ONE of the good consequences of the Global Financial Crisis (GFC) is a complete re-
think of the foundations of economic analysis.
Out of the thousands of ideas that begin to challenge economic orthodoxy, in my view
two books stand out. The first is Nassim Taleb’s idea of anti-fragility, which
challenged the whole basis of conventional risk management. The other is the 2012
Nobel Laureate Andy Roth’s pioneering work on market design.
Stanford Professor Roth’s new book Who Gets What-and Why: The New Economics
of Matchmaking and Market Design, goes back to the fundamentals of markets.
Conventional economics was dominated by the idea of free markets, followed by the
ideology of minimal government. In simple layman terms, Roth argues that markets
are everywhere, and makes the common sense argument that free markets can only
exist if there are effective rules, effectively enforced.
He quotes the free-market economist and philosopher Hayek, “There is, in particular,
all the different between deliberately creating a system within which competition will
work as beneficially as possible and passively accepting institutions as they are.”
It is too simplistic to suggest that free markets will work well, if there is no effective
state to enforce the standards and rules. The GFC demonstrated that under certain
conditions, free markets can fail. Roth’s insight is that markets are as old as human
behaviour – they evolve and adapt, but we can always design markets to function
better.
In other words, the state has a key role in markets, but this does not mean that the
state replaces the market as a mechanism to allocate resources and facilitate price
discovery.
There are of course two broad types of market – public markets and private or
(match) markets. We are all familiar with public markets, such as international trade
and commodity markets, as well as financial markets in foreign exchange, stock and
bonds.
These markets succeed because they are efficient (in the sense of low transaction
costs), transparent (with prices and volume data available to all) and generally have
high turnover and public confidence. However, every now and again they fail, with
large public consequences.
Roth points out that matching markets exist everywhere, from dating services, kidney
exchanges, job placement and college selection, but these markets are illiquid,
opaque and often do not work very well. They match demand and supply, but not
always successfully, because of information asymmetry and mistrust between buyers
and sellers. In fact, many of these markets do not involve money, such as students’
selection of schools and university places.
Roth uses new vocabulary to describe markets. A market that is thick is one that has
a lot of participants, but thick markets also face congestion, like a traffic jam or market
panic when everyone wants to get out, but can’t. A good market place is one that
makes participation safe and simple, with rules that are enforced and obeyed
effectively. In Roth’s view, a free market is not a “free-for-all”, but one that has well-
designed rules that make it work well.
Of course, most markets evolved through history and experience, often by trial and
error, but mostly through market failure and reform. Developing economies have more
incidences of market failure, because of the learning process.
For example, stock exchanges were often introduced to developing countries without
fully understanding local culture and behavioural characteristics. In the 1980s, it was
assumed that if a copy of the New York Stock Exchange was put into a developing
country, it would work well.
But the recent experience showed that it took a long time for the Chinese investors,
financial institutions and regulators to experience and understand how the complex
rules work or do not work. The A share debacle showed that the issues of market
manipulation, margin losses, illiquidity, inadequate regulation and bad corporate
governance were a consequence of market design. There were flaws that need to be
fixed.
Good market design means that we cannot assume that all Chinese investors have
the same degree of sophistication and experience as traders on the New York Stock
Exchange, which had experience with many years of market failure, with very
sophisticated regulators at the exchange and government level. “Best practice” does
not mean “best fit”. A Lamborghini drives superbly in superhighways, but will not
perform as well as a Jeep in bad roads.
Markets are of course networks, and a public network, such as a stock exchange,
also operates with many private networks that co-exist symbiotically with it, such as
the venture capital/private equity business that seeks good start-ups for eventual
listing on the stock exchange.
Furthermore, there are illegal markets, such as syndicates that operate to manipulate
shares, engage in insider dealing and short-selling, which take advantage of lack of
supervision or enforcement activities. Proper supervision of sophisticated public
markets also need good understanding of how these “private” markets, sometimes
called shadow banking and “dark pools” operate.
Roth built his theory of market design not through ideology, but common sense.
Private markets operate mostly through strategic decision-making or game theory,
because the number of participants is limited, with limited information.
Public markets have mass participation, making them subject to mass behaviour,
where common sense may not lead to good common outcomes, such as everyone
running for a crowded exit in panic that leads to market crash.
What looks simple can be actually very complex, but what is very complex works on
simple algorithms. Building sophisticated Asian stock markets therefore requires
making the markets more simple for retail investors, which means that there must be
strong institutional investors with long-term perspective and professional
management to give the stock markets “thickness”.
It also requires very sophisticated regulators and policymakers who understand that
as markets become more complex, it is important to re-design the market algorithms
regularly to prevent behaviour that can become predatory and manipulative.
Herein lie the contradictions between state and market. The market thrives on
mistakes – because it is fundamentally zero-sum – your loss is my gain. The state
bureaucracy works on asymmetric rewards – success may not be rewarded whereas
failure is seldom tolerated. But long-run stability, as Minsky pointed out, leads to
instability.
Getting the simple balance between state and market requires careful market design.
This is more complex than we imagined before Roth.
Tan Sri Andrew Sheng writes on global issues from an Asian perspective.
A version of this article appeared in The Star Online, 3 October 2015
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