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WHAT’S THE MATTER WITH WALL STREET?
And How Do We Fix It?
Even after the global financial meltdown of 2008, economists have clung to Adam Smith’s “Invisible Hand” theory of an always selfregulating market that benefits private and public interests alike. But Duke University professor John Staddon is here to tell that there’s also another, darker force at work on Wall Street—a “Malign Hand” that guides all ...
WHAT’S THE MATTER WITH WALL STREET?
And How Do We Fix It?
Even after the global financial meltdown of 2008, economists have clung to Adam Smith’s “Invisible Hand” theory of an always selfregulating market that benefits private and public interests alike. But Duke University professor John Staddon is here to tell that there’s also another, darker force at work on Wall Street—a “Malign Hand” that guides all human interactions, including our finances.
Combining psychology, behavioral economics, and other sciences, Staddon’s explosive new theory reveals the underlying principles behind the economic crisis, exposing the invisible mechanisms that drive our markets today. You’ll learn how we can:
Using economic theory, global market trends, and psychological research, Staddon’s electrifying book is both analytical and prescriptive—with a number of possible solutions to our most pressing economic concerns. You’ll learn about the wrong assumptions that underlie our present system, basic rules for managing risk, and the real reasons behind the market’s greatest successes and biggest disasters.
You’ll hear surprising insights into the delicate relationship between Wall Street and Washington—with assessments of the bailouts, the Dodd-Frank bill, and other attempts at financial regulation. Best of all, you’ll discover realistic solutions that can stop the boom-and-bust cycle once and for all.
Compelling, controversial, and remarkably thorough, The Malign Hand of the Markets will change the way we plan our future, manage our finances, and build our fortunes.
The Malign Hand
This book is mainly about financial markets, where the malign hand has its most dramatic and hard-to-detect effects. But it may help to fix ideas if in this chapter and the next I begin with some examples from other areas of human social life. The malign hand is rarely the only process at work. There are usually factors such as Smith's invisible hand that counteract its destabilizing effects. There must be, or else society would have collapsed long ago. But, because malign-hand effects are usually both hard to see and delayed, there are certainly many other fuses smoldering all around U.S. Here are a few places to look.
Bureaucracy and Politics Bureaucracy is the "operating system" of any organization, from individual firms to the whole economies. Ever since the wonderful work of English naval historian C. Northcote Parkinson—a very serious satirist—everyone knows that bureaucracies have a natural tendency to expand beyond the size necessary to perform their original function. Parkinson's most memorable data was a table showing that between 1924 and 1928 the number of capital ships in commission in the Royal Navy declined by 68 percent while the number of Admiralty officials increased by 78 percent. Much the same happened in the British Colonial Office: as the colonies shrank almost to zero from 1935 to 1954, the number of Colonial Office officials increased more than fourfold. Parkinson even proposed mathematical formulas to describe these increases. A relatively recent example that has attracted surprisingly little attention, so used have we become to the disconnect between a bureaucracy and its intended function, is the North Atlantic Treaty Organization. Founded in 1949 as a collective defense effort against possible attacks from the Soviet Union, its raison d'être vanished when the Soviet Union collapsed in 1989 and the Warsaw Pact ended in 1991. Was NATO disbanded? No, expanded.
Austrian economists and the public choice movement in the U.S. have shown, more or less, why bureaucracies increase in this way: because the incentives for the bureaucrats are never perfectly aligned with those of the organization of which they are a part. Short-term gain for the bureaucrat often means long-term problems for the rest of us—the malign hand. Every bureaucrat wants to hire more people and expand his role. Budget rules that encourage a department to spend all its allocation every year—lest its next-year budget be cut—are a ratchet that allows only upward growth. Salary scales that give largest weight to the number of employees an individual supervises, encourage hiring. Each new hire creates work to justify still more hires, and so on.
Competition is the natural antidote to the malign hand. The bureaucratic dynamic may not matter too much in a competitive environment. The firm whose bureaucracy gets out of hand will lose in competition with more efficient firms—so long as the expansionist tendency intrinsic to all bureaucracies does not infect all firms equally.
But government bureaucracies are different because there are fewer checks on their growth. The government can therefore swell with little restraint—until a crisis forces change. The 2009 economic crisis in the UK, for example, is clearly associated with a massive increase in public-sector employment in preceding years. In response to the crisis, the 2010 coalition government apparently intends to actually reduce the number of public-sector employees by 11 percent to a still large 4.92M and has made noises about even more severe cuts.
