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It’s always a good morning when I wake up to the new edition of the Real World Economics Review in my inbox. This issue may be of particular interest for readers of this blog, who recall my review of David Westbrook’s excellent book, Out of Crisis: Rethinking Financial Markets. You should still read the book, but in the meantime, Westbrook has condensed his thoughts into a 12 page article, ” Tragedy, law, and rethinking our financial markets.” The general ideas are similar, although there are a few Marx references peppered in. I’m excerpting below the fold, so as to encourage you to read the whole thing.

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Realizing that it is somewhat unadventurous to merely review and regurgitate other reviews of quality work, I decided to purchase, read, and review David A. Westbrook’s Out of Crisis: Rethinking Financial Markets. In that spirit, I also urge you to read the book for yourself and draw your own conclusions. This, I believe, is an important book for our times. Here are my (somewhat long) thoughts:

In one sense, this book is very modest in its aims. In the introduction, Westbrook admits that, “it is sociologically and psychologically implausible that our administrative agencies will rethink our financial markets at all well and except under extraordinary circumstances.” However, as the title implies, in order to get out of the crisis, we must move ourselves from the limited framework of thought that has dominated policy for decades. And, of course, we are in extraordinary circumstances. Even so, introducing a new paradigm of thought, even while acknowledging that it may fall on deaf or corrupted ears, is an ambitious undertaking.

Against the current backdrop, Westbrook’s rethinking seems quite necessary. Indeed, he argues that the crisis represents the birth pains of a transition to a new era of financial capitalism (replacing the era of portfolio management, which spanned three decades). Entering this era with anything less than a new framework of thought will leave policymakers two or three steps behind. As Westbrook argues, even our grammar and language for markets needs to be reshaped.

So, what are the assumptions with which we move forward in this bold rethinking? First, Westbrook seeks to dispel the somewhat irrelevant bifurcation between governments and markets. This key move is related to another predisposition, the idea the financial markets are intensely social entities. Third, related to this, Westbrook want us to understand finance from a legal perspective as a series of contracts, rather than a set of property rights. Finally, Westbrook seeks to reemphasize the importance of uncertainty (sharply distinguished from risk) in how our financial markets operate.

Early on, he dispels with what he terms “melodramatic narratives” of the crisis, ranging from securitization to monetary policy, all of which are intellectually conservative because they operate within the same structure of thought that led to the crisis. Not among their number is the exploitation-inequality-uneven demand explanation that is common in Marxian and institutionalist circles, and that I’ve trumpeted on this blog on many occasions. In many ways, Westbrook’s argument is tangential to this narrative, as he is primarily probing the financial crisis, which is one (albeit major) part of the economic crisis. As a law professor, it doesn’t seem to strike him as to whether his narrative of the broken framework is sufficient for a broad economic crisis; however, this wrinkle doesn’t make his argument any less relevant.

The path that the financial sector has taken in recent decades is broadly indicative of an attempt to move from uncertainty to risk, inserting knowledge as the previously missing link. As Westbrook argues, however, the contractual nature of financial instruments weakens the ability to execute knowledge in a way that constructs the more simple risk. The failure to see this disconnect has led to the false allure of diversification, in which risk is managed by spreading resources over a number of purportedly independent investments. Again, going back to contracts, Westbrook argues that diversification, or “portfolio management,” necessarily reduces transparency. This story echoes the mainstream account of subprime-based CDOs, but builds on it by arguing that a whole range of securities and derivatives can fall prey, and the underlying causes run deeper than a shock to housing prices or the like.

So where has the government been in all of this? Westbrook argues that the zero-sum conception of the government-market relationship has “legitimated” bureaucratic irresponsibility. He faults the free-market ideologues for insisting that market priorities supersede societal goals or human ramifications. However, he also cautions that much is unknowable for regulators, who thus should seek performance over design, so as to stay ahead of the curve. Markets must be approached as they are: existing in a social space.

It is at this point that Westbrook makes one of his most important contributions, urging a reshaping of our metaphors and grammar for markets, so that they don’t replicate the false dichotomy between government and markets. His most useful metaphor, I think, is “tensegrity”: a structure in which elements pull against each other, but the structure remains as long as the link are tight- the structure is “integrated by tension.” The tension, in this metaphor, is credit, underscoring the notion that credit is the lifeblood of the modern financial system. He also uses ecology as a metaphor, and says that we should think about markets not as a jungle but as a garden, a place “of both planning and necessity.”

Where does these intellectual move lead us? First of all, we shift our focus to systemic risk, as Westbrook argues, acknowledging that diversification is pretty much meaningless for our situation. His hope is that systemic risk “become a concept…that broadly organizes thought.” There will always be structural weaknesses in a regulatory regime; however, basically misguided policy puts us in a far more precarious position. Confronting uncertainty as a certain reality is a difficult-financially and politically-but necessary consequence of acknowledging systemic risk. Thus, while systemic risk appears to be moving to the forefront in intellectual discussions- I say this mainly on the basis of VoxEU articles in the last year- the discourse is not occurring in the radical (i.e. to the roots) way that Westbrook encourages.

We also must carefully consider the risk of constructing what Westbrook calls a “courtier economy,” in which the powerful use their money and influence to capture the (de)regulatory process. He sees the construction of this class as one of the first steps toward a protectionist and militarized world, as a courtier class inevitably will push national policies that engender international tension.

At first glance, Westbrook’s argument seems to push for a “balanced” approach to the economy in which more socially-embedded markets gain more influence. However, there is no blueprint for what a socially-embedded market looks like. We certainly know what it doesn’t look like; a Polanyian view of the last few decades easily exposes the failures of the market-utopian drive. However, there are no assurances that the markets of the future will actually be regulated as if they are socially constituted. Are we to trust that this rethinking will help us get things right next time, or that reconceived markets are even the right way forward?

