There is obviously much more to the full understanding of the current
financial crisis, but the root is this conflict between the genuine social value
of increased variety and spread of risk-bearing securities and the limits
imposed by the growing difficulty of understanding the underlying risks imposed
by growing complexity.
Here is more. Arrow, of course, has long been interested in issues of complexity and computability, even though his work is within the usual neoclassical confines. One way of putting the point is that starting a new market creates a negative externality on other people by eroding their knowledge and understanding of context and thus limiting the general ease of economy-wide transparency. I’m not sure this is true (we usually think of the extra market as adding knowledge), but it is an interesting way to categorize current problems.
Thanks for Arrow’s sentence. He correctly points to the great dilemma posed by risk sharing (and I’d add to why markets will never be complete in Arrow’s neoclassical world).
I disagree, however, with your comment about the imposition of a negative externality on other people. Please read Hayek and Sowell again and ask Jim Buchanan about what he wrote about externalities 40/50 years ago. It doesn’t make any sense to think of markets as keepers of the status quo–any transaction implies new knowledge and therefore it erodes existing knowledge.
I was under the impression that the innovation was in unregulated (and thus unstable, unsafe) areas of finance. The new financial problems have originated in these unregulated areas not because of unfamiliarity, but because they were unstable.
No amount of information about risks prevented bank panics before regulation. Why should more information make these new, unregulated financial instruments safe?
People don’t have to buy into these new products.
You don’t have to play the negative externality game. The banks that didn’t play (or limited their play) are sitting pretty, even though the government is FORCING them to give up equity stakes to save face at the other banks.
This is Warren Buffett’s main lesson- don’t lose money. Know what you own. Circle of competence. You don’t have to swing, wait for a fat pitch. etc. etc. etc. Of course, Buffett is rich because people will never learn this lesson.
I was taught (way back when) that markets are, ideally, only the conduits of information. It’s when the message comes solely from the medium (“The only thing we had to know about these swaps was that someone else would buy them…”) that trouble arises… Then we’re both feet in the realm of “animal spirits.”
Just an unrepentant classicist’s view…
Talebs hits Economists hard . . . .
http://www.youtube.com/watch?v=ABXPICWjFIo
The extra market cannot “add knowledge.” It adds a new information input. This is where Hayek’s conception was incomplete. The prices don’t “mean” anything valid, UNTIL they are responded to and adjusted by demand. For you to help compose demand, you need to bring some knowledge which comes from outside the market.
In the words of Herbert A. Simon, “What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention, and a need to allocate that attention efficiently among the overabundance of information sources that might consume it.†
And in addition to “information overload,” there’s also “narrowing of attention.” This is a long-term change because of the continuous specialization of work in the economy. It narrows the area of each person’s expertise, and it is narrowing further and further in each new generation (unless occasionally, some disciplines are synthesized.)
For example, none of us has the time to learn everything that is necessary to thoroughly understand ALL of the following: climate change, complex financial securities, wildlife extinction, the crisis in medical care. So we rely on experts and agents.
But, if the rest of us don’t have enough information competence to evaluate them, and the results of their shoddy performance many do real damage before it can be corrected, then we need regulations regarding their competence and responsibility. So, Milton Friedman’s arguments about licensure were also incomplete.
I would argue that a ‘new’ market opens new possibilities too. Paraphrasing Arrow there is a process of learning-by-participating in the market or being involved in it. This may explain why people who was not involved in the subprime market may feel so hard to grasp the intricacies of derivatives and financial instruments.
Also, these financial instruments are valued subjectively and lately these valuations have become more and more pessimistic.
If there was a great proportion of people investing (or financing their house) in this ‘new’ market and at the same time trusting in the specialized knowledge of brokers. We may have the case that if these brokers are still experimenting with these financial instruments, then the effect of learning-by-participating in the market is amplified at an increasing rate of propagation from the ‘specialists’ to the non-specialists. The latter may be specializing or discovering in which specialist to trust.
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