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Kenneth Arrow gets a sentence
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.
Posted by Tyler Cowen on October 16, 2008 at 07:29 AM in Economics | Permalink
Comments
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.
Posted by: E. Barandiaran at Oct 16, 2008 7:46:29 AM
Chris Blattman links to this from Paul Krugman:
You might have supposed that the process would have been more or less linear: as European knowledge of the continent advanced, the maps would have shown both increasing accuracy and increasing levels of detail. But that's not what happened. In the 15th century, maps of Africa were, of course, quite inaccurate about distances, coastlines, and so on. They did, however, contain quite a lot of information about the interior, based essentially on second- or third-hand travellers' reports. Thus the maps showed Timbuktu, the River Niger, and so forth. Admittedly, they also contained quite a lot of untrue information, like regions inhabited by men with their mouths in their stomachs. Still, in the early 15th century Africa on maps was a filled space.Over time, the art of mapmaking and the quality of information used to make maps got steadily better. The coastline of Africa was first explored, then plotted with growing accuracy, and by the 18th century that coastline was shown in a manner essentially indistinguishable from that of modern maps. Cities and peoples along the coast were also shown with great fidelity.
On the other hand, the interior emptied out. The weird mythical creatures were gone, but so were the real cities and rivers. In a way, Europeans had become more ignorant about Africa than they had been before.
It should be obvious what happened: the improvement in the art of mapmaking raised the standard for what was considered valid data. Second-hand reports of the form "six days south of the end of the desert you encounter a vast river flowing from east to west" were no longer something you would use to draw your map. Only features of the landscape that had been visited by reliable informants equipped with sextants and compasses now qualified. And so the crowded if confused continental interior of the old maps became "darkest Africa", an empty space.
Of course, by the end of the 19th century darkest Africa had been explored, and mapped accurately. In the end, the rigor of modern cartography led to infinitely better maps. But there was an extended period in which improved technique actually led to some loss in knowledge.
Between the 1940s and the 1970s something similar happened to economics. A rise in the standards of rigor and logic led to a much improved level of understanding of some things, but also led for a time to an unwillingness to confront those areas the new technical rigor could not yet reach. Areas of inquiry that had been filled in, however imperfectly, became blanks. Only gradually, over an extended period, did these dark regions get re-explored.
Posted by: bunbury at Oct 16, 2008 8:21:50 AM
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?
Posted by: Mike Huben at Oct 16, 2008 9:01:10 AM
I don't even think Arrow has to invoke externalities. Creating a new market creates information costs even on market participants, although in a "normal range" the benefits from specialization tend to outweigh the information cost. And Tyler's objection pretty much amounts to an argument that dI(M)/dM > 0 for all M, which goes against everything we know about production functions and about transaction costs.
Posted by: ogmb at Oct 16, 2008 9:21:06 AM
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.
Posted by: Andrew at Oct 16, 2008 9:32:18 AM
The quote from Krugman sort of gets to the nub of the problem.
New technology of ships and trading mapped the coastlines with a much higher degree of accuracy, while the old technology of caravans in Africa retained their relative inaccuracy. Information in economic is monetization which is required to measure the aggregate performance.
So, we reached a point in which the round-off error of sea trade was equal to the value of the African interior, and the interior was abandoned.
Why non-linear?
Capital value is estimated from the series of economic transactions over time. If you double your precision in measuring capital value, then your sequence of economic transactions goes up 2log2, a partial power law. Efficient market theorem tells us that all economic measurements seek the same precision in the aggregate.
Africa could not meet this standard with interior caravan trade, and so caravan capital value was estimated at the ports, monetization ceased in the interior. Contrast this with America, where rail roads began to criss cross the country to meet the new standard of precision.
Estimation theory and market efficiency theorem combine, estimation theory adding a second constraint on markets. The constrain of estimation theory makes the economy jump from one configuration to another, quantum jumps.
Each configuration is meant to arrange the sectors such that they all more or less measure with the same precision, or they are abandoned as uncertain entries in the balance sheet.
Posted by: MattYoung at Oct 16, 2008 9:35:44 AM
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...
Posted by: TD at Oct 16, 2008 9:45:38 AM
I have now read Arrow's column in The Guardian (the sentence is in the last paragraph of his column). I suggest to read it because Arrow does not make any reference to externalities and market failures (references to market failures are made in Thoma's comment on Arrow's column and to which Tyler links for Arrow's sentence). Arrow knows what he's talking about--his column is an excellent summary of the extension of general equilibrium theory to deal with uncertainty. Both Thoma and Tyler attempt to elaborate on Arrow's sentence but they misconstrue its meaning.
Posted by: E. Barandiaran at Oct 16, 2008 9:57:05 AM
Talebs hits Economists hard . . . .
http://www.youtube.com/watch?v=ABXPICWjFIo
Posted by: at Oct 16, 2008 10:35:37 AM
"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."
I'm not sure about this, but it wouldn't surprise me if it were true.
The problem isn't solely that banks (commercial and investment) were engaging in risky instruments; the problem is that this riskiness was compounded due to heavy leverage.
Either the capital & leverage ratios need to be carefully monitored by the boards and shareholders (who really need to be far more active in general) or more regulation needs to be introduced.
Posted by: meter at Oct 16, 2008 10:45:41 AM
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.
Posted by: Lee A. Arnold at Oct 16, 2008 11:12:10 AM
I googled
kenneth arrow complexity
to learn a bit more and the first link that shows up is this post. Wow!
Posted by: londenio at Oct 16, 2008 11:20:18 AM
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.
Posted by: Pedro P Romero at Oct 16, 2008 2:35:25 PM
Arrow's analysis is pretty symptomatic of what is wrong with equilibrium economics. If you start off with perfect knowledge and work backwards it will take you fifty years to work out the bleeding obvious.
My preference is for Minsky's analysis, but I can't believe no-one has cited Coase on this problem. Read pages 8 - 10 of Coase's The Firm the Market and the Law eg:
"If the traditional markets of the past have diminished in importance...new markets have emerged of comparable importance ...I refer to commodity exchanges and stock exchanges....All exchanges regulate in great detail the activities of those who trade in these markets...It suggests...that for anything approaching perfect competition to exist, an intricate system of rules and regulations would normally be needed....they exist in order to reduce transaction costs....When the physical facilities are scattered and owned by a vast number of people with very different interests...those operating in these markets have to depend on the legal system of the State."
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