(Dt. Sunday, March 9, 2008)

A New Perspective on the Role of Markets in an Economy

This article is organized into three sections: I. Introduction II. Examples III. Concluding Remarks.

I. Introduction

The struggle between two economic theories -- communism and capitalism -- occupied the major part of the history of the twentieth century. One of the main differences between these two philosophies is the role of the individual in a society. Communism took a totalitarian approach in which the freedom of the individual was largely subordinated to the needs of society. Moreover, capital was not to be allowed to accumulate in private hands, but was to be explicitly devoted to the good of all society. Whereas capitalism, especially in the form promoted by the Chicago school of economics, held that the individual was to be provided with the maximum freedom and that in a law-abiding society, the individual only needed the mechanism of the market to interact with the rest of society. The view of the capitalists was supported by two strong beliefs. Firstly, the Renaissance ideals of liberty, equality and fraternity, which emerged from the cradle of the Protestant Reformation specified clearly that the individual was to be provided with the resources needed to pursue his/her own learning, labor and pleasures. Secondly, Adam Smith's Invisible Hand hypothesis argued that the markets would by themselves lead to the best outcome for society, if only the government did not interfere.

The history of the twentieth century shows that the countries that adopted communism failed economically, rather drastically. As a result, by the end of the twentieth century, almost all the countries in the world have adopted the market mechanism, with varying degrees of conviction, for determining prices and other conditions of trade. Of course, in the meantime, work of economists on the asymmetry of information (notably George Akerlof, Michael Spence and Joseph Stiglitz) had taken into account that in many situations, the two parties involved in the trade in a market have unequal information about the object that is being traded. One of the implications of this analysis was that it was not necessary that the markets would be either stable or fair under the influence of an Invisible Hand. This paved the way, from a theoretical point of view, for the role of government in regulating the functioning of the markets. These government regulations are to be determined in a democratic way in modern times, and thus political studies once again played a very important role in economics, like in the nineteenth century. In particular, the problems in economics could not be settled in a purely mathematical way. Professors Paul Krugman and Joseph Stiglitz are two famous examples of economists playing active roles in the political system in recent times.

On the other hand, the grand consensus that had emerged at the end of the twentieth century about the indispensable role of markets in the economic life of a nation has made it imperative to gain a clear understanding of exactly what a market is. In the broadest sense, markets appear to be a natural biological instinct. The video footage on Discovery Channel of Emperor penguins assembled in Antartica in huge colonies to find mating partners during their reproductive season and to breed successfully in extreme climates, is clear evidence of it. For several thousand years, humans have been utilizing the market mechanism for such common daily pursuits as vegetable markets, or before that, barter trade.

It is generally accepted that it was Adam Smith that first developed a theoretical foundation for the role of markets in the economic life of a nation. In his analysis, the role of markets was to ensure perfect competition among the sellers to help in determining the optimal price of the object that was traded. A century later came the Marginal revolution, under which the major factors in valuing a product is its marginal utility to the buyer and the marginal cost of production to the seller. The price of the product, which was determined by the aggregate demand and supply in the market, then determined the production level. More recently, economists have studied the influence on the economic situation brought about by asymmetry of information between the two parties involved in the trade. Additionally, from the time of John Maynard Keynes, economists have tried to find theoretical explanations for market behavior based on the behavioral psychology of the individual players. Since the 1940s, economists have also relied on techniques from game theory. Statistical techniques and time-series analysis have been instruments for gauging the functioning of the markets for a long time now. Finally, in recent decades, stochastic calculus and Monte-Carlo methods have been used for modeling market behavior.

In all of these developments, the assumption has always been that the interaction between the buyer and the seller is instantaneous (some exceptions are described in the examples below). No matter that the buyer and the seller had different information about the product, or that they had different propensities for the risk involved in the transaction, the transaction itself is considered to happen instantaneously. However, in the examples that I have given below, such an assumption does not seem to reflect reality adequately. In fact, it appears that when the object being traded is only of moderate value then the transaction can be assumed to be instantaneous without loss. However, when the trade is worth, say, billions of dollars, then the duration of the transaction invariably becomes a significant factor.

