How the market orders itself

I’m a fan of American Ninja Warrior. It’s a TV show and obstacle course competition that originated in Japan and is now serving up summer entertainment for us ninja wannabes.

Those who seem the most adept at conquering the tough obstacles are those with free running and parkour background and training. These are the dudes that use their creativity to jump and flip off of normal, everyday things like park walls and stairs. They sometimes jump from building rooftops. For them, it’s an art and it’s all about the creativity in how they get from one obstacle to the next.

I’ve noticed in many of the competitor profiles on the show, the contestants are working out at new-style parkour gyms, like this one (fun video). These gyms offer obstacles similar to what you might find in a park or urban setting and some obstacles that you see on American Ninja Warrior, like cargo nets, warped walls, the quad steps and salmon ladders.

Many of these obstacles are currently hand made out of plywood, boards and pipe from the home improvement store.

If the show and sport continues to gain popularity, this will be an excellent example to watch how the free and invisible hand of the market organizes resources to satisfy the desires of people looking to improve their fitness with American Ninja style obstacle courses.

Watch more parkour/obstacle gyms open up. I wouldn’t be surprised to see an American Ninja Warrior-branded gym.

Watch companies start to make the obstacles for these gyms and for individuals as the handmade obstacles give way to the professionally designed and made obstacles. I wouldn’t mind having a go at the warped wall.

Just as cities installed skateboard parks, perhaps they’ll lay out new Ninja Warrior parks.

This trend could fizzle and go nowhere. But, if it grows, it’ll serve as a good example to watch as people try to respond to other people’s’ desires. Not everything will work. It will evolve and it may look different down the road. But, nobody is guiding this centrally. The invisible hand is at work.

The invisible hand is not the free market

Many people say that the housing bubble was caused by a failure of the invisible hand.

When I encounter such folks, I like to make sure they understand what the invisible hand is.  Many believe invisible hand is synonymous with free market.

It’s not.

The invisible hand is how a free market produces socially desirable outcomes.  It is not the free market itself.

So, what is the invisible hand?

It’s the incentives we face when we make the trade-off decisions that we encounter each day and how we respond to those incentives.

Some of the trade-off decisions might be: Do I go to work?  Do I buy a cup of coffee?  Do I refinance my house?  We face many invisible incentives around each of these decisions.  How much work do I have?  How much vacation have I banked?  What am I going to do with my time off?  Is the coffee good? Is it far out of my way?  Will there be a long line? Is the new mortgage rate worth the closing costs?

Others face trade-off decisions too.  Investors hire business managers to generate good returns on their investments.  Business managers, to stay employed, have to decide how to grow sales.  Do we try a new product or open locations in new markets?

The incentives that help guide our decisions is the invisible hand.  It’s invisible because we can’t physically see incentives, but they’re there.

Adam Smith claimed that the incentives in the invisible hand tended to produce socially desirable outcomes in a free market with little government regulation because in a free market we choose when and how to interact with each other.

That choice to interact or not is the key to producing socially desirable outcomes.

Consider the cup of coffee that you bought this morning.  Did you force the coffee shop to sell it to you? No. Did the coffee shop force you to buy it? No.

You and the coffee shop owner both chose to trade because you both felt like you came out ahead by doing so.  You valued the cup of coffee more than the $2 it cost you.  The coffee shop owner valued the $2 more than the cup of coffee he sold you.

That’s called a voluntary, mutually beneficial trade.  Value was created on both sides of the transaction — for you and the coffee shop owner (though most people forget about the value created for the customer, they only see the ‘profit’ for the coffee shop owner).

Smith’s famous quote illustrates the value creation engine of the invisible hand incentives nicely:

It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest.

We choose to interact with the butcher for the very reason he chooses to interact with us:  self interest.  We both benefit from the interaction, otherwise we would pass it up.

When things don’t appear to produce a desirable outcome, we are quick to blame the invisible hand.  We say it failed.

But, we shouldn’t rush to judgement.  What really happened is that the incentives changed somehow so some people traded even when they did not benefit from doing so.

We should look to identify where this occurred, because that will tell us what went wrong.

Alan Greenspan, for one, told Congress that he overestimated the self-regulation of the free market.  (That self-regulation being that two parties of a transaction prudently seek to come out ahead.)

