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  • Removing Uncertainty from the System

    When a Nobel Prize-winning economist tells you something is too complicated to understand, pay attention. That is just what Nobel Laureate Gary Becker said about the financial crisis in Tuesday’s Wall Street Journal.

    The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have limited understanding of the aggregate risks created by the system. That is, insufficient appreciation of how the whole incredibly complex financial system operates when exposed to various types of stress.

    There are two important points about complex systems (such as international financial markets) packed into Becker’s observation. First, the key to understanding financial markets is at the system level, not at the level of individual components. Not only is the whole is greater than the sum of the parts; things happen at the system level that cannot be explained merely by reference to the individual pieces, even if you can identify and understand all of the pieces.

    Second, as Becker himself notes, “In light of such limitations, it is difficult to propose long-term reforms.” If the whole system acts in ways that cannot be predicted by examining the parts, there can be no sure-fire fix. Whatever you do is subject to some uncertainty.

    Still, Becker offers three reforms:

    • increasing capital requirements on investment banks and money funds
    • speedy sale of Fannie Mae and Freddie Mac by the governmet
    • resisting future bail-outs to reduce the “moral hazard” problem

    Becker does not say “no government;” his first recommendation is regulatory. But he does warn us that the complexity of the problem counsels some modesty in attempted solutions.

    Posted in Economics [slideshow_deploy]

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