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The limits of markets: Spreading risks in an uncertain worldBy: Procyon MukherjeeThe last decade saw unprecedented changes in the functioning of the financial markets,whether they operated ‘freely’ and ‘fairly’ is a matter of debate, but the denouementshave little room for debate as to the nature of the implications on policy actions for thefuture. The spate of innovations in these markets were triggered by the need to findinstruments that could systematically deal with risk and simultaneously create anenvironment where growth could be maintained in a large portfolio of stocks in aneconomy that had reached maturity and that had long ceased to be local. But the effectsof risk and its temperance through the innovation was more a creative destruction of thehuman psychology that challenged the limits of ‘bounded rationality’, as framed by thethesis of Kahnemann and Tversky.Recently I chanced on this example of risk taking while driving on the highway, wheretwo drivers shared a car. When the question came to sharing the effects of speedingviolations made by each driver, the risks taken by each driver increased under thecondition that fines were to be shared than under the condition when each wasresponsible for his own action and therefore for the violation as well. This is a slightdeviation from the original Kahnemann-Tversky model that proved that we are more risk prone when it comes to fending against losses, while risk averse when it comes toderiving benefits from gains. This example tends to prove the point that when risk isshared between participants then people become more risk prone than when they werealone to shoulder risk, the precise model followed by the investment banks in spreadingthe risk through the introduction of the credit default swaps and creating a product thatcould be traded in such a way that it left the trails completely rootless to the origin, abrilliant recipe for disaster as the world saw in good time.The maturing of re-insurance market and its growth in the last decade attractedinnovation in the form of other hedge instruments like the credit default swaps thatworked in a slightly different manner than re-insurance. While re-insurance worked in aregulated environment, CDS worked in an unregulated territory (thanks to theCommodity Futures Modernization Act 2000) and the former depended on Law of largenumbers to hedge risks by setting loss reserves and counter-balancing, while the latterthrived on offsetting with other dealers and transactions in the underlying bond market.But the Midas touch of innovation lay in the fact that owners of insurance contracts hadto have an interest in the product in form of ‘owning’ the debt for example, whereas forthe buyer of a CDS does not need to own the underlying security or other form of creditexposure; in fact the buyer does not even have to suffer a loss from the default event(Mark Garbowski (2008-10-24). "United States: Credit Default Swaps: A Brief InsurancePrimer" …"like insurance insofar as the buyer collects when an underlying securitydefaults ... unlike insurance
, however, in that the buyer need not have an "insurable interest" inthe underlying security". The unregulated environment of CDS made any amount of exposurepossible as Lehman and AIG underwrote due to lack of transparency which hastened theirdemise, but it would be interesting case study to understand the market forces that failed to act
 
when the risk was being multiplied in a common pool of transactions where many participantswere acting as counter-parties as guardians of risk.The failure of the market to act in good time is an indication of the limits of markets wheninformation is imperfect, the very subject on which Stiglitz or Akerlof got their Nobel. But thefrenzy that such market behavior helped to proliferate and exude through a range of productsstarting with stocks, housing, and other assets and commodities, is a matter of deep introspectionthat many have started to delve into. My enquiry would be limited to two defining questions:
1.
 
If markets have limits and there is need to intervene, as in the case of recent deluge of bail-outs, how does the future look like for markets in general and financial markets inspecific terms?
 
2.
 