He was specifically referring to trades where investors bought mortgage-backed securities from banks.  Investors bought these for what would turn out to be much more than they were truly worth.  In fact, these investors had an insatiable appetite for mortgage-backed securities.  So much so, that banks created as much as possible by lending to just about anyone no matter their credit history and ability to pay.

But, Alan Greenspan was wrong.

He didn’t understand why investors bought this stuff.  He thought they were incorrectly overvaluing mortgage-backed securities based solely on the expected payback.  If that’s all investors were buying, Greenspan would have been right.

I doubt any of these investors would have lent money directly to many of the folks who they lent money to through the mortgage-backed securities.

So why did they did they lend money to them through the mortgage-backed securities?

Because politicians in government changed the incentives by signing up taxpayers as unwilling, and unknowing, co-signers.  The taxpayers are the folks that traded in this house of cards when it did not benefit them from doing so. 

As Russ Roberts points out in his 2010 white paper, Gambling With Other People’s Money, mortgage-backed security investors weren’t only lending to folks unlikely to repay.  They were lending to these folks with U.S. taxpayers as co-signers.

Think of it this way, a friend with a bad credit history asks you for a loan.  The payment your friend would need to repay the loan would be more than half of his income.  Do you lend him the money?

Judging the transaction solely on its merits — that is, your chances of receiving the loan  back — you’re not likely to lend him the money.

But, what if your friend’s rich Uncle Sam co-signs the loan?  If your friend stops paying, Uncle Sam will pay what’s owed.  Will you make this loan now?

More likely.  But now, you’re not judging the loan purely on the merits of your friend.  You are factoring in the value of the co-signer.  Having the co-signer changed the incentives for you.

Russ Roberts makes a good case in his paper that’s exactly what investors in mortgage-backed securities did — and they turned out to be right.  And, this is the piece of the incentive structure of subprime mortgage-backed securities that Alan Greenspan missed.

Critics of this argument say that there was no explicit guarantee from U.S. taxpayers.  Roberts argues that the pattern had been established with previous government bailouts.  And, I’d argue that politicians from both sides of the aisle were in such a fervor to “expand the dream of home ownership” that they had been sending strong signals that they wouldn’t let these investors go under (though I think they hoped it wouldn’t come to this).

So, it wasn’t the invisible hand of the free market that failed.  What caused the failure was the introduction into the incentive structure a forced trade with U.S. taxpayers in co-signing the loans of people who would not have been able to get a loan 20 years ago.

Now, I do think there were other factors that contributed.  There was an overconfidence in the ability of statistical models to somehow group bad credit risks in a way that lowered risk.  There was also the fever of rising housing prices, which caused more people to want to buy homes just to be able to sell them a few months or a year later at a higher price.

But, even these things really had the implicit guarantee of the U.S. taxpayer underlying them.  Without this guarantee, the demand for housing would not have increased as rapidly, driving up prices.  Without this guarantee, we may have been more skeptical of those sophisticated risk models.

As Roberts has stated, “Capitalism is a profit and loss system.  Profit encourages risk-taking and losses encourages prudence.”  Having the U.S. taxpayer as co-signer reduced the chance of loss and reduced prudence in just about every decision in the chain.

Government’s weakness: It doesn’t have to add value

In this previous post, I wrote about how government is overhead and that increasing overhead is probably not the way to improve a bad economy.

I compared the economy to a burrito-making business, with the private sector being the burrito-making and selling part of the business and the government being the overhead functions like accounting, legal and IT.

In this post, I’ll explore the limits of that overhead a bit more.

The value creation engine of our society is greatly under appreciated.  Without the burrito making part of the business, the overhead jobs for accountants, lawyers and IT folks at the burrito company would not exist.

The value creation engine in the economy is voluntary mutually beneficial trading.  When two parties trade voluntarily, they do so because they both come out ahead — otherwise, why would they trade?  Since they both come out ahead, value is created.

We each trade with others every day.  It’s hard not to.  We do it so naturally that we take it for granted.

Try this exercise.  The next time you buy something, ask yourself why you bought it.  What benefits did it provide you that made it more valuable than whatever it was that you gave up to buy it?

