Wisdom Dawns on the Importance of Market Liquidity

I've been crying myself hoarse for years about the need for liquid (i.e., competitive) markets. A free market does not mean a laissez-faire market. It means a market that is guaranteed to be liquid, with plenty of buyers and sellers, and with no player large enough to influence prices through its actions alone.

The recent noises emanating from the Obama administration are a welcome indication that this lesson has been learnt. The world has paid - is continuing to pay - a very heavy price for the state of market illiquidity that has resulting in some players becoming too big to fail.

Someone rightly said that if a company is too big to fail, it's too big to exist.

We need aggressive antitrust, not just in the interests of fairness, but in the interests of our very survival. I hate to argue by pandering to practicality over principle, but that seems to be the only argument that works. Monopolistic and oligopolistic markets are unfair, but that doesn't seem to bother people. Monopolistic and oligopolistic markets can lead to systemic collapses that end in a deep recession - that probably gets more people to take notice and act.

The European Union recently acted boldly in fining Intel over a billion Euros for abusing its monopoly in computer chips. We need more such action against all monopolies, not only other IT monopolies like Microsoft but its counterparts in every industry.

By keeping markets liquid, we keep them healthy and our livelihoods safe.

The Current Financial Crisis - My Biggest Fear

So Congress rejected the bailout plan, the markets reacted by (what else?) crashing, and now the world is waiting with bated breath to see what happens next.

This being an election year when the contest is particularly close, truth can safely be expected to be the first casualty. The name-calling and one-upmanship between the candidates and their parties has already begun.

There is great temptation on the part of everyone involved in the debate to take the path of maximum populist appeal. The unanimously agreed villain of the piece? Deregulation. The solution? Lots of regulation.

Aaarrrrgh!

So now the answer is to control, stifle, smother and shackle the economy so it can't collapse? You poor sods, now you've really done it!

No one can recommend the free market in the current climate without being booed, it appears. The free market (taken in the sense of an unregulated market) has now been blamed for all the world's ills. Yes, the lack of controls has been a major culprit, but it wouldn't have been such a killer if the market had been truly competitive. The collapse of a few players wouldn't have developed into the market-threatening crisis that it has now become.

In the process of blaming the free market, I fear we may be walking away from the one thing that can get us out (and forever keep us out) of this kind of mess - a free market! And my regular readers know that when I say "free market", I mean a liquid market. A market with plenty of competition. Because freedom for me does not carry the petty meaning of a freedom without restrictions. It means a freedom that cannot be taken away. Only liquidity (the inability of any single player or small group of them to influence the rest of the market) can protect the freedom of all players in the market. To enjoy freedom, we need to (paradoxically) accept the constraints demanded by freedom, i.e., the guaranteed powerlessness to unduly influence others.

I think we should start using the phrase "liquid market" or "competitive market" instead of "free market" from now on. The term "free market" has been tainted, ironically because the financial markets weren't really free but highly illiquid and oligopolistic with a few very large and powerful players who operated without the checks on their behaviour that a competitive environment would have naturally provided. It's no use trying to educate people about what the term "free market" should really mean. In the aftermath of a systemic collapse, no one wants to hear what would appear to be hair-splitting or intellectual sophistry. People cannot now be convinced that a free market is the solution we need and not the problem.

I think we need to start characterising the problems of the last few years as an "oligopoly", an "illiquid market" or as "cronyism". Any and all of these terms would be an accurate description. And we should then point to "liquid markets", "competition", "transparency" and "accountability" as the answers, rather than "regulation".

Competition provides most of the regulation we really need. All we need to do is ensure that our markets stay competitive.

Regulation by government bodies is important and has its place, but knee-jerk legislation mandating more regulation will exacerbate the problem. Complexity hinders transparency.

Will the wisdom of crowds see through the current round of election-sozzled name-calling and understand what the economy really needs?

I'm hopeful, but not optimistic.

My Economic Philosophy - 7 (The Place of a Welfare State in a Capitalist Economy)

(This is the seventh of n pieces on my emerging economic philosophy called Liquidism.)

The Welfare State has always been synonymous with Socialism and generally viewed as incompatible with Capitalism. This belief has polarised opinion along rather simplistic lines, between those who favour government support for the needy, and those who believe that all economic decisions should be made by "market forces" (a term that implicitly excludes the government). And then there are the pragmatists who believe in a mixture of the two, unencumbered by any ideology.

