"The Most important First Step is to Limit Leverage"

Update: Here is a link to the discussion (it's in the comments to the post).

I will be hosting a Firedoglake Book Salon for Robert Frank's The Economic Naturalist’s Field Guide today from 2:00 - 4:00 PST, and this column touches upon several of the topics likely to come up in the discussion (I'll add an update with a link to my opening comments when it begins, questions are encouraged and can be entered in comments at the link I'll provide):

Flaw in Free Markets: Humans, by Robert H. Frank, Commentary, NY Times: There is broad agreement that Alan Greenspan ... was wrong to have believed that market forces alone would insulate society from excessive financial risk. ...[C]ritics fault Mr. Greenspan for having overestimated the strength of competitive forces, a point he essentially conceded... But the financial crisis was not caused by a shortfall in competition..., it was fueled by competition’s growing strength.

Adam Smith’s theory of the invisible hand, which says that market forces harness self-serving behavior for the common good, assumes that markets are competitive... The invisible hand, however, requires not just strong competition but also two other preconditions. The economic models that spawned Mr. Greenspan’s former optimism simply assume those conditions, despite compelling evidence of their absence.

First, those models assume that rewards depend only on absolute performance, but ... payoffs are often tightly linked to relative performance. When a valuable new piece of information becomes available to the investment community, for example, the lion’s share of the gain goes to whoever trades on it first. For an individual firm..., it is thus completely rational to invest millions of dollars in computer systems that can execute stock trades even a few seconds faster than others. But rivals inevitably respond with similar investments. Taken together, these expenditures are wasteful in the same way that military arms races are.

A second problematic assumption of standard economic models is that people are properly attentive to all relevant costs and benefits... In fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift. ...

During the recent bubble, unregulated wealth managers created mortgage-backed securities that enabled investors to magnify their returns through financial leverage...

Many experienced analysts had warned for years that those derivative securities were vastly overpriced, but Mr. Greenspan assumed that prudent concerns about the future would prevent investors from taking foolish risks. ...

Wealth managers faced a tough choice..., many customers would desert them if they failed to offer the higher-paying, but riskier, investments. Managers also knew that if markets turned against them, penalties would be limited by the fact that almost everyone had been following the same strategy. The resulting collapse was all but inevitable.

Memories are short. Immediately after a severe flood, most people are reluctant to build on a flood plain. But land on flood plains is cheaper, and the prospect of short-term advantage quickly lures many to abandon their caution. That is why many jurisdictions adopt strict regulations against building on flood plains.

The same logic dictates regulation to limit the damage caused by financial bubbles. The ... most important first step is to limit leverage. ... Relaxed regulation and increased competition now confront investors with temptations that growing numbers of them are ill-equipped to resist.

Alan Greenspan’s erstwhile faith in the invisible hand notwithstanding, it was never reasonable to have expected market forces to protect society from the consequences of this risky behavior.