II. Examples

My proposal for research is to consider the influence of the duration of interaction between the buyer and the seller on the functioning of the markets. I have listed the following examples where such a consideration could be meaningful:

1. Housing Mortgage Markets: The recent mortgage crisis, which has forced many financial institutions to take write-downs in billions of dollars, has brought to light the fact that millions of householders had been sold on mortgages about whose risks they did not fully understand. Looking at it from my perspective of duration, one sees that the householders expected to enter into a commitment over the long term -- up to thirty years. Whereas once the mortgage was signed, the seller (typically a neighborhood bank) was free to slice and dice the value into much smaller parts and sell it to other financial institutions which then traded them on Wall Street at high volumes using computerized trading. Now, one of the problems here is that to make the sale sweeter, the institutions selling the mortgages to the householders suggested that they could take advantage of the low medium-term interest rates that were prevailing at the time of purchase of the house, say five years ago. As a result, the householders invariably chose to go with mortgage rates which were variable during an initial period, after which they would switch to the fixed long-term interest rate. However, after five years, the initial period of adjustable interest rate has got over, and households find that the long-term interest rates have gone up so much in the meantime, that they could not afford to switch to the fixed rate prevailing today. According to the seller of the mortgage, the transaction was done five years ago, at an instant, and the seller is out of the picture having sold off the mortgage to other parties. Thus the market mechanism was adopted in this case without due consideration for the duration for which the transaction should have been considered open.

2. Capital Market Liberalization: East Asian crisis in the late 90s highlighted the vulnerability of free markets to the destabilizing effects of short term speculative capital. Before the crisis, proponents of free market ideology recommended opening up capital markets totally without any restrictions to the flow of capital into and out of the country. In retrospect, some considerations about the duration of the capital investment in the country's financial markets from foreign financial institutions would have served as a stabilizing influence.

3. Political Elections: The election of political leaders in a democratic country can be seen as a market (an auction market). The candidates usually go through a long period of campaigning, in which they interact with the voters. This interaction leads to better appreciation of the candidates by the people, and reciprocally, to better appreciation of the people's problems by the candidates. Thus the duration of interaction is an important factor in the selection of the best candidate here. However, at present, an economist would only have tools like theories of social choice, or game theory, or public policy, or behavioral psychology, or statistics to explain the selection process. None of these tools would consider the duration of interaction to be a determining factor. I note here, as an aside, that in recent times psephologists have gained some measure of expertise in predicting the results of an election a couple of days in advance. In spite of our lack of knowledge about the precise nature of democratic elections, these processes have been the best mechanism for due considerations of the problems of the people.

4. International Relations and Trade: Economists have been interested in exchange rates and international trade for many centuries. However, the methods they employ to determine the relative values of currencies would only take instantaneous information on the demand and supply of currencies. There is no mathematical framework for incorporating the robustness of the relationship between the countries. Yet the appearance of strength in the political and historical relations among a group of countries has gone a long way towards determining the long-term value and the stability of their currencies. I must make a disclaimer here that some ad-hoc theories of stochastic calculus have been used to model exchange rate mechanisms. In particular, the concept of martingales could account for the changing dynamics of the exchange rate over time in a probabilistic framework. However, these theories would only be effective if the probability distribution of the risk involved is known a-priori. Such assumptions are too stringent, since political relations and trade between countries are hardly probabilistic in nature.

5. Warranty of Purchase: While I was explaining these ideas to my wife, she pointed out to me that warranties of purchase provide a means for extending the duration of a transaction. A buyer of a car has a warranty for a certain period, which holds the manufacturer of the car as liable for any repairs during this period. This is an example where the risks of the transaction, which are not known in a deterministic manner at the time of purchase, is nevertheless more equitably shared by extending the duration for which the transaction is kept open. Here the nature of the risk (probability distribution) can be inferred a-priori from statistical data of previous sales, and hence the manufacturer can calculate the expected value of the warranty at the time of selling the car.