I have evolved a different view, and my philosophy not only provides an ideological basis for the pragmatic approach but also lays down clear guidelines for how big the Welfare State can be.

I have written about what is known as the "Australian model". From a social perspective, the Australian model is a wonder of the modern age because it manages to reconcile a capitalist economy with elements of a Welfare State, such as state-subsidised healthcare and social security. From a purely economic perspective too, the Australian model is a wonder because it has managed to deliver 17 straight years of growth while the rest of the world reconciled itself to the "inevitability" of periodic recessions.

What's the secret?

The economic model is no big secret. It lies in responsible government spending that yields a (growing) budget surplus and thereby refrains from provoking the inflation that unfailingly follows deficit financing. As a bonus, the budget surplus delivers flexibility in investing for the future (the Future Fund) and acts as a cushion against economic shocks. The secret also lies in an alert central bank that promptly raises interest rates as inflation rises and lowers them when the economy slows. These two levers of the economy, when prudently applied, maintain conditions of low inflation, low unemployment and uninterrupted growth.

Of course, the Australian economy could do with even greater efficiency, and this can only occur when the oligopolies in its various markets are broken, but that is not the topic of this post.

Returning to the social perspective, how does Australia manage to be a successful capitalist economy while also supporting aspects of a Welfare State? Even if it works (as it clearly does), isn't there at least a theoretical contradiction between the two?

My answer is no, there's no contradiction, because the perceived dichotomy between a Welfare State and a capitalist economy is false.

It leads back to the fundamental definition of "freedom". If freedom is taken to mean the untrammelled freedom of individuals to act, only constrained by the rights of other individuals and with no "controls" by external authorities, then every act of government (as a player in the market) is seen as a violation of freedom. The model of a "free market" by this definition of freedom is a laissez-faire system where government does not interfere with the functioning of the market, either as a regulator or as a bulk consumer.

If, however, freedom is seen as something that must be guaranteed never to be taken away, then some controls are inevitable. The model of a "free market" by this definition of freedom is a liquid market with a large number of buyers and sellers, where no single buyer or seller (or a small group of them) can significantly influence prices or the stability of the market as a whole. Actions by government violate no principles as long as the market stays liquid.

And this explains the seeming paradox of a Welfare State within a capitalist society. By itself, government action in a market is neither good nor evil. The crucial question is whether such action breaks one of what I would call the three pillars of the economy (a balanced budget, the right level of money supply and healthy levels of competition in the market).

The Welfare State is an example of government spending. Is this a legitimate activity in a market economy? In a democracy, government is an agent of the people in a legal sense, and so government spending on behalf of the people is really no different from individuals spending their own money. The various mechanisms of democracy ensure that the agency of government spends the money of its principal (the people) in a way that serves the interests of the principal. I believe that government spending in a functioning democracy is legitimate, as long as it does not lead to a budget deficit.

(One could argue that government spending that leads to a deficit budget is also legitimate because in a democracy, it reflects the will of the people. I disagree, because deficit budgets in effect borrow from the future. They are inflationary, and they rob our descendents of wealth. Our children, grandchildren and unborn descendants do not have a vote, even in a democracy. We have no right to rob them of their wealth without their consent. And so government spending has legitimacy only as long as the budget stays balanced.)

The constant demand by "free-market" advocates to privatise social security seems pointless to me. I can't see any economic reasoning behind it, merely an ideological one stemming from the dubious definition of freedom as an absence of external controls.

So how large should the Welfare State be? As large as the budget allows. The government is a consumer on behalf of the people, and like any consumer, should live within its means. "Free-market" advocates tend to criticise "big government", but to my mind, the problem is not "big government" but "irresponsible government". I say, if the government has the revenue to sustain a large Welfare State without running into deficit, then go for your life! There are no absolute limits (in dollar terms) to the size of a Welfare State. The only limit is the size of the budget.

So in my opinion, there is no contradiction between a capitalist economy and a Welfare State. Those who start off with an inferior definition of freedom ("no controls on individual freedom") exhibit a knee-jerk opposition to any action by government, which seems a bit silly to me. To those who define freedom as something that cannot be taken away, it is obvious that there are clear-cut principles that determine what governments can and cannot do. As long as the Welfare State abides by those principles, its proponents need not be apologetic or defensive about its existence.

We can have our cake and eat it too.