If savings balances investment in U.S. in form of housing and stocks, and the severeshortfall in savings is balanced by the flow of ‘outside’ money into U.S. how does U.S. inabsence of long term leading indicators of economy exude the confidence that itsgovernment deficit of earning over spending not have implications for future generationsliving in depravation while the present enjoy partial benefits?I would try to delve into the first question by framing the first puzzle: If markets are free howcould we create giants in the likes of GM and Chryslers who were not efficient by any standardand were not the best in terms of customer satisfaction, but still were able to grow bigger andbigger every year by either creating barriers that were engineered to stop entry of competition intheir segments or were based on invisible subsidies that the tax payers were unable to see, butwere forced to dole out that replaced the pool of funds that could have been otherwise used togrow the economy? The growing of the big and the shrinking of the small cannot be explained soeasily by the invisible hand of the market, as the market is supposed to work on the principle of efficient allocation of available resources aimed at maximizing gains for the sum total of all theparticipants, not partially for some while worsening for the whole.Partial benefits for some while increasing losses for the entire pool of consumers is a more recentstudy, empirical observations can be relied on as follows:Investment banking example: The giants created by Wall Street in the likes of Investment Banks:Goldman Sachs, Morgan Stanley or Meryl Lynch raises the obvious question if markets createdthem did they generate value for the whole? How do we measure this value for the whole society?What are the metrics to be used?The answer to this question is perhaps yes, they did add value for the whole, because they createdproducts and services and opportunities that did not exist before and thus create enormous wealthfor the society, for example they created the whole paradigm of mergers and acquisitions thatconsolidated industry players, they helped companies to trade in block shares and create wealth,they insured risk and thus created opportunities for people to take risks that could create wealth,they themselves returned money on equity to the extent of fifty percent thus creating wealth forthe existing shareholders and the list could go on. But at the same time when they createdproducts for the market that over-leveraged various asset classes in the market they multipliedrisks and that in unregulated territories brought in severe distress to the markets. The marketsthrough the self correcting mechanism did bring in parity by the de-leveraging process, but it
 
wasn’t through the natural mechanism that we are so familiar with but through interventions of the government and the Federal Reserve and at great peril to many participants in the market.Automotive Example: Creation of giants by the markets (left to themselves !) is a debatable topic,at least in the context of the North American market, since for many years these markets were onprotected turf and only recently when the world became more a level playing field the situationdramatically changed. If choice is limited and trade is restricted through visible or invisiblemeans markets would only allocate inefficiently and the participants in the market would throughan asymmetric transmission generate value for some while neglecting the same for the rest. Thebest example is the power of large GM with market shares so huge that every rule by the book could be written to their advantage starting from garnering mortgage rates to dealer discounts toname anything that matters. Unfortunately all that really mattered was the product itself and theservice whose decadence missed the reality check by the markets that apprised them, the financialmarkets in particular and the time delay in response saved the day for GM for a very long time.The increase in the power of the financial markets to influence the ultimate fate of corporations isa more recent phenomenon, with the worldwide web providing a unique opportunity forincreasing transactions that increases activity and speed that increases the ability to take positionsthat would have been otherwise impossible to achieve. The double digit growth of the financialmarkets in the last decade dwarfs the pale 5% growth of the pharmaceutical market or even lessfor the rest of the markets. But the ubiquitous nature of power of intervention to preside over theother markets is quite a recent phenomenon. With 18% of U.S. GDP being linked to the Financialmarkets and with the plethora of products that channelizes money from all over the world intothese markets, the power is hardly to be questioned, but the nature of market forces that modulatedemand and supply into these markets leaves many questions unanswered. With large part of theinformation flow being in the hands of some of the participants, and with the problem of Giantsand Goliaths playing the game of dice that would chart out the destiny, the denouement is aforegone conclusion; the giants win in most occasions, while Goliaths make big wins in allrareness.The low long term interest rates provided the icing on the cake for the financial markets to thrive.The housing boom was orchestrated with innovations on credit default swaps, the surge in stockscame from the euphoria about the future that the real economy failed to stimulate. But themarkets had limits to self-correct. In fact it took a quite a protracted period of gloom to stabilizewith foreclosures and bankruptcies to correct, which could have been corrected without thesehappening had the markets had the intrinsic ability to proactively change the course of movements that are unsustainable. The greater emphasis on indicators that are surreal (thefinancial markets have a special fondness for such indicators) and the rapid innovation in this areagives us the nature of direction in which Financial markets want the rest of the markets to move.The firms that have not gone public and whose shares are not traded on the stock exchangeperhaps have fared far better in the recent downturn, as they did not have to mirror themselves forevery action to find how the markets responded, not on their products but on the various metricsthat the financial markets decided to measure them with. The generation of wealth and its erosionhowever did not happen in an equitable manner and the spoils were never shared amongst theparticipants. Even in this example there is reason to believe that the power of big over the smallprevailed.So in the final analysis there can be no doubt that markets are limited in their scope when itcomes to self-correction, as the world is entrenched in a myriad of products and services thatcould influence us in a million ways, but fail to create symmetry. If supply would find its own
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