6. Interest on Loans: The time value of money is an example where duration is indeed taken into account in a financial transaction. However, it seems to be an extremely deep question why interest should continue to compound at exponential rates on large sums of money over long periods of time. That said, on small amounts (relative to the borrower’s income), money has been lent at exponential rates for ages and a whole industry has subsisted for these financial transactions for the purpose of their precise calculation. Moreover, in recent years, the institution of micro-finance has been shown to have beneficial effects on poor countries, thanks mainly to the work of Dr. Mohammad Yunus. Now, financial analysts have been somewhat successful in modeling the probability that a borrower would return the loan using stochastic analysis, time-series and some statistical techniques. However, all of these techniques assume that the nature of the risk is known before-hand. For example, due to changes in public policy or natural disasters in the future, if the interest rates have to change, it would be nearly impossible to know the probability distribution of the risk. This unpredictability has often led to money lenders charging exorbitant rates of interest in the rural areas in poor countries and has been a major cause of large-scale poverty.

7. Financial Derivatives: Derivative instruments can be employed to simulate an extension of the interaction between the buyer and the seller. For instance, if the buyer would also buy an option on the security, it provides him/her a safeguard against the vicissitudes of the value of the security. Again, this is made possible because one knows a-priori the nature of the risk involved. For example, it is a reasonable assumption that in a Western democracy the price of a stock would follow geometric Brownian motion. This assumption makes it possible to calculate the price of a call option using the Black-Scholes formula. Another point to note is that derivative instruments have no prejudice against the speculator or the hedger. A hedger may buy an option to safeguard his/her investment. Equally well, a speculator may use the relatively high leverage of derivative instruments to make a quick killing. Both these players have been known to be integral to the market for ages and financial derivatives do not prefer one over the other.

III. Concluding Remarks

Examples 1, 2, 4 provide instances where consideration of duration of interaction between the buyer and the seller in a market could have provided better insights and possibly avoided drastically unfavorable outcomes. Examples 5, 6 and 7 provide instances where the duration has already been partially taken into account to provide a better outcome. Example 3 is an instance where the best mechanism is adopted, in spite of our lack of theoretical knowledge about its functioning. Also, I note here that whereas the examples on housing mortgages and financial derivatives mentioned above show that the market mechanism does not show any preference for the hedger or the speculator, my proposal for having an extended duration of interaction would mean that the hedger is preferred somewhat more than the speculator.

In a capitalist country, the scope and application of the concept of a market is constantly being extended. Markets for new commodities and financial instruments are frequently being created. It is this dynamic nature of the market mechanism that makes it important to obtain a clear definition of the concept of a market. If markets were static and the settings they could be applied were fairly standard, then the intuitive understanding that people possess of the concept of a market would be sufficient.

It is my understanding that Karl Marx was the first person to have pointed out the subtle asymmetry in the exchange of goods for money -- whereas money can be transferred instantaneously, there are usually many unsolved implications when a property or a loan or commodity is transferred. Marx’s solution was to completely eliminate the market, and have the State prescribe the price, liquidity and supply. One should note here that Marx’s approach completely relies on the instruments of law to solve an economic problem. Even in a capitalist country, if the market mechanism fails, for example, in the case of bad debts, bankruptcies, or severe economic conditions like unemployment, inflation or stagnation, then the only recourse is to turn to the legal framework. The crux of my proposal is to enable the market mechanism to solve more economic problems on its own, before the necessity of going to a legal court or public policy arises.

My research proposal can also throw some light on the recent debate about how much capitalism and democracy are related and whether they are essentially independent. The example of the rapid growth of China in the last twenty years having adopted free market policies even while maintaining a strict communist form of government has served as the main motivation for this debate. If one views the defects of the current usage of the market mechanism from my perspective of duration of interaction between the buyer and the seller, then one could get some new insights about how far capitalism can go without democracy. In particular, the example of political elections in a Western democracy mentioned above, shows that a large part of the risks and uncertainties regarding the economic performance of a country are sorted out in the public debates during political elections, which allow for an extended interaction between the people and the candidates. This serves as a compensation for the fact that markets, as understood currently, exchange objects instantaneously. The robustness of the political system provides some compensating assurance to the risks of such instantaneous exchanges in the market. In the absence of such a political system, the successful functioning of the markets in China owes a large part to the a-priori success of free market policies in the West and in East Asia. That said, one must also note that China has a recorded history that goes back over five thousand years, and that Chinese society had been organized as an empire for most of its recorded history. These facts also contribute to the fact that Chinese society has functioned efficiently as a single economic unit in recent times.