Why financial systems need regulation - and the economic Libertarians are wrong

In yesterday's column I explained the importance of incentives to our economic system. But humans are not like rats in a laboratory responding to simple incentives like food pellets. Rather, we are complex and we relate to incentives in a subjective way.


As a result, humans are capable of misunderstanding what will happen as a result of their behavior.  A person may think:

• "if I do A then I will get B" 

but the reality might be that 

• "As long as C or D don't happen and if I do A then I will get B"

These sorts of complexities are very common, and very difficult to understand for even the most knowledgeable person. 


In the perfect world of the theoretical economist, everyone would have perfect knowledge of the system and all of the current information. If that is not hard enough, it's also assumed that everyone will make completely rational decisions.  The economist even named this perfectly rational person "homo economicus" (the economic man). Nobody has ever met him!


So, back in the real world. There is far too much data for any person to understand. There are far too many interactions for any person to grasp. And to make matters worse, some humans cheat, corrupt, steal or are simply unskilled at their jobs.


And this is why financial systems need effective regulation - our markets just are not transparent enough. It's simply impossible. 


The free market libertarians reading this are jumping up and down right now in outrage. They want an unfettered system where the market will regulate itself. I'm sorry, but it is just a bad idea. 


To support my case, take a look at the Australian and US financial regulation systems.  In Australia, the system is regulated by the "three peaks" - ASIC, APRA and the Reserve Bank, in concert with the Treasury.  In the US, the system is regulated by a disconnected collection of state and federal bodies.  As a result, all of the Australian financial system is effectively regulated.  That includes banks, other mortgage providers, public companies, property markets, insurance companies... Whereas in the US, the regulations are looser, with many gaps.

If regulation is unimportant, and the market can self regulate, then it shouldn't matter.  But it does. Take a look at how the sub-prime housing market was able to get out of control in the US, compared with Australia. Over 14% of mortgages in the US were sub-prime at the peak in 2006, whereas Australia had around 1%.

And then, what happened next? The loans went very bad in the US, and kick started the global financial crisis. As there weren't so many of them, they didn't go nearly so bad in Australia.

Unfortunately, around the world there are many more examples of financial systems suffering due to poor regulation.  Another great example has been the failures in the Irish system, resulting in frauds, overcharging of consumers and bank bailouts by the public.


So, what's this got to do with ordinary people, incentives and the free market?

Well, "If I am confident that C or D won't happen, I will try to do A so I can get B".

But if I can't trust the system, because nobody understands the rules or plays by the rules, it will provide me with an incentive to abandon the system, and do something else, outside the legal, free market.

Effective regulations in our financial system are good for everyone. Letting the free market run wild is not.

Let me know what you think

Mark S

If you want to read some more, try these links:
ASIC: The integration of financial regulatory authorities – the Australian experience
Reserve Bank: A Comparison of the US and Australian Housing Markets, May 2008
APRA - www.apra.gov.au
US Govt Accountability Office: Financial Regulation...
Financial and Energy Exchange Group

The free market does more good than harm - for proof, see China

After writing a couple of items about the socially liberal half of the blog's title, today's column focuses on the economic rational side.

So, let's start with my main premise - the free market does more good than harm.
And ... The main benefit of the free market is INCENTIVES.

Source: Wikipedia

A quick aside. My academic training is in Psychology. That means I have a good understanding of what makes people behave the way they do. One of the main drivers of behavior is the expectation of a personal reward - we call it positive reinforcement. Positive reinforcement works for people, rats, and every animal in between. If we receive something that we want, in return for doing something, then we will respond, and do it. In most cases, positive reinforcement is more effective than punishment - offering an incentive is more powerful than issuing a threat.

These reinforcements, or incentives, are at the heart of the free market system - it allows personal rewards to be offered to individuals in return for certain behaviors that are valued by others. The incentives inspire action. If I do something that the market wants, I'll get something I value in return. This simple process unlocks many powerful forces - creativity, innovation, design, production, technology, and more.

The free market is often criticised, particularly by those on the economic left of the spectrum. They would favor a system that focuses on the collective rather than the individual. That is, a socialist system. From a social perspective, this is underpinned by the ideal of treating everyone equally within a society. However laudable that goal is, from an economic standpoint, it just doesn't work.

