TOC The market rules Your Turn

March 3, 2009

Rational rule making requires the combined talent of a clairvoyant economist, to account for future costs and benefits, and of a consummate politician, to rally those whose interests are hurt. A tall order in the best of time, certainly an improbable task in the face of innovation.

To improve the odds one can suppress innovation, a prescription whose serious side effects are always lethal long term according to the historical record. But isn't the opposite extreme, leaving rationality aside as an overrated tool and forgoing rules altogether to avoid costly errors, more appalling than appealing? Michael Schrage himself sees the need for "cost-effective rules of engagement" as a condition to reap the fruits of interoperability, this cornucopia of innovations.

Take Twitter for instance, an innovation living on borrowed time. As Richard Waters succinctly puts it, "will this online fad makes money ?" (*). We have been there before, sixteen months ago to be precise. Then the media was all aflutter about Facebook, the same Richard Waters asking "how Facebook can justify its valuation?". As Facebook's subsequent clumsy attempts to answer this question have shown, the crux of the matter is whether such value depends on invading the users' privacy.

As it continues to rely on self-restraint from the innovators, the Federal Trade Commission does them a disservice. In the absence of real rules, it is incumbent on these rational economic agents to test how far they can go till they kill the goose to get the golden egg. This is not what innovation is all about. Adopting some clear rules on eprivacy ahead of time would refocus these companies.

May I remind them that Google's original business model so far remains the best innovation of the past ten years. Its formula needs not threaten user privacy as it simply monetizes searches with space both clearly delimited and in a limited supply auctioned to advertisers. That of late Google has become as besotted as any starving startup by the riches which comes from invading user privacy is another story we have covered elsewhere.

Gillian Tett provides another example by suggesting "to put the true value of CDOs out in the open" (**) (1). In a previous column, she compared the complex securities at the root of the current financial crisis to rotten meat in cold storage. Now she advocates to open the freezer and auction off its content "to get a bit of market price discovery". To be sure unregulated lending innovation landed us into a fine mess but the point here is that no price discovery mechanism can itself be implemented to sort it all out without some rules.

Has Gillian Tett in mind to auction off the meat right out of the freezer? I hope not. Better keep the freezer shut tight, turn over the auction to some lottery operator and admit this way of discovering prices is like asking blind voters to name color samples in a paint shop. More efficient, if more offensive to the nose, would be to take the time for the meat to thaw and allow would be buyers to smell the underlying facts. As Gretchen Morgenson warns us (***), some mortgage based securities are not even properly documented. Some homework here is clearly overdue.

Last week I offered some advice to the FTC with respect to behavioral advertising. If I were to help rule makers in general, what could I say, even as I confess to be neither particularly politic nor much of a clairvoyant?

My first suggestion would be to favor decentralization whenever feasible. Since errors are bound to occur, better they be scattered and small. Since backwater innovation is more difficult to control, it is bound to prosper according to Jonathan Zittrain (2). On average the outcome will be both more robust and vibrant. This is why I bemoan that, from a fantastic tool for decentralization, Internet has been perverted by data aggregators into a highly efficient collection agency. This is why I push for recommendation systems to be globally local. This is why I am in favor of markets, whether based on price or on value.

However please ensure such markets are not victims of one the four plagues which cripple them into harmful caricatures of themselves.

Asymmetry is the first. How come lenders can penalize students for trying to get them to compete? How come Google can claim its ranking decisions must be protected by secrecy when it denies meaningful privacy to its users? How come companies are allowed to bundle a consent to hand over personal data with transactions users cannot do without, a form of blackmail ?

Gillian Tett's CDOs auctions may be less asymmetric than most as complex security sellers appear to know the content of their freezer as little as putative buyers. But why not compel market participants to account for all relevant facts rather than be satisfied by their impartial suppression?

Rejection of trade is the ultimate market asymmetry. One form is to assume the underlying goods or service is free to begin with. This well known externality trick is the cause of increases in pollution nobody believe sustainable anymore. I claim the same goes with personal data and time.

Another way to reject trade is but to assert a normal right which comes with ownership. Until Apple Computer proved it wrong as Saul Hansell points out (****), the recording industry spent years fighting the Internet. One should be wary before condoning piracy and innovations such as the iTunes store cannot be had on demand but copyrights are rules and rules would evolve appropriately it it were not for pronaocracy.

The third market failure is the worst. Decentralization will not work if independent actors all agree to a rising trend. If this trend encounters no physical limits, expect a bubble. And the more efficient the market, the worse the bubble. Allow me to mix my metaphors. Markets promote liquidity, which is good. But try to run with a basin full of water. Under the right momentum, liquids can easily slosh out of control. Rules to dissipate an excess of exuberant energy are not to be disdained on principle.

The fourth plague, the most insidious, is to forget limiting the rulers' role. Letting for instance market makers use their privileged position to capture market data for themselves undermines the very purpose of the market. The belief he had this insider advantage helped Madoff pull off his scam.

My last suggestion will perhaps appear the most controversial until one considers the Greek made it about 2,500 years ago. Try to dampen star systems. Stardom and its unchecked rewards inevitably engender hubris and envy and these all too human foibles are poison to society. For the effect of hubris look at Google, look at Sir Goodwin. In defeat and in shame, the former head of Royal Bank of Scotland did not fall on his sword as some past captains have been known to do. As Jane Croft and George Parker relate, he left instead with his well padded pension plan (*****).

I wish I could buy Simon Kuper's argument that the sport industry is better managed (******). "Only the truly excellent get outsized rewards" and "performance appraisals are almost totally transparent". But would have a whole generation of bicycle riders fallen to opaque performance enhancement practices if not in the hope of these few outsized rewards? Today, aren't sports too much about envy-driven truth extension?

Rule making is an art, not a science. It does not mean its practice cannot be as rational as it is necessary. Twitter or twit, your choice!

Philippe Coueignoux

  • (*) ........... Sweet to tweet, by Richard Waters (Financial Times) - February 27, 2009
  • (**) ......... Time is nigh to put the true value of CDOs out in the open, by Gillian Tett (Financial Times) - February 27, 2009
  • (***) ....... Guess What Got Lost In the Pool?, by Gretchen Morgenson (New York Times) - March 2, 2009
  • (****) ..... Why Are iPhone Users Willing to Pay For Content?, by Saul Hansell (New York Times) - February 26, 2009
  • (*****) ... Pension for former chief executive sparks anger, by Jane Croft and George Parker (Financial Times) - February 27, 2009
  • (******) . Bankers can learn from sport about fair play on pay, by Simon Kuper (Financial Times) - February 27, 2009
  • (1) for more details about financial acronyms, see CDOs and ABS in the Wikipedia
  • (2) see Jonathan Zittrain in the author's index of these fillips
March 2009
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