Discussing a Quotation

Robert Waldmann

“Nobody else gets hurt if you buy a lousy mortgage pool,” Cochrane said. “The government doesn’t need to write a new rule every time someone buys a rotten tomato. Investors will demand the right amount of transparency, complexity, and risk-sharing – or monitoring of mortgage pools – unless they all get bailed out and learn to count on a bailout instead.” — John Cochrane 2007

via Matt Yglesias

Now I don’t plan to obsess about Prof Cochrane, but he does express a widespread view very briefly and clearly here. I discuss his thoughts after the jump.

Brief and clear before the jump. Long and rambling after. Sorry.

in 2 sentences Cochrane made 2 quite different arguments in favor of laissez faire.

1a. Consenting adults should be allowed to do whatever they want so long as they don’t hurt anyone else
1b Market transactions do not typically cause any externalities (pollution is a special case not relevant here)


2. Market transactions will be Pareto efficient for the contracting parties, because the world must be in Nash equilbibrium or maybe will get there soon as people learn from their mistakes.

1a is implicit. I agree with 1a. 2 is a common argument (especially at Chicago Business School). I don’t agree with 2, but I don’t want to talk about it.

My point in this post is that 1b is plainly false. This is an argument which I have made again and again at this blog, and I’m still trying to get it right.

Market transactions typically (I mean generically, that is, for an open and dense set of economies) cause externalities through prices (pecuniary externalities). If you buy an apple, I can’t buy that apple. I might have wanted to buy it, so your transaction reduces my welfare. This is obvious and so what. For the purposes of our beliefs in freedom (statement 1a) it doesn’t matter, because I don’t have the exclusive right to the apple. “gets hurt” means something like “is worse off than he or she would be if the contracting parties didn’t exist. My not being able to contract with one of them is for me to lose something which isn’t mine and isn’t harm of the sort that justifies bringing in the state.”

It just isn’t true that banning or allowing a transaction between agents has no effects on the welfare of other agents. It is true that it doesn’t “harm” them in the legal sense, since the benefits of banning the transaction to the third party are not something to which the third party has a right.

The 2 paragraphs above are blindingly obvious. However, Cochrane really needs to assume they false.

The standard result in economic theory which supports laissez faire is the first welfare theorem which states that the free market equilibrium is Pareto efficient, so you can’t make everyone better off by restricting free market transactions. The theorem does not say the market outcome is the best possible for everyone, just that interventions will help some people and hurt others.

This happens, because there can’t be a change in market prices which helps everyone. Total sales equal total purchases, so the effect of a change in prices on the sum of the wealth of all agents (measured in numeraire good) must be zero. Some gain and some lose. The sum of welfare in utils can increase or decrease, but money metric welfare must stay the same, so it can’t be that everyone is better off.

This is true under the assumptions of the first welfare theorem.

One key assumption is that there are complete markets so that all conceivable financial assets exist and ar traded. Clearly it makes no sense to study financial innovation starting with the assumption of complete markets. The financial sector is assumed. Different financial possibilities are not allowed.

Cocrane’s argument against restrictions on new financial instruments is based on the assumption that markets are complete. Such an argument makes no possible sense. If markets were complete, then new financial instruments couldn’t possibly make any difference (they would be identical to a portfolio of existing instruments).

As proven by Geanakoplos and Polimarchakis, if markets are incomplete, except for somem amazing coincidence, there is a restriction on voluntary transactions of financial instruments whcih makes everyone better off than they would be under laissez faire.

The reason is the pecuniary externalities which I mentioned above. Trade in financial assets will affect future prices. Even in the simplest model with financial assets all sold in just one period and which last just one more period, the financial transactions will affect people’s wealth and that will affect demand for goods unless everyone has identical homothetic preferences (that’s one of the possible amazing coincidences).

For each possible outcome, the effect on prices will help some people and hurt others. The sum of the value of the gains in losses in dollars (or apples or whatever) will be zero. The sum of the change in happiness in utils will not be zero unless everyone always has the same marginal utility of income (or apples).

Crucially, chicago economists accept that agents maximize expected utility. Thus, to them (and to me) an agents interests are described by the sum of happiness in different states times the probability of that state occuring.

Now restrictions on financial transactions will help some people and hurt others. There is no result at all that the benefit and harm must add up to zero or that the same people are helped by a restriction or anything like that.

Basically fiddling with purchases and sales of financial assets, a meddling state can fiddle with welfare in many different ways. Except if these different ways happen by pure coincidence to have exactly proportional effects on agents* the meddling state can manage pretty much any vector it wants with a linear combination of restrictions on transactions.

*(or something like that — formally except if by pure coincidence the matrix of changes in welfare has rank lower than it’s order up untill order equals population)

This means that, except for an amazing coincidence, the state can manage a vector of changes in welfare with all positive elements — that is a Pareto improvement achieved entirely by meddling with voluntary transactions between free rational agents.

OK so why is the market outcome Pareto efficient if there are complete markets ? Well the reason is that, if there are complete markets, then the marginal utility of income (or apples) in different states of agent A and of agent B must be proportional. Otherwise they eould gain from a further transaction. That the vectors of changes in welfare are exactly proportional is not an amazing coincidence, it is a property of equilibrium with complete markets.

The idea that pecuniary transactions don’t count is based on two ideas. First it is a violation of natural liberty to count them and second that, while they help some and hurt others, it balances out some how.

The second argument only makes any sense at all if there are complete markets. Now since a regulation can make everyone better off, everyone would support the regulation. That means that enacting it doesn’t violate anyone’s liberty.

Bascially there is a very common argument that

1) our approach to the regulation of new financial instruments should be based on economic theory and, in particular, general equilibrium theory
2) General equilibrium theory says if and (generically) only if, there is no remaining possibility of profitable introduction of new financial instruments, then the best regulation is no regulation.
3) therefore the best regulation of new financial instruments is no regulation.