So, to make this point clear, let's look at the most compelling chart that shows the benefit to economic systems that have moved from socialist to free market.

Chart source: Wikipedia

The big one of course is China, and the statistics are compelling. China is now the world's second largest economy - and all of the growth has occurred since the shift to a market economy.

Incentives drive economic activity. By and large, this is a very good thing.


Let me know what you think.


Mark S

Social policies and economics must work hand in hand - we don't want to turn into Zimbabwe

Why do social policies matter?
Isn't it just all about the economy?
If a country has a weak economy, won't it just be in poverty and make all of the social policies irrelevant?

I understand the logic behind this line of thinking - but it is really a convenient excuse for some countries to ignore the well-being of their citizens, and ultimately it is flawed logic.

To explain, let me quote from the "Commission on the Measurement of Economic Performance and Social Progress" set up by French President Sarkozy in 2008. This body is better known as Stiglitz-Sen-Fitoussi, who are the Commissioners, and it is assisted by a "Who's Who" of the world's economic and social policy experts..


It should be obvious that no single number can summarize anything as complex and variegated as “society”. But, inevitably,  certain numbers – in particular GDP – have taken center stage ... such a number may be misleading if it were applied to all purposes, and especially as a broader measure of societal performance. 


Measurement of “present” economic performance also includes an assessment of “quality of life”. Quality of life includes the full range of factors that make life worth living, including those that are not traded in markets and not captured by monetary measures. While many of our measures are directed at ascertaining short-run movements in the level of market activity ... the time has come to make a clear move from measuring production to measuring welfare, to try to close the gap between our measures of economic performance and widespread perceptions of well-being.

So here we have some of the world's leading economists explaining that it's not just all about economic measures.  Quality of life measures do matter, and quoting Stiglitz et. al. once more "...what we measure shapes what we collectively strive to pursue - and what we pursue determines what we measure."

For a stark piece of evidence, take a look at this chart of Zimbabwe's Human Development Index.  When Mugabe's land policies were implemented in the late 1990s, in combination with his human rights abuses, it hurt everyone.  The economy declined rapidly and the country's performance on social measures was easily the worst in the world. The social policies were a major factor in what hurt the economy.

Social policies impact on the economy and the economy impacts on society and quality of life. They both matter.


Let me know what you think.

Mark S

What's this whole socially liberal and economic rational thing?

Over the long weekend I've spent some time talking about the position I have on social and economic issues over several glasses of wine and whisky.  So, I thought, why not start writing about what I talk to people about.  And given that I've titled this blog SocialLiberalEconomicRational, that seems like a fair place to start.

A good place to begin is to briefly explain what it all means.  In the media, you hear a lot about the left of politics and the right of politics.  Those terms really refer to economic positions.  The far left are the socialist approaches to economics - they are not in favor of free trade, and strongly favor social welfare.  The far right are in favor of the free market, in everything including social welfare.  Those who call themselves 'libertarians" (especially in the US, like the Tea Party) are economic libertarians on the far right.

But what gets left out of these conversations is attitudes to social issues.  I'm an extreme social libertarian, not an economic libertarian.  A good way to find out where you are is to take one of these little political tests.  The world's smallest political quiz is pretty good, even if it is sponsored by the economic libertarians.  The red dot shows where I sit on that spectrum. It's ironic that this labels me as a Liberal, given that in Australia of course the Liberals are not liberal at all.

Another good test is the political compass.  This is a bit longer, and has the economic left-right and social up-down axes.  You can see that I sit in the same spot on this test as on the first one - so that gives some credibility to both measurements.





What's interesting about this test is that they have mapped some world political leaders on the grid as well, so you can see where you sit. Kevin Rudd and Gordon Brown are still on the chart - but you get the general picture!  I'm closest to the Dalai Lama and Nelson Mandela. There are a lot of people who are like me, but look at where all of the politicans are - they are nowhere near us.

What's also important is the shift over the past few decades.  The major parties have all shifted towards being more socially conservative and economically right.  If you want to read more about the patterns, based on UK data click here.

So, this is the heart of my blog.  Socially liberal, and economically rational people like myself and the Dalai Lama are not represented in our current democratic system.

Let me know what you think.

Mark S