naked capitalism

I know it’s dangerous to judge an article by its synopsis, but Harvard Business Review articles, unlike their academic cousins, are designed to be easy-breezy, so there is much less risk in taking one of its previews at face value. Here is what the HBR says Yale economist Robert Shiller presents longer form in its January-February edition:

Corporations use a combination of debt and equity to finance their investments and operations. Nations, in contrast, rely exclusively on debt. When a nation’s economy stalls and its debt continues to grow—you may have noticed this happening a lot recently—disaster looms for the country’s taxpayers. This is why Europe is in turmoil right now. But things don’t have to work this way.

Here’s an audacious alternative: Countries should replace much of their existing national debt with shares of the “earnings” of their economies. This would allow them to better manage their financial obligations and could help prevent future financial crises. It might even lower countries’ borrowing costs in the long run.

National shares would function much like corporate shares traded on stock exchanges. They would pay dividends regularly. Ideally, they’d be perpetual, although a country could always buy its shares back on the open market. The price of a share would fluctuate from day to day as new information about a country’s economy came out. The opportunity to participate in the uncertain economic growth of the issuer might well excite, rather than scare off, investors—just as it does in the stock market.

Mark Kamstra of York University and I have mapped out how these new national shares could work. We propose that they pay a quarterly dividend equal to exactly one-trillionth of a country’s quarterly gross domestic product, the simplest measure of national earnings. We could call these shares “Trills.” A Trill issued by the U.S. government, for instance, would have paid $13.22 in 2010, in four quarterly installments. The payoff in future years would vary, of course. If the economy surprised us on the upside, dividends would go up; if it slumped, dividends would fall.

Shiller has done some useful work on the psychology of bubbles, which one would think would make him leery of seeing yet another market as a solution to every problem. He appears to have contracted Arrow-Debreu Derangement Syndrome. For those of you lucky enough never to have encountered it, a brief synopsis from ECONNED:

The scientific pretenses of economics got a considerable boost in 1953, with the publication of what is arguably the most influential work in the economics literature, a paper by Kenneth Arrow and Gérard Debreu (both later Nobel Prize winners), the so-called Arrow-Debreu theorem. Many see this proof as confirmation of Adam Smith’s invisible hand. It demonstrates what Walras sought through his successive auction process of tâtonnement, that there is a set of prices at which all goods can be bought and sold at a particular point in time.42 Recall that the shorthand for this outcome is that “markets clear,” or that there is a “market clearing price,” leaving no buyers with unfilled orders or vendors with unsold goods.

However, the conditions of the Arrow-Debreu theorem are highly restrictive. For instance, Arrow and Debreu assume perfectly competitive markets (allbuyers and sellers have perfect information, no buyer or seller is big enough to influence prices), and separate markets for different locations (butter in Chicago is a different market than butter in Sydney). So far, this isn’t all that unusual a set of requirements in econ-land.

But then we get to the doozies. The authors further assume forward markets (meaning you can not only buy butter now, but contract to buy or sell butter in Singapore for two and a half years from now) for every commodity and every contingent market for every time period in all places, meaning till the end of time! In other words, you could hedge anything, such as the odds you will be ten minutes late to your 4:00 P.M.meeting three weeks from Tuesday. And everyone has perfect foreknowledge of all future periods. In other words, you know everything your unborn descendants six generations from now will be up to.

In other words, the model bears perilous little resemblance to any world of commerce we will ever see. What follows from Arrow-Debreu is absolutely nothing: Arrow-Debreu leaves you just as in the dark about whether markets clear in real life as you were before reading Arrow-Debreu.

And remember, this paper is celebrated as one of the crowning achievements of economics.

Even though it is pretty obvious that Arrow-Debreu does not have practical applications (Phil Mirowski reports that Debreu published the theorem even after being told it was Turing non-computable), economists still fetishize “completing markets”, which is code for coming closer (which is still not at all close) to the Arrow-Debreu fantasy of complete markets by introducing yet another scheme to trade…..something….particularly if it relates to the economy. (We also discuss how another, less celebrated economic paper of the 1950s, Lipsey and Lancaster’s Theory of the Second Best, demonstrates that efforts to come closer to an unattainable ideal state can actually make matters worse).

Shiller himself, as his latest scheme attests, has been keen to promote new trading markets. He is the Shiller of the Case-Shiller index. And he didn’t develop it to see his name in the papers every month when the index is updated. The monetization opportunities come via developing investment products related to the index. And that usually depends on reasonably active forward/futures markets developing around a new index.

The problem with all these new markets is for deep enough trading to occur, you need natural buyers and sellers. There are a lot of cool sounding products that never take off because there is really only one side of a trade, a hedger who wants to lay off risk that no sane person would take because it is too hard to model and price it. As Amar Bhide noted in his book A Call for Judgment:

Commodities exchanges are always trying to develop and launch new derivative products. They have new product groups comprising members of the exchanges and full time staff who try to systematically gauge demand and design contracts that will have the broadest possible appeal. Nevertheless, most new products fail to attract and sustain the level of interest necessary to maintain an active market. As mentioned in the previous chapter, derivative products that were introduced with much fanfare, but failed to survive, include futures on the CPI, the municipal bond index, and the corporate bond index.

It isn’t just committees of futures exchanges that have a hard time. Robert Shiller has been trying to promote trading in contracts on housing prices for at least a decade. Many versions have been tried. None has been traded actively.

Apparently exchange trading involves what are known as ‘network externalities’. Successful contracts which are liquid attract more traders which make them even more liquid. Illiquid contracts wither away.

Furthermore, although there is considerable luck in whether a contract succeeds, success also requires, according to the CME’s Leo Melamed, “planning, calculation, arm-twisting, and tenacity to get a market up and going. Even when it’s chugging along, it has to be cranked and pushed.” To make the CME’s S&P 500 contract a success, Melamed called in all his chits: every trader for whom Melamed had done favors was asked to trade the future; every member of the CME was asked to spend at least 15 minutes in the trading pit; and Melamed himself spent as much time trading the S&P contract as he could.

Such efforts can only be devoted to a few contracts. Doing this for tens of thousands of OTC derivatives is out of the question.

To Shiller’s particular concern, about overleveraged European countries, he seems unfamiliar with the idea that their plight is the result of their lack of control over their own currencies. And as Greece reminds us, their is a long tradition of state defaults and restructurings, although the process is more fraught than the well established Chapter 11 bankruptcy format.

And as Thomas Ferguson pointed out, you could achieve pretty much the same results as you would from Shiller’s scheme by instituting socialism. But something so straightforward eliminates all the opportunities for private parties to take their cut.