I’m sure you have heard of the water scarcity in California, and many are saying that there should be a ‘free market’ for water. In Australia, more autonomy has been given to the water users and this has allowed the farmers to survive severe droughts while protecting the environment. That doesn’t mean to say though, that the government is idle. Its help is still needed to ensure efficient functioning of the market and to step in and manage in the case of any unintended consequences of trade.
Arguing against the call for a ‘free market’ for water, John Whitehead said,
The water market will never be a “free market” in the true sense of the word. A plea to the water authority (i.e., government) to price water more rationally is a plea for policy reform towards a better use of incentives. Free markets only exist when there is no government regulation of buyers and sellers, no taxes, no subsidies and no nothing. An efficient free market for water is a difficult thing to pull off since it is a common-pool resource. It is easier for the pizza market to operate efficiently since pizza is a private good…. “Free Market Environmentalism” played a key role in my early thinking about Coase and environmental economics too. My conclusion was that free market solutions wouldn’t work. Call me an unserious (inserious?) economist.
What is a common pool resource or CPR? The Wikipedia definition is that it is a type of good consisting of a natural or human-made resource system (e.g. an irrigation system or fishing grounds), whose size or characteristics makes it costly, but not impossible, to exclude potential beneficiaries from obtaining benefits from its use”. And because it is a common good, certain considerations must be taken to ensure that the usage is equitable, efficient and environmentally sustainable.
Perhaps I should have mentioned at the beginning that the purpose of my bringing up the water market is not to expand on environmental economics and scarcity, but to entertain a little thought experiment. Putting aside all minute objections, what if we consider the financial market as a system, a common pool resource?
Two reasons why: firstly, it is a resource system with multiple direct and indirect beneficiaries, including society as a whole. Secondly, there is a concern of sustainability and stability when we talk about the financial market – either as technical issues, for instance, liquidity, volatility, banks and contagion effect, default risk and many others, or as societal issues or externalities such as inequality, fraudulent behaviour, unfair trading and more.
From “Water Markets in Australia: A Short History”, to ensure that property rights to access water are secure, the elements of water market design should be such that:
- there are low barriers to entry and few impediments to trade
- there are low transaction costs
- the market participants are well informed
- the market participants take account of all the costs and benefits generated by their actions (that is, any externalities are internalised)
Drawing from these points for the water market, lets examine whether we have the elements of a good design for the financial market.
On one hand, trading costs are no longer a problem. The rise of electronic trading have greatly pushed down the cost. The large number of funds, including ETFs has democratized access to low cost diversified portfolios. Looking from this view, transaction costs for participating in the financial market is low and becoming lower still.
On the other hand, with regards to barriers to entry, certain areas of the markets are only available to those with deep pockets, e.g. hedge funds, venture capital funds, individual overseas stocks, to name only a few.
Following on to the next point, are the market participants well informed? Undoubtedly an efficient market is only possible with perfect information. What this means is that any publicly accessible information should almost immediately be priced in – but is this so in the real world? How prevalent is insider trading? While HFTs continue to make a living from being a few milliseconds faster, regulations and rigorous enforcement of disclosure and insider trading rules have created a reasonably level playing field.
And so we come to the last point, which is the main reason for this article. Do market participants take account of all of the costs and benefits generated by their actions, that is, are all of the externalities internalised?
What happens when externalities are not internalised? Perhaps the most prominent failure here was the financial crisis where very thinly capitalized banks were playing a game of heads I win, tails you lose. The Volcker rule was written to prevent deposit insurance to be abused again in future.
What other externalities should we consider? What other financial practices are destructive to the ecology of the financial environment? What about that London trader who moved the market from a small suburban house? Or that Barings guy in Singapore?
In addition, should the risk to the financial ecology brought on by a particular instrument be subjected to a form of Pigouvian tax? (That would be interesting, wouldn’t it? Sadly, not measurable nor doable in my opinion but maybe the bank balance sheet charges in the UK could be classified as such).
Another potential source of free-riding with unintended consequences is the rise of trend following trading. While value investors and market makers are a calming element in the market as they bet on reversals (buy the dip, sell on euphoria), momentum investors pile in on trends and exacerbate movements up and down, leading to increasingly violent reversals as nobody wants to be the greater fool. This increases volatility, which could in the long run increase the cost of capital, hurting the market ecosystem and the economy in the process.
With regards to the societal costs, should we consider pensioners, one of the vulnerable beneficiaries of these financial instruments, as a special group in designing or regulating the market? Should the issue of inequality be considered, i.e. have the rich access to the more sophisticated tools of the market? What about in the event of a major market crash, which strata of the society will bear the most loss and should we care?
Maybe in this instance, my opinion runs similarly to that of Robert Shiller, where he said that he is neither ‘free market’ nor a Keynesian. In his latest book with Akerloff, “Phishing for Phools”, they wrote, “competitive markets by their very nature spawn deception and trickery, as a result of the same profit motives that give us our prosperity”.
To my mind, the answer never lies in heavy market interference, the role of policy makers are not to act like a spigot that turns the water tap on or off at will, but rather as a sift, or a water filter that takes out the undesirable sediments, the filth that may make the water less drinkable for the general population.
Thus yes, stocks and bonds and numerous other instruments may be private goods, but it would be prudent to view our collective financial markets now and again, as a common good from which we all as beneficiaries drink from.
Therefore, these markets should be designed:
- with stability in mind for the confidence of the participants, and
- with a serious concern for sustainability – not only for our future (retirement) needs but also for our future generations that should reap the fruits of today’s investments.
Then and only then, may we avoid what can become the tragedy of the commons.