Friday, August 5, 2011

Two interesting links...

I'm traveling today and will probably have little posting time for several days, but here are two interesting links:

1. John Kay has an illuminating essay identifying a common pattern in many financial and economic problems and linking them (loosely) to the structure of one simple, if diabolical, auction-type game:
The game theorist Martin Shubik invented an unpleasant economists’ party game called the dollar bill auction. The players agree to auction a dollar bill with one-cent increments to the bids. As usual, the dollar goes to the highest bidder. The twist is that both the highest bidder and the second-highest bidder must pay.

You might start with a low bid – but offers will quickly rise towards a dollar. Soon the highest bid will be 99 cents with the underbidder at 98 cents. At that point, it pays the underbidder to offer a dollar. He will not now gain from the transaction, but that outcome is better than the loss of 98 cents. And now there is a sting in the tail. There is no reason why the bidding should stop at a dollar. The new underbidder stands to lose 99 cents. But if a bid of $1.01 is successful, he can reduce his loss to a single cent.

The underbidder always comes back. So the auction can continue until the resources of the players are exhausted. The game must end, but never well. There are reports that over $200 has been paid for a dollar in Shubik’s game.
Kay goes on to describe how the structure of this game -- drawing participants to keep wagering a little more so as to avoid a greater loss bears a striking similarity to the recent "solution" agreed to for Greece (" It is plainly better to write down Greece’s debt, even to agree a permanent underwriting of the Greek economy, than to risk the breakdown of European economic integration.")

2. Money is  a fascinating thing, clearly essential to the functioning of modern economic systems, but also often stirring up instability. Banks have historically played a special and priviledged role in the creation of money by having the legal right to take in deposits and lend out against them, with only a fraction kept in reserve. This effectively multiplies the amount of money flowing in an economy and makes it possible for many more beneficial (and non-beneficial) activities to be undertaken than would otherwise be the case. This lending is also a source of instability through bank runs -- the sudden and often cascading withdraw of funds from the economy as depositors rush to get their cash back out for whatever reason, real or imagined. For this very reason, the priviledge banks have to take in deposits and loan against them comes along also with strict regulation (capital requirements, etc.). 

By way of Economist's View, I came across this very important essay by Morgan Ricks in the Harvard Business Law Review (not something I would ever be likely to peruse at random, I can tell you). Ricks points out that the so-called "shadow banking" system which has arisen in the past two decades has come to play a "money creation" role much like traditional banks, yet is not generally subject to the same regulations. In essence, an entire industry associated with the term "money markets" now takes in money (which can be taken out on demand almost instantaneously) and invests this money in longer-term speculative projects. He estimates that this shadow banking system now accounts for more than half the money creation in the US.

Of course, it was just this banking system outside of the banking system that was at the core of the financial crisis. Ricks makes a powerful argument it seems to me that the regulations originally devised for banks should be applied to any firm which plays a money creation role, regardless of what they might be called. (Warning: the paper uses some fairly dense banking jargon at times.)