Monday, 6 December 2010

Snake Oil And The "Science" Of Liberty

A hat-tip to @rorysutherland, who drew my attention to a paper called "The Science of Liberty" by Paul Zak, self-styled "founder in the field of neuroeconomics" with the following tweet on 1 December :
" expect to hear a lot more about Oxytocin in marketing writings going forward. This is a good piece."
The paper purports to provide a basis for lighter financial regulation, but ironically points in the opposite direction. It was funded in part by the John Templeton Foundation, a conservative philanthropic organisation, whose President also supports "Let Freedom Ring", the lobbying outfit that also supports the "Tea Party"; and partly by the Gruter Institute for Law and Behavioural Research.

I hope I don't do Paul's reasoning any injustice, but I understand his thesis to be as follows (italics are mine):
  • His research found that "a brain chemical called oxytocin (ox-ee-TOE-sin) is released when a stranger takes money from his or her pocket and intentionally gives it to another person in order to demonstrate trust tangibly... the more money the person receiving the trust-denoting transfer receives, the more his or her brain releases oxytocin. Oxytocin levels, in turn, predict how much the second person will reciprocate the first person; that his, how trustworthy she or he will be."
  • This process is "nearly impossible to inhibit".
  • However, 2% of those studied did not reciprocate, and "there is a technical word in my lab for these folks: "bastards (sic). Not people you want to have a coffee with... On the other hand, two percent isn't bad. It means most people most of the time are trustworthy, and the others can be identified with a slight bit of investigation."
  • Participants go out of their way to punish moral violations in the market "when observers of ethical violations are in a position to punish the violators".
  • As a result of these findings, Paul argues that "virtue is in fact the very foundation of trade... The market can be fabulously large if most people, most of the time, behave morally, and if their moral tendencies are supported by a legal system in which property rights are protected and contracts enforced."
  • Accordingly, Paul asserts that "Economic systems that provide for freedom and limited oversight recognize human dignity and the desire for self-direction."  Such "economies are complex, adaptive, and evolving systems that need no controller. Just a clear set of rules that are enforced by some independent regulatory body."
  • "A number of studies have shown that too much oversight crowds out our innate sense of virtue (Gneezy and Rustichini, 2000). A fine for every violation decouples transgressions from the moral violations to a "greed is good" justification. This is Enron and the like" [includes Ford (Pinto gas tanks) and USSR].
  • In other words, the Enron scandal was created by overly intrusive regulation, and therefore we should have less of it.
Certainly at this last point the logical elastic band finally snaps.

Ironically, far from presenting a basis for lighter financial regulation, I'm afraid Paul Zak's research into the effects of Oxytocin shows exactly why people need greater protection from the snake oil salesmen, who understand it's effects only too well. The "bastards" are out there, and even two percent of the population means there are actually a lot of them. They can be tough to challenge, especially once they've generated a bandwagon effect. And other market participants are not always in a position to punish these rogues, at least not in time to prevent them doing significant harm - due diligence does not scale well. Finally, Alan Greenspan, former Chairman of the US Federal Reserve advocated light touch financial regulation for 40 years, and lived to regret it:
"In Congressional testimony on October 23, 2008, Greenspan acknowledged that he was "partially" wrong in opposing regulation and stated "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity — myself especially — are in a state of shocked disbelief." Referring to his free-market ideology, Greenspan said: “I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.” Rep. Henry Waxman (D-CA) then pressed him to clarify his words. “In other words, you found that your view of the world, your ideology, was not right, it was not working,” Waxman said. “Absolutely, precisely,” Greenspan replied. “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.” Greenspan admitted fault in opposing regulation of derivatives and acknowledged that financial institutions didn't protect shareholders and investments as well as he expected."
"...[T]the unvarnished invisible hand story, although right in a fundamental way, is wrong at the level of detail and approximation that is necessary to explain what we need to know about macroeconomics.

The old story about capitalism is correct: it gives us what we think we want. But capitalism does not act as its own policeman if we fail to watch over it and give it proper directions. It actively, competitively, seeks the most profit-maximising opportunities. Capitalism will follow such opportunities wherever they lead us...

If [we] are willing to pay for real medicine, it will produce real medicine. But if [we] are also willing to pay for snake oil, it will produce snake oil. Indeed, nineteenth century America had a whole industry devoted to fraudulent patent medicine."
Now, I'm no fan of the Nanny State. I don't believe regulation acts as a market catalyst. And I've written often in support of better regulation rather than simply more of it. It's also clear that the financial regulation spawned by the accounting scandals like Enron failed to avert the latest financial crisis, and is unlikely to avert the next without a fundamental change in the importance that we attach to wealth creation.

But this paper perhaps may serve as further evidence that regulation should be aimed at improving transparency at the point when people first engage with a financial service or its promoter. Simplifying products, documentation and disclosures is critical. Another tactic may be to move away from vertical to horizontal models for intermediation.

More limited oversight is not an option.

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