David R. Henderson  

Would Posner and Weyl Ban Gambing--and Tennis?

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Robin Hanson reports on a popular article based on a paper by law and economics professors Eric Posner and Glen Weyl in which they advocate a kind of Food and Drug Administration for financial instruments. The paper is titled "An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets." Here's part of the abstract:

We propose that when firms invent new financial products, they be forbidden to sell them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if they satisfy a test for social utility that focuses on whether the product will likely be used more often for hedging than for speculation.

I guess that's because, you know, the FDA has worked out so well.

But to the point. They get that being able to hedge is valuable. But they think that speculation is not. Why? They write:

By contrast, when a person speculates, that person exposes herself to increased net risk without offsetting a risk faced by a counterparty: she merely gambles in hopes of gaining at the expense of her counterparty or her counterparty's regulator. Speculation is a zero-sum activity, which, in the aggregate, harms the people who engage in it, and which can also produce negative third-party effects by increasing systemic risk in the economy.

They continue:
When two people bet over whether a coin will turn up heads, they each incur the risk that they will be poorer in the future, when, assuming that they are risk-averse, the gain will not be sufficient to outweigh the loss in terms of utility. Thus, rational people will not engage in speculation in the first place unless (1) they like to gamble (in which case there are cheaper ways, like casinos, to satisfy this preference), (2) at least one party is confused (which we believe is extremely common), or (3) they are engaging in regulatory arbitrage (which is also extremely common). Thus, there is no social gain from permitting speculation.

QED.

I don't know if they back up their claim that casinos are a cheaper way to gamble. That doesn't seem obvious to me at all. But if we take their argument seriously, they should want to ban gambling also. After all, gambling is zero-sum. Actually, it's worse: when you take account of the costs of gambling--setting up a casino, etc.--it's negative-sum.

In a separate article, they do write:

Our skepticism about speculation shouldn't imply that we oppose all forms of gambling. In controlled and appropriate contexts, it can be a source of entertainment for people who are aware of and willing to accept the potential losses. But participants in financial markets are usually seeking financial security rather than entertainment, and they typically have little sense of the risks they are taking on.

In other words, those who gamble in financial markets are less informed, according to Posner and Weyl, than those who gamble in those really-cheap casinos. I didn't see them give any backing for this claim.

Let's take it further. Take tennis. Tennis is zero-sum also. When one player wins, one player necessarily loses. Moreover, there's the cost of the tennis court. Also, tennis is time-intensive. It's probably worse than many forms of gambling that take just pushing a few buttons. So if we take Posner's and Weyl's argument seriously, there's no good reason not to ban tennis.

Have I left something out? I have. It's the pleasure of playing tennis. I think rational people do play tennis and one reason is that they enjoy it.

Similarly, many rational people gamble and enjoy it. On a flight from Las Vegas to San Jose in 2001, I noticed that the crowd on the plane seemed particularly mellow. I was alone and so I started to listen to conversations and heard lines like the following: "I found this game in x casino that was a really fun way to lose $40 slowly." That's when I came up with the line (I'm not saying it's original with me but I did come up with it on my own) that Las Vegas is Disneyland for adults. When I was a graduate student at UCLA, many of my professors bet on particular stocks. I recall the late Earl Thompson calling me late one night because he had heard that I was betting on Piper Cub and he wanted to know what I knew. Maybe these professors were more ignorant of the risks than gamblers in Vegas--I don't know--but they enjoyed the game. By the way, sitting in their offices in Bunche Hall and calling a broker--even in those days--was cheaper than flying to Vegas.

So the same argument that can be used for allowing tennis can be used for allowing gambling and can, in turn, be used for allowing speculation. Moreover, there's an even stronger case for allowing speculation: speculation produces a public good, the good of price discovery.

By the way, Robin Hanson performs an excellent reductio ad absurdum in his post, pointing out that the same argument Posner and Weyl use in their popular piece would lead to the conclusion that the government should ban conversations about elections.


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CATEGORIES: Finance , Regulation



COMMENTS (16 to date)

Wow, that's pretty scary.

And this in particular ...

>> "The agency would approve financial products if they satisfy a test for social utility that focuses on whether the product will likely be used more often for hedging than for speculation."

It's not clear to me why that's any of the government's business.

Insight writes:

"will likely be used more often for hedging than for speculation"

Even if you accept their premise that this fin-FDA can do a good job making this assessment (btw, at what cost?), and even if you accept their premise that hedging is "good" and speculation is "bad," how does one reach the conclusion that the above test is useful?

It could easily be the case that speculation is slightly bad yet hedging is extremely good, so the benefits from a small amount of hedging might outweigh the costs from a large amount of speculation.

rpl writes:
...a test for social utility that focuses on whether the product will likely be used more often for hedging than for speculation
With any financial product, even the "good" ones, who are the hedgers' counterparties supposed to be, if not speculators? Perhaps they can find people who need to hedge in the other direction, but in many cases the need for hedging is going to be asymmetric between the two sides of the market. Without speculators to take up the slack, people who need to hedge won't be able to.
Doug writes:

It's even worse then you point out David. The paper naively assumes that hedgers only trade with hedgers, and "speculators" only trade with "speculators."

Most times markets naturally have more people wanting to hedge one side then the other. Therefore you need speculators on the other side willing to bear the risk (for a small expected premium). In addition to that many hedging markets are inherently illiquid, but still correlated to more liquid markets. There you need speculators trading one market against the other and keeping the price fair and in line.

Then sometimes those illiquid markets need participants to provide liquidity for a small premium. These market makers are by definition speculators. Going further sometimes the speculators reach their natural risk limits and are forced to liquidate (e.g. after a big market dip), now you need more speculators willing to step in and relieve the previous speculators of their losing positions without vastly disrupting the market.

