Leigh Caldwell says that, thanks in part to people’s cognitive biases, markets can fail and so “Government regulation …may be a way of improving how the market works rather than replacing it.” His use of the word “may” is well judged. The fact that decision-making is subject to cognitive biases is not, in itself, an argument for government intervention, because governments can be as irrational as market participants. The notion that the state is rational is as fanciful as the notion that it is benevolent.
Take just five examples.
1. The “fighting the last war” error. Alistair Darling wants banks to hold higher capital assets ratios. This would have been the solution to excess lending. But it deepens our current problem, which is insufficient lending.
2. The availability heuristic. Governments can overweight the significance of rare but salient events, and so over-react. This is what led to the dangerous dogs act.
3. Misperceiving randomness. A related error is to fail to see that freak events are just freaks, and do not require a response. And example of this error was when a convicted rapist won the lottery and then-Home Secretary David Blunkett promised to find ways to ensure this didn’t happen again - oblivious to the fact that the law of probability was a sufficient safeguard.
4. Promoting over-confidence. Leigh gives a good example of this. If the government ensures that customers are better-informed, it might merely encourage them to take risks. I suspect this helped contribute to the mis-selling of financial products such as split cap investment trusts; some consumers, believing the products were regulated, over-estimated their security.
5. Ignorance of less obvious mechanisms. For example, the US’s tacit support for Iraq in its war against Iran in the 1980s helped strengthen and embolden Iraq to invade Kuwait. A less dramatic example is that higher alcohol taxes might promote binge-drinking, not reduce it.
I could go on. My point is merely that there is no guarantee that government rationality can act as a bulwark against private sector irrationality. Indeed, it may be that pressure from the mass media mitigates against the government acting rationally. The choice is not: irrational markets vs. rational government? It’s irrational markets vs. irrational government.
Take just five examples.
1. The “fighting the last war” error. Alistair Darling wants banks to hold higher capital assets ratios. This would have been the solution to excess lending. But it deepens our current problem, which is insufficient lending.
2. The availability heuristic. Governments can overweight the significance of rare but salient events, and so over-react. This is what led to the dangerous dogs act.
3. Misperceiving randomness. A related error is to fail to see that freak events are just freaks, and do not require a response. And example of this error was when a convicted rapist won the lottery and then-Home Secretary David Blunkett promised to find ways to ensure this didn’t happen again - oblivious to the fact that the law of probability was a sufficient safeguard.
4. Promoting over-confidence. Leigh gives a good example of this. If the government ensures that customers are better-informed, it might merely encourage them to take risks. I suspect this helped contribute to the mis-selling of financial products such as split cap investment trusts; some consumers, believing the products were regulated, over-estimated their security.
5. Ignorance of less obvious mechanisms. For example, the US’s tacit support for Iraq in its war against Iran in the 1980s helped strengthen and embolden Iraq to invade Kuwait. A less dramatic example is that higher alcohol taxes might promote binge-drinking, not reduce it.
I could go on. My point is merely that there is no guarantee that government rationality can act as a bulwark against private sector irrationality. Indeed, it may be that pressure from the mass media mitigates against the government acting rationally. The choice is not: irrational markets vs. rational government? It’s irrational markets vs. irrational government.
Obviously there is no "guarantee"; that does not mean that in some contexts there might be a "comparative advantage" for the government that makes it more able to act rationally than the market. The issue should be put in comparative rather than in absolute terms. This is Stiglitz's view, indeed http://www2.gsb.columbia.edu/faculty/jstiglitz/download/papers/1989_Onthe_Economic_Role_ofthe_State.pdf
In general, the state -just like most bureaucratic organizations- is procedure rather than outcome-oriented which makes it a more conservative institution.
Posted by: citoyen | July 28, 2009 at 09:28 PM
he notion that the state is rational is as fanciful as the notion that it is benevolent
Not only no guarantee but almost a guarantee in the opposite direction.
Posted by: jameshigham | July 29, 2009 at 08:21 AM
Thanks for the writeup Chris - you make some good points.
I have responded in more detail to the point about 'how rational is the regulator?' in the following item: http://www.knowingandmaking.com/2009/07/buzz-about-behavioural-finance.html
Posted by: Leigh Caldwell | July 29, 2009 at 05:46 PM
This is just one idea, and perhaps displays no more than my limited imagination. If there are better ideas out there, that amount to more than "implement something called "market socialism" and then - alacazam! - full employment!" then I'd love to hear them. http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html
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