What was your next best use for your money?  Could you have spent it on something else? Save it? Why did you buy it instead of your next best use for the money?

Why do you show up to work to trade your time and skills for money?  Is that time or skill not worth as much to you as the time you give up?

The reasons you trade (or not) and the value you gain from the trade is Adam Smith’s Invisible Hand.   Your actions or inactions send signals through the price system on how much you value or don’t value things so that other individuals will respond and oblige to provide you more of what you do value.

In that sense, the price system was one of the earliest and best communication networks (although it doesn’t send information on why you value the things you buy, which befuddles many company managers).

Taxes paid to government, unlike voluntary trade, is compulsory trading forced by the government.

That’s not to say that some value isn’t created in that forced trade.  Government does create value for society, just as the overhead functions create value for the burrito business.  Governments provide citizens with security, law enforcement and justice systems, for example, that may benefit all of us.

But, since taxes and government are forced, it does mean that this trade does not have to create value for both sides of the trade.  That’s the important distinction that is glossed over by all sides of the debate on taxes and government.

When debating what government should or shouldn’t do, one side tends to provide examples of where they think government is worth the taxes paid.  The other side provides examples of where they think government is not worth it.

They never settle their dispute because they both can be right.  Neither side sees the full view that government can create value, but it’s not necessary that it does create value since government can force collect on taxes. Government gets money whether it creates value or not.

With voluntary transactions, it is more of a necessary condition that both sides come out ahead.   Voluntary trading that does not result in both sides coming out ahead usually dies out quickly because sooner or later the side that’s not coming out ahead voluntarily decides not to trade.  That’s a natural check on non-value added trades.

There’s not a natural check on what creates value with government and that’s why government can and does tend to grow far beyond where it adds value, which means it destroys value — or makes us poorer.

This also happens at successful companies.  Once a business finds a successful product and reaches a level of sustainable income, its overhead functions tend to grow faster than the value creation side of the business.

Some of this growth is good.  More overhead can make the business function more consistently.  But, it doesn’t have to all be good.  Just like with government, there’s not natural check (like the Invisible Hand) to limit the size of overhead and the “right” size of overhead is not clear cut.  Eventually bureaucrats feed off the flesh and muscle of the business and destroy value.

The overall limit on the size of overhead is the business’s income and many successful businesses have failed because management let overhead grow too large.

The overall limit on the size of governments (all of them — local and federal), is the value created by the private sector.  We are lucky that capitalism has created such a wealthy private sector.  It has allowed us to afford a good sized government.

But we are spending and destroying that wealth faster than the private sector is creating it.  Which means we are dipping far into our “rainy day” fund.  As Margaret Thatcher said,

The problem with socialism is that you eventually run out of other peoples’ money.

I’ll go a step further.  The problem with growing government so large is that you eventually run out of other people.

Don’t mistake this for an argument that essential government functions — especially those listed in the Constitution like defense — should be privatized.

Rather, we should be aware of this weakness of government and understand it has brought us to our current situation.  Further, we should keep this mind when evaluating what spending should be cut and consider private alternatives for the areas of government that are destroying value.

Testing the Invisible Hand on “What Would You Do?” and The Office

In his Wealth of Nations, Adam Smith wrote about the Invisible Hand of markets.  The Invisible Hand can allocate resources without  specific, direct action.

I don’t have to order gasoline from an oil company weeks ahead of time, I show up at the gas station and it’s ready to be purchased.  The Invisible Hand works through self-interest, supply and demand and competition and is guided by price and buying signals.

In his Theory of Moral Sentiments, Smith also writes about four sources of moral approval that keep our behavior in check.  Those sources of moral approval are our senses of prudence, propriety, benevolence and justice.  These four sources govern our interactions with others.

I consider this an extended Invisible Hand.  Our behavior toward one another is guided by signals from others that let us know how well we are applying our four senses of moral approval.

While watching ABC’s What Would You Do? this evening, it occurred to me that the idea of the show is to push beyond the edge of the envelope of our senses of moral approval and see how others in the area react.

What happens is that we see the Extended Invisible Hand in action.  Other people act as a check on behavior that is deemed inappropriate.

Continue reading