Should it be the case that they are, I hope they are conceived from Westbrook’s framework: that class tensions, uncertainty, and complexity are confronted head-on; that bureaucrats acknowledge their role and consider systemic issues in their designs; that we have more garden and less jungle. In an e-mail, Westbrook points out that he hopes this book serves as a political intervention in our society. The measure of its success as such will inevitably be whether we begin to hear the words “social” and “markets” in the same sentence from regulators, and whether we observe a change in our metaphors and an acknowledgement of contradictions. Understanding this book requires that we make the leap in accepting the constitutive role that discourse has. This pill is easier to swallow for intellectuals than for the quants and paper-pushers, whose language has been handed to them, their jargon ingrained. Westbrook is aware of these difficulties, yet one cannot blame him for seeking something of a revolution in thought.

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Via Mark Thoma come three reviews of one new book, Out of Crisis: Rethinking Our Financial Markets, which is written by David A. Westbrook. The book uses legal and political perspectives to analyze the economic crisis and,

“shows how markets are a form of social and political organization. Consequently, the divide between markets and governments that continues to structure thought across the political spectrum is too simplistic.”

The reviews are very substantive, so I’ll tackle the first today and the other two tomorrow. The first review is from Mae Kuykendall, who frames this book in contrast to Reinhart and Rogoff’s data-driven approach to the crisis:

Westbrook identifies an intellectual problem in the moment and provides a warning about habit. Professionals in finance and law must not assume a reversion to the mean that the idea of crisis can imply, he says…We’re in peril, without a governing paradigm and at risk of letting simple stories substitute for “conceptual renewal.”

Further, Westbrook argues that the prevailing orthodoxy has left us with a reconstruction project. Confidence in markets went too far and burrowed into our institutional design…For Westbrook, “This time the failure is different,” and waiting for a reversion to the mean is to be passive in the face of institutional and, Westbrook tells us, political crisis…

[Rogoff and Reinhart's] primary message to the reader: “We have been here before.” With centuries of data comes insight. So their biggest plea for the future of sound finance is data…

[Westbrook] gives us prescription at a grand level—a call for conceptual renewal within the “discursive community” of finance and a recognition that finance is now concerned with a web of legal contracts, or words, instead of the tangible things traditionally connected with measuring and preserving value…The grounding insight is that markets are political constructs, like games. So efficiency is not the only concept to gauge a market’s health.

In his theory, Westbrook turns to a factor about which the neo-classical economist has no insight to offer and which has a changing import for the tasks financial elites must master: the language in which we execute and regulate economic life. Westbrook directs us to a critical insight for this crisis: we are collectively enmeshed in a tragedy of language, using it to govern financial exchange in ways that are naïvely representational or, in the alternative, unrealistic about the power of a linguistic construct to constrain the world. Disclosure as a strategy, given to us by our savants of the last finance reset, assumes what the English professors tells us is really a childish idea: that language serves as a window to a real picture…

In our other principal strategy– risk management– language is asked to set up containers for large swaths of poorly described arrays of claims on something real. The tragedy is the contradiction. We believe, like children, in being told what our basket of claims contains, and we rely, like language engineers, on the idea that a big enough basket of abstractions—claims on too many things to try to understand with the faith of children looking through a picture window—is conceptually safe.

The nation—our government, meaning Congress and the administration (Westbrook tells us, the Bush-Obama sequence)– is there when the gears of tragedy grind to an unhappy resolution…

Westbrook warns us about this temptation…To fix the institutions of finance, elites are using words to rearrange and contain…

Westbrook’s tactics are, instead, reconstructive and architectural. Design for failure. Have institutions that can fall on their own…

Remember that markets are constructs, so do design. Match the scaling of architecture to the uncertainty of sustained confidence in price, value, counterparty liquidity.

Bad outcomes call for rewrite, revision, new content…

Macroeconomists have little interest in personality, only in the human folly revealed in a growing data file…

But Westbrook, taken with our time and place, describes the motives and players in the folly we can claim today. And these—the motives and we the players, our meritocratic culture– concern him. Our ideology of the market, and our naivete about the reasons that drive how we participate in, regulate, and analyze markets, are an innocent corruption.

The crux of Westbrook’s conclusion, then, is the concern that:

Few among us have purses lined with the booty from a bribe, but not a few have entered a courtier class, and have found a post in a market of courtiers…

Such a cosseted class might well plot just our recent roadmap for recovery: keep accountability at bay and make risk opaque. If need be, beggar thy neighbor and arm to the teeth

Thinking of markets as social constructs and delving into the representativeness of language are not approaches that neoclassical economists take. What we have here, then, is a very alternative narrative of the crisis, one that delves into root causes that go far deeper than economists dare tread. It seems that Westbrook goes even deeper than the Polanyian notion that markets are embedded in a social and political structure. They are also constructed by society and by language. There is no recourse to the simplistic notion that, “in the beginning there were markets.” Maybe there were markets from an early point in human prehistory, but our markets are just as much a product of our discourse on how economies function as they are a result of institutions.

Granted, it makes my head hurt thinking of the ways in which discourse can define structures, but it is certainly true that contracts and profit are socially constructed narratives in their own right. Choosing to emphasize those things leads to a certain type of economy and a certain type of markets. Our day-to-day language then serves to reinforce those structures. In particular, Westbrook’s so-called courtier class uses the language it chooses to define the future structure of the economy. As the next review will point out, this language leads to a simple (and potentially damaging) narrative of markets versus regulation, but we’ll get to that later…

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