Hayek’s attack on central planners can fit markets too

December 22, 2013 1:37 pm

Hayek’s attack on central planners can fit markets too

By John Authers

Universal approach that could mean funds go to wrong borrowers

Modern financial markets have many critics, and perhaps Friedrich Hayek’s name should be added to the list.The great Austrian thinker is regarded as one of the fathers of free-market economics. But he might have had little truck with the way free financial markets now operate.

That is the contention of the economist Amar Bhidé, of Tufts University in Boston. He convincingly argues that, five years after a financial crisis born of a failure in the mortgage market, we are still not learning or applying the right lessons.

For Mr Bhidé, Hayek’s attack on central planning was an attack on the lack of local information available to central planners when making their decisions. Soviet bureaucrats sitting in Moscow, for example, could not possibly know enough to dictate to farmers in individual fields about how to plant their crops.

Mr Bhidé contends that, similarly, when financial markets are made more liquid, so that they can carry more volume, harmful and distortive homogenisation becomes inevitable. “To make anything liquid, you have to impose on it a certain collectivisation akin to central planning,” he argues. “You have to treat essentially different people as if they are the same.”

Mortgage markets could not be possibly be so liquid if every trader took account of all the factors that make each borrower and each mortgage different, he contends.

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The solution should be to accept a small and illiquid local market for trading mortgages. But instead, banks decided to rely on modelling. “Stick it all into a computer model which has been designed by someone far away, exactly like a central planner, and it spits out a rate for everyone.”

Proposals to reform markets meet reflex opposition because they will dent liquidity. But it does not follow that a more liquid market will produce a better or fairer result. Indeed, liquidity implies less judgment, and less local knowledge.

This insight applies equally well to, for example, foreign exchange, where total global transactions exceed $1,000tn or $1 quadrillion per year – far in excess of the world’s total production each year. Again, computer models, ignorant of local circumstances, have imposed their version of reality on the many countries that now complain of “currency wars”.

Mr Bhidé concedes that liquid markets allowed for the extension of far more credit. But scale in finance is not necessarily a good thing. “Virtually all of the growth in global credit has been based on a system that is not based on the kind of local knowledge that Hayek identified.”

Extending more mortgages – as lenders were encouraged to do – has no merit if they are extended to people with no hope of repaying them, or if they are made at the expense of making loans to small companies needing money. Misallocation of capital has many silent victims.

The most popular line of attack against securitisation is that it splits economic principals from agents: the lenders who decide on the loan lack “skin in the game” because they sell the risk to someone else.

But Mr Bhidé points out that plenty of mortgage brokers and bond traders bought mortgage-backed bonds on their own account. They were simply mistaken.

Rather than force lenders to hold on to more of the loans that they have extended, he says that we should fragment markets once more. As it is, “the mortgage market conjoins lots of individual mistakes and makes it one giant mistake”.

This implies a harsher version of the Volcker rule, which will keep banks out of proprietary trading. Realistically, it is impossible for a bank to have the necessary local knowledge to conduct lending prudently when it is involved in as many different businesses as are today’s universal banks. Mr Bhidé’s version of Volcker would “break out of those banks those activities which simply cannot be prudently undertaken by a public utility”.

He would also “require that all banks be examined for their due diligence of individual credits and risks that they take on their books”.

This is counterintuitive. Liquidity is often presented as a self-evidently “good thing”. But Mr Bhidé suggests that liquid and anonymous markets should be the exception not the rule. As it is, financial markets have been artificially homogenised: “made like copper or tin when in fact they are dealing with claims that are so idiosyncratic that without government support they wouldn’t survive”.

Mr Bhidé’s plans for returning judgment to the economy are solid, even if they carry the risk of triggering institutional upheaval. A good Hayekian can have serious problems with financial markets as they have come to operate.