Friday Interview: The Malign Hand of Financial Markets | Eastern North Carolina Now

   Publisher's note: This discussion on free markets with Dr. John Staddon, James B. Duke professor of psychology and professor of biology and neurobiology emeritus at Duke University, is an excellent Friday Interview here today on the Carolina Journal Radio.

Duke's Staddon documents 'insidious' forces guiding Wall Street actions

    RALEIGH     Anyone who has spent much time studying economics has heard about the "invisible hand," a concept tied to the classical economic notion of the power of free markets to improve our lives. But Dr. John Staddon, James B. Duke professor of psychology and professor of biology and neurobiology emeritus at Duke University, has written a book about a much less praiseworthy force. The book is titled The Malign Hand of the Markets: The Insidious Forces On Wall Street That Are Destroying Financial Markets and What We Can Do About It. Staddon discussed key concepts from the book with Mitch Kokai for Carolina Journal Radio. (Click here to find a station near you or to learn about the weekly CJ Radio podcast.)

    Kokai: The "malign" hand: Tell us how you came up with this concept.

    Staddon: Well, it's actually pretty well-known, but it's known under a whole variety of names. The most common one is the tragedy of the commons. The tragedy of the commons works like this: You've got Farmer Joe. He has his sheep. He adds another sheep. He makes more money as a consequence of that, and so he adds another and another, and all of his friends add them, and eventually they deplete the resource on which they all depend. So, it's a time-dependent phenomenon from where benefit to the actor, to the agent, continues, but the effects on the community are sometimes positive and eventually negative.

    So, if you put one final sheep on the commons, the whole thing collapses, and everybody loses money. And this mechanism operates in all markets at one time or another, and the problem is, the benefits are focused on the individual, but the cost is delayed and then shared by everybody.

    Kokai: What we hear from economists sometimes is "concentrated benefits and disbursed costs."

    Staddon: You've got it. You've got it. And it has too many names: externalities, the tragedy of the commons, the agency problem. There are a whole lot of names for this thing, and that's the problem. There are too many names for it. But, really, it's all the same thing, which is benefit to the individual but cost to everybody else.

    Kokai: And I understand that one of the reasons to label it the "malign hand" is as a contrast to this notion of the beneficial or beneficent "invisible hand." Why make that distinction?

    Staddon: The invisible hand is where benefit to me is also benefit to everybody else, and this is simply the opposite effect: benefit to me, but cost to everybody else. And to the extent that one of them predominates over the other, you have a systemic problem.

    Kokai: I get the sense in reading through the book that one of the reasons you wrote it was that you feel that the economics profession has not adequately addressed this issue, or has completely ignored it in some respects.

    Staddon: Yeah, well, they have names for it, as I say, tragedy of the commons and so on, but it tends to disappear with sort of free-market fanatics. When they think it's always the invisible hand -- well, I'm a free-market guy, I believe in free markets -- but I think you have to have rules that minimize the chance that you're going to wind up with the malign hand.

    Kokai: Now, much of your book focuses specifically on what's wrong with the financial markets. As you were putting this together, what were some of the key things you saw that just don't work with the financial markets?

    Staddon: Let me give you an anecdote. I've been reading a book by a very able economist, Robert Shiller. He's the co-inventor of the Case-Shiller Index of [Home] Prices. That's pretty well-known, and it's a defense of the free markets and finance in particular as a contributor to the common good.

    And he takes, as an example of the wonderful way that these free markets work, something called securitization. And you've probably heard of securitization. It was apparently first engaged in by Freddie Mac, which is a federal agency, but it was brought to its finest peak of perfection by one Lew Ranieri. ... And what it involves is taking not one, not two, but hundreds of mortgages, putting them into a bond, dividing the bond into tranches, that is layers. Layer one always gets paid off. Layer two only gets paid off if layer one has been paid off, and so on and so on. And this is generally regarded as a really bad idea, but not for Professor Shiller. He thinks that it's great because now we can really assess the risk associated with these mortgages.

    If you look at the data, it's the opposite. I mean, in fact, if you have Joe Blow as the mortgage originator, and he gives the mortgage to some poor guy who wants to buy a house, well, he's got an interest in seeing that this guy is capable of paying, I mean, that he is a good credit risk, and so on. But once this mortgage is bundled up with others, it becomes harder and harder and harder. What's the solution to that?

    To Professor Shiller, the solution is rating agencies. So you can look at what the rating agencies actually did, and over the years, the proportion of what Matt Taibbi might call "crappy mortgages" increased in these bonds over the years, but the rating for all the bonds stayed the same. So the rating agencies in fact were complicit in allowing these folks to market very bad securities.

    Why? Because [of] what psychologists would call a bad reinforcement schedule. The mortgage guy -- the mortgage originator -- had every interest in giving mortgages, and very little interest in worrying about their security, because he could sell them on ... into these securitized things, these securitized bundles. So securitization, in fact, far from being a good idea, is a really bad idea -- I mean, extraordinarily bad idea.

    Kokai: People will have to read the book to learn more about the malign hand and how it exists, but let's take the remaining moments that we have to talk about some of the ideas you have for addressing it. You do think that there are some things that can and should be done to help address the possible impact of the malign hand. What are they?

    Staddon: One of them is to fight the tendency of all financial markets to shed risk. I mean, the whole aim of everybody in the financial system is to pass on risk to other people. And there are wonderful phrases for this. They say, "Well, risk should be passed to those best able to bear it," as if there's some kind of, you know, socialistic welfare state. It's a grotesque idea. Of course, what they're doing is shedding responsibility. They're shedding responsibility for the actions that they have taken, and I think rules should be in place to prevent that, and they're not complicated. They're really not complicated.

    One rule I talk about, I call the "insuranburn rule." This comes from a wonderful book by V.S. Naipaul, A House for Mr. Biswas. "Insuranburn" refers to the fact that in Trinidad disreputable people would buy a house at a discounted price, insure it for a much higher value, and then burn it and collect the insurance. Well, great for them, right?

    It seems like a good idea. How could that possibly happen in financial markets, when in fact, if you look at financial markets, you might find that many of their products amount to "insuranburn"? They're insuring something that they have very little interest in, and now they have an interest in destroying it. So an "insuranburn rule" is one very obvious thing to do.