Filters and The Financial System

Chris Dillow published yesterday:

Standard Econ 101 tells us that, under some circumstances, free markets filter in activities which maximize efficiency and consumer welfare and filter out sub-optimal ones.

However, these circumstances are not ubiquitous. Nick Bloom and John Van Reenen have shown (pdf) that there are “a large number of firms who appear to be extremely badly managed” – which means that actually-existing markets don’t wholly filter out inefficiencies. In their new book Phishing for Phools George Akerlof and Robert Shiller describe how, markets select not for welfare-enhancing behaviour but for “manipulation and deception.” And we have several models – ranging from Akerlof’s market for lemons to Tervio‘s talent markets and Witte’s survival of the unfittest theory – which show that markets can filter in bad products, mediocre employees and lucky bluffers rather than filter them out.

However, inadequate or counter-productive filters are not just a problem in some markets. They are also a problem in hierarchies. The Dilbert and Peter principles (pdf) tell us that firms promote incompetents, in part because managers lack the ability to spot ability.

My point here is partly to remind us of the old truism that there is failure in markets as well as governments. But it’s also to endorse points made recently by Arnold Kling and Dani Rodrik. Economics, they say, should not be (just) about model-building but model selection….If we were serious about improving markets and the state, we would focus much more upon the question I began with. We’d ask of particular markets and state functions: what behaviour is filtered out and what in, and how can we improve these filters? I fear, though, that the bad filters which select against good policy-making prevent this question gaining the prominence it deserves.

Pablo Picasso, 'Bull - plate 1', December 5, 1945 (lithograph)
Pablo Picasso, ‘Bull – plate 1’, December 5, 1945 (lithograph)

Markets evolve over time. Long gone were the days when Venetian brokers carried slates with figures of sales to meet their clients, and with the prevalence of electronic trading, we are seeing the demise of the pit of brokers with their hand gestures. FinTech or financial technology means software is now king. In addition, investing themes have developed to include value, growth and lately, momentum, not to mention even more advanced quantitative models. Risk management has become far more sophisticated and has moved from an afterthought to an integral part of most financial processes. Globalisation has meant that international markets react to each other’s fortunes almost instantaneously.

Over time, there have been both active and passive selections of ideas, associations, methods, technology, rules and regulations that allowed our markets to prosper. This leads me to consider the importance of natural selection in ensuring the survival of the species. Darwin wrote,

Can it, then, be thought improbable, seeing that variations useful to man have undoubtedly occurred, that other variations useful in some way to each being in the great and complex battle of life, should sometimes occur in the course of thousands of generations? If such do occur, can we doubt (remembering that many more individuals are born than can possibly survive) that individuals having any advantage, however slight, over others, would have the best chance of surviving and or procreating their kind? On the other hand, we may feel sure that any variation in the least degree injurious would be rigidly destroyed. This preservation of favourable variations and the rejection of injurious variations, I call Natural Selection.

In essence, there are many kinds of filters, but the idea is to let some things through and some things out. A filter does not even have to be in the form of market regulations, but also in the form of a good market that gets rid of bad ideas. A well-functioning financial system not only depends on the efficiency of flows, but also on an Efficient Market Selection, a set of filtering mechanisms used by both the markets and policy makers to guide the evolution of the markets towards efficiency.

Borrowing the phrase, “rejecting injurious variations” from Darwin, we are no longer as Adam Smith wrote, “It can seldom happen, indeed, that the circumstances of a great nation can be much affected either by the prodigality or misconduct of individuals; the profusion or imprudence of some being always more than compensated by the frugality and good conduct of others”.

Bernie Madoff, Enron and multiple other duplicities bear testimony that the actions of the few these days can be very costly to the many. In addition, it’s not only the duplicity of market participants but also through the complexity of financial contracts that we include undesirable elements into the markets. This strengthens the case for filters in the financial markets.

In a recent post I stated the following:

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.

Embedding filters adds complexity, whereas the freedom to market requires simple rules and few restrictions. The ideals of parsimony balancing the necessity of filters should be the uppermost concern because complexities are costly. Therefore, the design of good filters should be deliberated, but this then brings to mind the question of what makes good filters?

Therein lies the difficulty. Here, we are trying to fix a rigid network of filters into a financial system that is one half moved by cold profitable calculations and the other half by unpredictable, irrational and even fraudulent behaviours. Even equipped with the understanding behind the motivations of market participants, predicting each and every junction of market interactions the filters should exist at requires extensive research and diligent monitoring. Is this even possible?

In addition, it is time we think of the various parts of finance as forming a whole ecosystem. No more slap-dash solutions addressing one particular problem, but rather a comprehensive overview of how one filter might interact with another, how the consequences of one filter might bear out at a later time needing yet another filter to moderate the unintended effect.

Pablo Picasso, 'Bull - plate 5', December 24, 1945 (lithograph)
Pablo Picasso, ‘Bull – plate 5’, December 24, 1945 (lithograph)

The Desirable Attributes

Post-filters, what are the end products that we would be content with? Markets that are “free” and “frictionless” certainly come to mind, “fair” too is another word that we can include here.

Fairness comes down to two main elements: information (e.g. possession, distribution and dispersion of, insider/outsider) and rights and responsibilities (e.g. of shareholders, directors, advisors, corporate, funds, banks). A fair market that ensures their spread continues to inspire confidence in the rationality of financial activities. Such a market ultimately creates a positive feedback mechanism that links back financial markets to the underlying fundamentals.

Innovation in finance is a sign of a healthy market. Market filters should not be so rigid as to not recognise the need for flexibility and adaptability in the evolution of finance. Hence, “flexible” is another word that we should add to the compendium.

An example of how good intentions can go too far is what happened in the aftermath of Enron. Legislators created the Sarbanes Oxley act, which massively increased the compliance burden on public companies and included criminal penalties for managers. It is surely no coincidence that the number of listed firms has decreased from a peak in 1996 and that companies such as Uber are delaying listing until much later (if ever), therefore depriving ordinary investors of potentially extraordinary gains (privileged investors still get their early access).

While reliable accounting information is vital to the functioning of markets, here is an example of an overzealous “filter” that clearly shows how such a construct can limit freedom and increase friction. However, one could also argue that this helped restore faith in accounting standards and was at least temporarily useful, but perhaps like many branches in the evolutionary tree, some should die off.

Delicate Membranes

Filters are necessary in the evolution of our financial markets. There is a fine line between keeping out ideas and practices which are harmful and yet, not stifling the activities as well as market innovations at the same time. An underlying philosophy of filters should be that they retain and promote markets that are free, frictionless, fair and flexible.

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