Public-sector growth in the U.S. is probably worse and forces to reduce it much weaker. Public-sector unions have been growing in recent decades while private- sector unions have declined substantially. The private sector is generally subject to competitive restraint, the public, not so much. Current statistics are hard to evaluate; but recent small drops in U.S. unemployment have all been dominated by Federal hires. The pain of the recession is already being borne almost entirely by state governments, most subject to balanced-budget laws, and the private sector. There are proposals to both cut the public sector and freeze salaries in the UK. As of the end of 2010, no such proposals had been made in the U.S.
Government growth is promoted by both internal and external forces. I've already said something about internal forces. Here is an example of how external forces work. In 2010 the State of North Carolina decided, in its wisdom and following recent tradition, to pass a law targeting substantial tax breaks at the company Microsoft. The purpose? To induce Microsoft to open a new facility in the state which, it was hoped, would create new jobs and generate new tax revenue in excess of the concessions. Alas, NC's generosity was exceeded by Virginia's. The Old Dominion upped the ante and Microsoft opted to open its facility there.
Rather to my surprise, a conservative friend thought the original NC plan a good thing—because it promised to turn a profit for the state. Maybe so, if profit is the only motive by which state governments should be guided. But the malign-hand possibilities are pretty obvious—a bidding war between states, a diversion of the state's attention from the needs of its citizens to profit flowing to the government, not necessarily to the people, potential for conflict of interest and corruption, distortion of priorities, creation of a new incentive-administration bureaucracy, and so on. Nevertheless, the case against subsidies of this sort is far from open-and-shut.
Much, much stronger is the case against that accepted staple of U.S. democracy: pork. Recently deceased Alaskan Ted Stevens, longest-ever serving Republican senator, is an iconic figure in this. Stevens was much loved in Alaska for his capacity to attract Federal funds to the state. Citizens Against Government Waste reports that "Sen. Stevens has helped bring home a total of 1,452 projects worth $3.4 billion between 1995 and 2008." His efforts peaked in 2005 when he got the Hogzilla Award for bringing home $646 million of U.S. taxpayers' money to Alaska.
But why is pork bad? Is it really wasteful? Wasn't Stevens just doing what he was elected to do, helping his state? Individual projects may be wasteful, but even if all are carried out with exemplary efficiency, there is an inevitable bad result of a very different kind. The problem isn't waste but the malign hand. It works like this. Recall the tragedy of the commons: each farmer gains from adding cattle to the common land, but the result eventually is overgrazing and a general loss. Just as every farmer gains from adding to his herd on the common land, every representative gains from each diversion of Federal funds to his own district. The general loss is shared by each individual, but only after a delay, and only in small measure. Concentration of benefits, but delay and dispersion of costs, is always a problem if those who pay the cost have less influence than those who incur it. So it is with pork and with many government programs that don't look particularly local—defense projects, intentionally spread over many states, for example. Legislators are voted in by the people of their states, who see the immediate benefits of pork. But the pork is paid for—if it is paid for at all—by residents of all states, who have little voice in projects other than their own. Because all feed off resources of the central government, central resources are either depleted, like the commons, or, more likely, they increase to meet demands that grow without limit.
"Increase"—that's the problem. Unlike the land commons, the Federal government is not limited. Central gover
Excerpted from The MALIGN HAND of the MARKETS by JOHN STADDON. Copyright © 2012 by John Staddon. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Chapter 1 The Malign Hand 3
Chapter 2 Democracy, Fairness and the Tytler Dilemma 23
Chapter 3 Value and Reason 35
Chapter 4 Efficiency and Unpredictability 55
Chapter 5 The Housing Bubble 67
Chapter 6 Market Instability and the Myth of Comparative Statics 87
Chapter 7 Growth and the Conservation of Money 99
Chapter 8 Debt, Inflation and the Central Bank 117
Chapter 9 J.M. Keynes and the Macroeconomy 145
Chapter 10 Financial Markets are Different, I: Problems and Some Solutions 165
Chapter 11 Financial Markets are Different, II: Risk and Competition 195
Chapter 12 Financial Markets are Different, III: Regulation by Rule 217