Bottom-up Emergent Order in Financial Markets?

Lynne Kiesling

Matt Ridley helpfully points out something that’s grossly underappreciated in the sturm und drang over financial market competition and regulation in the past five years — the lessons of evolutionary biology apply to human-designed systems too, including financial market institutions and regulatory institutions:

What is the cure? A change of personnel will not do it. The search for chief executives who are not motivated by greed and for regulators who are sufficiently god-like to know how to design rules that cannot be gamed will never succeed. The truth is, the financial system, like the whole of human society, was not designed in the first place; it evolved. And the answer is to allow a better one to evolve.

My own personal experience reinforces my view here, as I was chairman of Northern Rock when it ran into trouble. During that crisis it quickly became clear that not only did I not fully appreciate the liquidity risks in the markets but nor did far more expert people, including rivals and regulators.

That experience, plus some appreciation of evolutionary biology, makes me suspicious of utopian solutions. Regulating Libor will not prevent a scandal somewhere else; reinventing Glass-Steagall’s separation of retail and investment banking would not have prevented the failure of Lehmans or AIG; paying executives in shares rather than cash to lengthen their horizons has been tried and it failed; a culture of compliance can become lethally complacent.

What we need is an evolved, organic, bottom-up system that hands power back to customers and gets innovation working on potential improvements. The way to get that is to open up the banking sector to plentiful competition, dismantling its cosy, crony oligopolistic structure – in which, for example, the biggest customer, the Government, hands the bigger firms handsome income streams from the taxpayer for bond issuance.

Yes. Yes, yes, yes. He then points out that there are substantial entry barriers, largely regulatory entry barriers, that have prevented the emergence of competing banks to provide clearing services more generally. And isn’t clearing really the service that’s essential, at the foundation of improving the efficiency of the interaction of the supply of and demand for funds? He also argues for competing currencies, because isn’t the central bank’s government-granted monopoly on currency issuance one of those scale-creating top-down-imposed entry barriers that reduces the resilience of systems?

He closes by suggesting that we reform in ways that enable us to put trial and error to work. Financial systems are not the only ones for which that recommendation would be beneficial.

2 thoughts on “Bottom-up Emergent Order in Financial Markets?

  1. Surely you are not advocating “trial and error”! Error causes losses and losses cause pain and pain causes lawsuits; and then, the lawyers win. This is the new age of “everybody gets a trophy” and “we don’t keep score”. You are still competing personally, so you obviously haven’t gotten the e-mail. (sarc off)

    US industry, through ANSI, has been far better at setting standards without being anti-competitive than have legislators and regulators, who apparently believe that they are more intelligent than the aggregate of all market participants. Government agents have relatively few qualms about forcing safe and reliable products from the market in the interests of higher efficiency, for example. ANSI could not and would not set standards which would drive incandescent light bulbs from the market, especially in favor of alternative bulbs which must be treated as a HAZMAT issue when they break.

    One of the most egregious examples of federal anti-competitive efforts was the attempt to structure energy efficiency legislation and regulations based on “site” efficiency, rather than “source” efficiency. Direct fossil fuel end uses experience their inefficiencies predominantly at the sites at which they are installed and operated. Electric devices are typically more efficient at the end use site, though they are often less efficient on a “source” basis, when all of the upstream efficiency losses are taken into account. US DOE preferred to use “site” efficiency because “source” efficiency was “just too hard”, even though it ignored the ~70% energy loss associated with electric generation, transmission and distribution. This regulatory approach would have made on-site co-generation appear to be less efficient than grid power, even though the co-generation installation was approximately twice as efficient on the basis of useful energy provided per unit of resource energy consumed.

  2. The financial system of the modern world was created by governments as a vital instrument of total war. The system of central banks and private banks dealing in fiat currency is a historical creation intimately connected with the history of war in the modern world.

    The mother of all central banks was the Bank of Amsterdam which helped the United Provinces to finance its war of independence (mostly as a part of the 30 Years War). The idea was brought to England with William III and financed England’s rise from peripheral player to dominant power of the world over the next century and a quarter.

    In the US, many democrats distrusted central banks as instruments of centralized state power. However, the financial exigencies of the Civil War required a response. The national bank system was that response.

    The national bank system was crowned with the Federal Reserve system on the eve of the World Wars. Roosevelt’s changes to the banking system were relatively minor, except for turning the dollar into a pseudo fiat currency by stealing the people’s gold and gold clauses, and declaring them to be contraband.

    The Bretton Woods system, designed in large part by J.M. Keynes, got us through the first half of the cold war. Richard Nixon abandoned the Bretton Woods system when it proved to be too confining to allow him to pursue his agendas.

    The current system of central banks which issue fiat currency and tend to fleets of private banks may owe its origins to history, but it is not an accident. It exists in order to allow states to conduct wars and their other functions, legitimate or not, such as entitlements.

    It is also not possible for us to expect that the system will disappear, even if the US is taken over by libertarians in the near future. A libertarian government would find itself maintaining a military establishment and conducting foreign policy. The minimum cost of that would be about 4% of GDP. Amortizing the existing debt of the US would cost about 5% ($1 @ 3% over 30 years is 5.1 cents). Even if all of the unnecessary departments of the Federal government were closed, the rest of the government would still run about 1%. Financing fiscal flows of that size, and maintaining the necessities of war, in case it happens, would still require a central bank and banking system.

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