In fact I estimate that most real world "hedging" markets, the actual hedgers typically make up less than 5% of the volume. Let's not forget that the actual definition of hedging itself is pretty fuzzy:
http://dealbreaker.com/2012/04/jpmorgans-voldemort-probably-isnt-that-magical/

Of course, I doubt Posner and Weyl bothered to do any actual research in the field. Or actually talk to professionals with experience participating in these types of market. Being at U Chicago. they're just down the road from some of the greatest trading firms in the world, but they probably didn't have time.

Robert writes:

I learned in finance 101 that for every hedge there needed to a speculator willing to accept the risk that the hedging firms are trying to avoid.

What about Basel I? What do they say about the risk of poorly designed regulation? Basel I, allowed the banks to keep 8% reserves on the equity portions of CDO's with MBS underlyings. The banks were allowed to keep all the risk while only keeping 8% reserves in a process to increase the banking regulation.

Ken B writes:

Why just new instruments? Doesn't the logic apply equally to existing ones? Like for example, stocks, gold, bonds, foreign currency.

Saturos writes:

Favourite line:

"In other words, those who gamble in financial markets are less informed, according to Posner and Weyl, ..."

Hey, you don't think that speculation might have anything to do with providing information, do ya? Or do you think you're more informed than everyone else on the markets with regard to the "true value" of assets? Gee, you guys must be rich.

Saturos writes:

Robert,

Yeah, that's right, speculators provide liquidity and information - as well as directly reallocating resources more optimally (http://www.newsday.com/opinion/oped/boudreaux-don-t-curse-the-oil-speculators-1.3645329).

AJ writes:

I'm not sure what to think about the economics of this article. We need a government agency to tell me if this makes sense and should be promulgated.

AJ

GIVCO writes:

Many of us here play games because we live in Utopia where all of our material needs and much more are met by banging on keyboards, reading or blathering for a few hours. Utopia is boring, so we play games, we make "voluntary attempts to overcome unnecessary obstacles".

Here's Bernard Suits fuller definition from The Grasshopper: Games, Life, and Utopia,:

To play a game is to engage in activity directed towards bringing about a specific state of affairs, using only means permitted by rules, where the rules prohibit more efficient in favor of less efficient means, and where such rules are accepted just because they make possible such activity…playing a game is the voluntary attempt to overcome unnecessary obstacles.
AngryKrugman writes:

I ask because I'm genuinely curious about the answer:

Does their point have more force when we consider a key difference between complex financial products and gambling? The people risking on their former are using other people's money, not their own. Especially given the agency costs endemic in those sorts of relationships and the complexity of the products, we might specifically be worried about employees booking what appear to be profits in the short-term--and collecting a bonus--when a loss is on the long-term horizon (for either shareholders, or, if you're at a bank, taxpayers). I suppose in a really efficient market, firms with bad corporate governance structures have more trouble raising capital, making them less efficient and so on, but still seems like the "other people's money" argument might still hold (especially in the case of banks backed by taxpayers, where incentives are skewed even more).

David R. Henderson writes:

AngryKrugman writes,
The people risking on their former are using other people's money, not their own.
Posner and Weyl make this point. Here’s the problem: In ALL their decisions, some of these people are using other people’s money. And ALL the decisions are risky. So, if that’s their reason, they should advocate laws preventing people from making decisions with other people’s money. By the way, such a law would immediately end ALL government.

Xerographica writes:

"By the way, such a law would immediately end ALL government."

Well...

Sometimes I worry that I over-promote pragmatarianism. But then I quickly come to my senses.

Your Money, Your Choice - Cait Lamberton

What If Taxpayers Could Decide How Their Money Is Spent? - Daniel Indiviglio

The Solution? Earmark Your Taxes - Russell Baker

What Is Personal Tax Earmarking? - L. S. Wynn

We, The People - Jack C. Haldeman II

Choosing Where Taxes Go - Brandy Mae

Joe Cushing writes:

If speculators were only trading with each other, you could make an argument that it is gambling. Speculators don't only trade with each other though. They trade with hedgers. Hedgers make predictable rational trades to lower risk. Speculators can take on that risk for a fee. The fee isn't explicit but it comes in the form of reduced profit to the hedge and capital gains to the speculator. Said another way, speculators get paid to take risk away from hedgers. The speculator also provides the service of reducing market volatility--a service which they are also paid for. It's not zero sum and it's not gambling.

blink writes:

Posner and Weyl's enthusiasm for regulation worries me, but I do not buy all of your criticisms either. First, claiming that casinos are cheaper ways to satisfy preferences for gambling seems uncontroversial. After all, this is a competitive industry catering to consumer preferences. Financial markets are not set up to maximize the same preferences; their primary function of course is to allocate capital. Thus, gambling and tennis make bad analogies because Posner and Weyl are more than happy to admit that merely playing creates utility quite apart from "winning".

You rightly attack their implied paternalism. Their argument is strongest, though, when they claim that the presence of uninformed financial market participants encourages speculation which destabilizes the market for everyone -- that is, they are claiming an externality. How do you respond?

Ken B writes:

blink

First, claiming that casinos are cheaper ways to satisfy preferences for gambling seems uncontroversial. After all, this is a competitive industry catering to consumer preferences.

As we say in Bridge, double.
First, entry to the business is tightly restricted, and locations tightly zoned. Only Indian bands can enter the market easily. And there are severe restrictions on the main direct competitor: internet gambling. So it's not that competitive. Often it involves travel, so it's not that cheap.
Not that I have should have to justify my preference for a form of gambling that isn't the cheapest. Perhaps we need an FDA for that.

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