Last night’s BBC programme on F. A. Hayek was interesting and, like the Keynes programme, gave the subject a fair crack of the whip. It is not by way of criticism that I write this blog post, but a comment by Stephanie Flanders raised an issue in my mind that deserves further elaboration.
The series of programmes had a focus on money. I guess the BBC would have struggled to get an audience for a series which had as its theme the analysis of extended economic orders and structures. As such, there was a lot on money last night and quite a bit of material on the difficulty of central planning. There was a little less emphasis on the way in which the market produces stable extended orders and the way in which markets can regulate themselves. In a very different context, these ideas have been developed by Professor Elinor Ostrom, the 2009 Nobel Laureate. She is one person who Krugman could not accuse of producing ideas that were not borne out by history – her whole academic method was to research exactly what was happening in real time.
At one point in the programme Stephanie Flanders pointed to Big Bang in 1986. She said (correctly) that Big Bang de-regulated financial markets. She said (correctly) that many Austrian economists argue that to underpin financial institutions with implicit government support, whilst allowing them to do what they like, is asking for trouble. However, what was important for Hayek was not whether or not markets were regulated, but by whom they were regulated. The most important event of 1986 was to move the regulation of financial markets from the market to the state (at first via a series of quangos).
Until 1986, from 1801 - or arguably before, securities markets had been entirely self-regulating. The stock exchange was a private body established in its modern form in 1801. From even before that time, it had conventions to ensure that those dealing were trustworthy. The stock exchange itself brought in the restrictions stopping those involved in broking from holding investments on their own book to prevent conflicts of interest. Those who broke the rules were not allowed to be members and, in the early days, the exchange faced the prospect of parliamentary action by those who objected to the exchange enforcing its rules and excluding certain people from dealing. Of course, anybody was free to set up a competing exchange and dealing off-exchange was entirely possible. A competing exchange could have allowed ‘dual capacity’. In the end, the London exchange was so successful with such high standards of probity that its motto became ‘my word is my bond’ – much better than today’s ‘I have ticked all the boxes so everything is okay’ attitude.
This was an evolved institution. There was the possibility of competition. The exchange could not easily have been designed by a statutory regulator – it could only come about through the trial and error process of competition. The exchange had a strong rule book both for members and for companies that were listing. This was not the brutality of market competition that is often portrayed by its opponents, but a sophisticated social order to provide for the regulation of the market. It was swept away in Big Bang. The market itself produced a more highly regulated order than government – but one that was always open to competition.
Interestingly, at roughly the same time, a government authority banned life insurance companies from fixing commissions paid to insurance brokers through a cartel. This was not a water-tight cartel – there were some companies (who often had poorer reputations) that paid higher commissions. The government saw this cartel as a distortion of the market. In fact, it was the market at work. There may have been some benefits to the insurance companies in the cartel because they forced commission levels down (to the detriment of insurance brokers), but the main benefits to both insurance companies and brokers was that it created a relatively clean market where brokers had incentives to recommend on the basis of the quality of the product rather than the level of commission. As long as the cartel was open to competition (and this one clearly was), the damage to the market from the cartel would have been very limited. Interestingly, the FSA is still today – 25 years on and several mis-selling scandals later – trying to clear up the mess that was, at least in part, caused by this decision to break up the cartel. The FSA is seeking to regulate the insurance intermediary market ever more in order to try to ensure that advice is unbiased – and, in doing so, the FSA is ironically reducing competition possibly to a greater extent than the cartel ever did.
Our understanding of how markets develop these sophisticated forms of economic and social co-operation is one of Hayek’s greatest legacies. These orders can never be designed; they can only evolve. These orders often also add a deeply social aspect to the market economy (think about all the self-regulating sports that evolved in this country – including soccer). Ignoring this lesson is perhaps another sense in which there has, perhaps, been too much Chicago and not enough Vienna in our financial markets.