March 29, 2011

The health of all economic systems depends in great part on generating the best information on a sustained basis. That a superior source comes from observing publicly regulated market exchanges among decentralized agents has done much to ensure the success of capitalism.

We have found capitalists to be their own worst ennemies. But it is also fruitful to understand the limits in principle of market-based observations.

The most immediate issue is that many observations are rendered moot by a lack of opportunity to act upon them.

For instance, take David Gelles and Andrew Edgecliffe-Johnson's insightful analysis of sports broadcast rights (*). Quoting "Jeff Zucker, former chief executive of NBC Universal", for whom "broadcasting right now ... is about event television, live television, sports events", they explain how this has created "sustained sports rights inflation", "cable and satellite subscribers absorbing increases in their monthly bills".

Such observations ought to entice new market participants, starting with performers, to deliver more sports events to eager viewers. The combined effect of stardom and economy of scale will unfortunately but quite rationally discourage most initiatives. Time may crush even the most formidable barriers to entry but not before two consequences have been enabled.

First, what should be an exchange open to innovation becomes a fight in a closed field among entitled oligopolists. Actually there are worse cases than sports events. What content publisher does not wish Apple iTunes to have a little less clout? What consumer does not dream of having more than two suppliers of local high speed internet?

Second, barriers to entry can reproduce before they die. London and, on a lesser scale, Boston owe their current banking fortunes to long gone seefaring preeminence. Noble by birth, the French aristocracy lost most of its privileges to the Revolution but the luxury industry it spawned during its heyday is alive and well and living in Paris.

This is not a reason to eliminate legal monopolies designed to protect intellectual property and foster creation. But one should avoid unduly extending their duration. Professor Ray D. Madoff is justified in recommending "Congress [...] set forth a relatively short term for the right of publicity to survive death (perhaps 10 years)" (**). Still wouldn't this right better limited to a dollar ceiling rather than a time duration?

Professor Madoff also declares "today the right of publicity clearly allows people to control the commercial use of their names and images during their lives". Given known practices at Facebook, such an eprivacy right appears to be another privilege of the noble by brand. Hoi Polloi can only hope that, once they die, Mark Zuckerberg has the decency to stop using them to advertise to their friends without their explicit and free consent.

Moreover Facebook is a perfect illustration for the next issue facing capitalism, i.e. market-based observations can be captured and traded upon by the market organizer ahead of everybody else. Do not social networks act as a new kind of market? As such they represent a beneficial advance. Unfortunately, Douglas Rushkoff warned us, a new class of privileged observers waxes ever bigger out of such unregulated information networks.

While indeed observed personal data fuels the rise of targeted advertising, in itself a legitimate pursuit, ad networks and advertisers exclude the persons under observation from their economic exchange and treat them as lazy objects rather than active subjects. As consumers, whether resentful or prudent, may learn to dissemble or flock to more discrete locales, observations may well decrease in both quality and quantity.

Outlaw markets and this issue goes away. A more realistic approach would be to prohibit market organizers, including social networks, from profiting from private information ahead of the public without the consent of the party whose information it is as a case of illegal insider trading. It may not deter the criminally inclined, at least it would raise the risks of skimming a whole "new asset class".

Ironically, the next issue arises on transparent markets, when human beings can easily observe one another. Every time such collective self observation prompts otherwise independent actors to agree among themselves and act in concert, the market mechanism only releases pretend information which can inflate bubbles or launch social flash fads which at their best disrupt production lines, at their worst ruin individual lives.

Social networks have greatly increased the virulence of popular trends but financial indexes have the same effect on traditional markets as they too amplify collective observations. As Gillian Tett writes about the so-called Vix (1), "[it] certainly does provide a powerful barometer of sentiment that can be quickly grasped by investors (or journalists) alike" (***).

The last issue is perhaps the most intractable. Observations can hide the reality they are supposed to represent behind a new reality, a recipe for trouble. For comic relief, read David D. Kirkpatrick and Kareem Fahim (****). "More than 30 coffins were carried to Martyrs Cemetery" in such a suspicious way that the authors assert "Colonel Qaddafi's Libya is a country where even a coffin is sometimes a question mark".

This calls back to mind tragic catastrophes caused by a defective security layer. This is the current explanation behind the hasty dismissal of key Renault executives. At another scale, the failure of its own emergency cooling system crippled the Fukushima nuclear power plant (2).

Back to markets, continue reading Gillian Tett on the Vix. Despite the fact "[underlying] equity prices were already completely transparent", "some investors assume it has predictive power for equity markets". In other words even observations derived from a visible reality may become the more powerful reality, the tail viciously wagging the dog.

Two months before the Japanese tsunami, Tim Harford compared nuclear power plant safety to financial regulation (*****). "Simplify the system, decouple it, or reduce the consequences of failure", he relays in conclusion. But notice how the first two solutions are impractical when dealing with market-based observations. In the latter case, layering is inevitable and decoupling a nonsense. We must come to terms with the limits inherent to capitalism and learn to "reduce the consequences of failure".

Market-based observations encounter inherent limits in providing pertinent information in an abundance of data.

Philippe Coueignoux

• (*) ......... Inflated assets, by David Gelles and Andrew Edgecliffe-Johnson (Financial Times) - March 25, 2011
• (**) ....... The New Grave Robbers, by Ray D. Madoff (New York Times) - March 28, 2011
• (***) ..... Surging Vix volumes could hold the key to investor trends, by Gillian Tett (Financial Times) - March 25, 2011
• (****) ... Elements Of Theater On View In Libya, by David D. Kirkpatrick and Kareem Fahim (New York Times) - March 25, 2011
• (*****) . What we can learn from a nuclear reactor, by Tim Harford (Tim Harford) - January 15, 2011
• (1) for more details, see VIX in the wikipedia
• (2) for more details, see Fukushima nuclear accidents in the wikipedia