, local area networks and the Internet did not exist already - they were soon to arrive - time sharing and clusters of terminals were available to the users and made computing much more convenient than in the 60s. Then further progress - lower cost, higher performance, ubiquity, mobile computing - reinforced this contribution.

Banks and insurance companies were, among the businesses, those which used IT the more quickly and completely. But with all the opportunities, computerization brought also dangers which were less apparent.

I think - this is for me a plausible assumption - that the policy of Ronald Reagan, president from 1981 to 1989, as well at that of Margaret Thatcher, prime minister from 1979 to 1990, would not have been exactly the same had not the computerization offered such opportunities. Computerization is certainly not the only cause of these policies, but it was the material cause that made them possible - such as, in the eighteenth and nineteenth centuries, industrialization was the material cause of urbanization, class struggle, imperialism and wars all the more devastating than the destruction was itself "industrial".

*     *

From 1975 emerged a new technical system based on microelectronics, software and the network. Experience acquired under the previous technical system, which was based on mechanics, chemistry, oil and electricity, did not help to explore the new continent that became opened to action. Managers, politicians, institutions were then seized simultaneously by the drill of discovery and by a disarray.

Temptation to speed up was strong because there was a lot of money to be made immediately. On a world market which had just been globalized by the network, algorithms allowed to identify arbitrage opportunities much more quickly than before, to automate transactions, to diversify indefinitely "derivatives" products.

Resulting complexity was a challenge for judgment and control, but it procured such profits that the best strategy, so it seemed, was to thrown overboard caution and controls and to go still further, faster, in the unleashing of financial innovation.

Then finance put pressure on the others sectors of the economy. Companies were subject to an untenable profit requirement, the best students were attracted to the trading floor with extravagant salaries, executives believed in the dogma of "shareholder value", distribution of wealth became increasingly unequal.

However one had to "laisser faire", to let it go always more and always faster. The governments of Europe adhered to the neoliberal dogma with the faith of illuminated extremists - hence without caution nor moderation. Public services were cut into pieces, open to competition and privatized, free trade was imposed without exception, globalization (favored by the lower transportation costs that allows computerization) encouraged, wages compressed. Jobs became scarce and eventually the inevitable crisis occured.

The "économistes atterrés" are right to denounce that, but they would have been more right if they went back to the material cause of the phenomena they report: the change of the technical system caused by computerization. It is very difficult for them, I know (see Nature and us)...

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