Sunday, June 13, 2010

May the Force Be With You

"Did you hear that? They shut down the main reactor. We'll be destroyed for sure. This is madness."
--C3PO (Star Wars)

One way to conceptualize effects of market interventions is by using force field analysis. I first became familiar with force field analysis in my quality management days when it provided a useful tool for improvement teams seeking to evaluate problem causes and implement remedies. Kurt Lewin (1943) was one of the first to express the concept in the context of change management.

The basic idea behind force field analysis is to identify forces that work for and against a situation that bring it to static rest. Then, by adding additional forces or taking some away, a sense can be obtained about the dynamics of subsequent interventions.


In the case of pure, unhampered markets, the dominant forces are optimism about a prospective good's utility, and pessimism about the good's utility. Optimism exerts upward pressure on prices and pessimism exerts downward pressure. These opposing forces balance each other at some point when markets 'clear,' thereby providing a natural regulating mechanism.

There are, however, people with particular interests who tend to be dissatisfied with the equilibrium that results from the free market's natural regulatory process. Sometimes, individuals might feel that the equilibrium is established at too low of a price and in need of stimulation--perhaps via low interest rate policy in the case of central banks, or loan guarantees in the case of Fannie Mae (FNM) and Freddie Mac (FRE). In other situations, individuals might feel that equilibrium is established at too high of a price and in need of suppression--perhaps via regulatory oversight of industry, or by outright price ceilings.


The figure above shows the outcome of one hypothetical group of interventions. In addition to the market forces of optimism and pessimism, additional interventionary forces are present, some designed to push prices higher and some designed to push prices lower. In this particular hypothetical, the end result is that prices stabilize at a level higher than the unhampered, free market price. As price moves further from the unhampered price, risk relative to reward increases.


Now suppose that a particular political administration decides that it would prefer less industrial oversight and subsequently removes the regulatory agency previously serving as 'watchdog.' As indicated by the figure above, with the suppressive regulatory force now removed, stimulative forces move the market higher, and prices stablize at an even higher level than before. Risk relative to reward has increased further.

Over the past couple of years, various pundits have claimed that free markets have failed, offering as evidence the seeming cause and effect between reduced regulatory oversight in various sectors and riskier situations that generated economic hardship. However, such claims ignore the fact that other interventionary forces were present when those regulatory forces were reduced or removed.

Unless regulation constitutes the only interventionary force imposed (and it rarely does), removal of regulatory forces usually does not create a free market situation. Indeed, removal of a single interventionary force may not even make a market 'more free.' Instead, the removal of one interventionary force may merely motivate a situation that makes an already hampered market riskier (as portrayed by our final figure above).

Risks that subsequently become realized are the consequence of interventionary action--not the lack of it.

Left unhampered, markets seek to balance risk and reward. Intervention hampers the natural balancing mechanism, and over time almost inevitably leads to increased risk--something counterintuitive and perhaps even incomprehensivle to proponents of government interference in markets.

position in SPX

References

Lewin, K. 1943. Defining the "Field at a Given Time." Psychological Review, 50: 292-310.

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