Fraud, fools and financial markets

Adam Smith famously wrote of the "invisible hand", by which individuals' pursuit of self-interest in free, competitive markets advances the interest of society as a whole. And Smith was right: Free markets have generated unprecedented prosperity for individuals and societies alike.

But, because we can be manipulated or deceived or even just passively tempted, free markets also persuade us to buy things that are not good for us or society.

This observation represents an important codicil to Smith's vision. And it is one that George Akerlof and I explore in our new book, Phishing For Phools: The Economics Of Manipulation And Deception.

Most of us have suffered "phishing": Unwanted e-mails and phone calls designed to defraud us. A "phool" is anyone who does not fully comprehend the ubiquity of phishing. He does not appreciate the extent of professionalism devoted to it, nor how deeply it affects lives.

Routine phishing can affect any market, but our most important observations concern financial markets - timely enough, given the massive boom in the equity and real-estate markets since 2009, and the turmoil in global asset markets since last month.


The writer believes that not only are there endemic and natural forces that make the financial system highly volatile, but also that swift, effective intervention is needed in the face of financial collapse. - PHOTO: REUTERS

As too many optimists have learnt to their detriment, asset prices are highly volatile and a whole ocean of phishes is involved.

Borrowers are lured into unsuitable mortgages; firms are stripped of their assets; accountants mislead investors; financial advisers spin narratives of riches from nowhere; and the media promotes extravagant claims.

But the losers in the downturns are not just those who have been duped. A chain of additional losses occurs when the inflated assets have been purchased with borrowed money. In that case, bankruptcies and fear of bankruptcy spawn an epidemic of further bankruptcies, reinforcing fear. Then credit dries up and the economy collapses. This vicious downward spiral for business confidence typically features phishes - for example, the victims of Bernard Madoff's Ponzi scheme - discovered only after the period of irrational exuberance ended.

Epidemics, in economics as much as in medicine, call for an immediate and drastic response. The response by the authorities to the Great Crash of 1929 was small and slow, and the world economy entered a "Dark Age" that lasted through the Great Depression of the 1930s and World War II.

The 2007-2009 financial crisis portended a similar outcome but, this time, the world's governments and central banks intervened promptly with an appropriately high volume of stimulus. The recovery has been weak, but we are nowhere near a new Dark Age.

For that, we should be grateful.

Yet, some now argue that the fiscal and monetary authorities should not have responded so quickly or strongly when the 2007-2009 crisis erupted. They believe that the primary cause of the crisis was what economists call moral hazard: Because risk-takers expected that the authorities would intervene to protect them when their bets went awry, they took even greater risks.

By contrast, our view is that rapidly rising prices usually reflect irrational exuberance, aided and abetted by phishes. The irrationally exuberant were not thinking of the returns they would garner if the authorities intervened to maintain the economy and the flow of credit (or, in extreme cases, moved to bail out their bank or enterprise).

Such possibilities were a marginal consideration in the euphoria preceding the 2007-2009 crisis: Those selling at inflated prices were making profits and buyers "knew" they were doing the right thing - even when they weren't.

The reluctance to acknowledge the need for immediate intervention in a financial crisis is based on a school of economics that fails to account for the irrational exuberance that I have explored elsewhere, and ignores the aggressive marketing and other realities of digital-age markets examined in Phishing For Phools.

But adhering to an approach that overlooks these factors is akin to doing away with fire departments, on the grounds that without them, people would be more careful - and so there would then be no fires.

We found out many years ago what happens when a financial epidemic is allowed to run its course. Our analysis indicates not only are there endemic and natural forces that make the financial system highly volatile, but also that swift, effective intervention is needed in the face of financial collapse.

We need to give free rein to the fiscal and monetary authorities to take aggressive steps when financial turmoil turns into financial crisis. One Dark Age is one too many.

PROJECT SYNDICATE


• The writer, a 2013 Nobel laureate in economics, is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. His latest book, co-authored with George Akerlof, is Phishing For Phools: The Economics Of Manipulation And Deception.

A version of this article appeared in the print edition of The Straits Times on September 19, 2015, with the headline 'Fraud, fools and financial markets'. Print Edition | Subscribe