Why a Bottle of Beaujolais is not the same as a Collateralized Debt Obligation (Updated May 2016)

I have updated this blogpost with a link to the new version of my paper. The new revised paper has the title of "Pricing Assets in an Economy with Two Types of People". 


Brad DeLong kindly tweeted a link to a working paper (updated to new version May 21st 2016) I wrote last year. Matt Yglesias asks Brad to explain the paper. Let me take a stab at that.

Every graduate student of economics learns, early in her career, that markets work well. The idea that ‘markets work well’ has a well defined meaning: allocating resources by buying and selling goods in free markets does at least as well as any other way of allocating them. Let me be more precise.

A society, to an economist, is a bunch of people and a bunch of goods. A good is something that people want. For example, a ticket to see the latest Star Wars movie is a good. A bottle of Beaujolais is a good: and so is a banana. I could go on. But the basic idea here is that everyone in society has preferences over different bundles of goods. I personally would prefer a bottle of Beaujolais and a banana to a trip to the movies: but you may rank things differently.

We need a way of thinking about abstract ways of allocating goods amongst all of the people in the society that is general enough to include the activity of buying and selling goods in markets as one possible allocation mechanism. Economists think about that idea by introducing an abstract individual that we call the social planner. The social planner is a non-existent benevolent dictator who knows the preferences of every person in society.

Imagine that we dump all of the goods that exist in a big pile in the middle of a very large imaginary room. Now let the social planner allocate them to people. For example, she might give everyone equal amounts of every good. That might sound like a good idea, but some people might not drink wine. They would prefer an extra loaf of bread to a bottle of Beaujolais. That idea suggests that some ways of allocating goods are better than others. If the social planner finds a way of allocating goods among people that can’t be improved on, without making someone in society worse off, we say that that allocation is Pareto Optimal.

There is not just one Pareto Optimal way of allocating goods. There are many. And some of them are very bad from a moral perspective. For example, if the social planner gives everything to one selfish person: that allocation is Pareto Optimal. Why? Because, in order to give food to starving children we need to take it away from the selfish person. And that, by assumption, makes him worse off. Pareto Optimality is a very weak concept.

But although Pareto Optimality a very weak concept it is an interesting concept because, if an allocation of goods is not Pareto Optimal, it is very bad indeed. Everybody in society, from the very richest to the very poorest person, could agree upon an intervention that would change things for the better.

Graduate students of economics learn, early in their careers, that markets allocations are Pareto Optimal. Markets may not produce outcomes that you or I judge to be morally acceptable. But they do not leave room for any obvious improvements that we could all agree upon. That idea, with a little reflection, seems to me to be obviously wrong. The ‘Global sunspots…’ paper provides one reason why.

Ok. That's the background. To understand my ‘Global sunspots paper…’ I need to go a little further by elaborating on the idea of a ‘good’.

Writing in 1959, the Nobel laureate, Gerard Debreu, suggested that the theory of markets that I just explained, is much more general than it at first seems. Debreu asked us to think of a good in a new way. A loaf of bread is not just a loaf of bread. It is indexed by location, date and state of nature. A loaf of bread in Paris on March 9th 2016 in the rain, is a different good from a loaf of bread in London England on July 20th if the sun is shining.

Financial economists took that idea and they ran with it. They argued that the financial markets provide people with ways of trading goods across space, time and states of nature. And because market allocations are Pareto Optimal, there is no possible intervention in the financial markets that can make us all better off. Government should get out of the way and let the magic of the market do what it does best.

According to financial economists, the financial instruments that are traded on Wall Street are unequivocally good. Equities, bonds, and exotic derivatives like collateralized debt obligations (CDOs)  all provide opportunities that connect people across time and space. To justify their confidence in the magic of the market, financial economists appeal to the mantra that they learn as graduate students: market allocations are Pareto Optimal. What could possibly be wrong with that?

The problem is a simple and obvious one. In order for markets to work well: we must all be able to take part in them. One of the most important functions of the financial markets is the ability to make bets on the future. If I think that the S&P 500 will crash next month, but you don’t, we have an opportunity to trade. And if I face different outcomes if the market crashes, or if it booms, I will try to insure myself by selling the market short in boom states and paying for that trade by buying the market in the crash state. It is my ability to make those trades, which ensures that market movements are not capricious. If a crash occurs, it occurs for a reason. And that reason is connected with the fundamentals of the economy. That, at last, is the theory. That theory is wrong.

That’s where sunspots come in. Writing in 1983, David Cass and Karl Shell picked up on a phrase that had been used much earlier by Stanley Jevons. Jevons thought that sunspots influence the business cycle through their effect on the weather. Cass and Shell meant something very different. They used the term as a spoof to mean capricious movements in market prices, and in the goods that we all consume, that are unrelated to fundamentals.

That leads me to the conclusion of my global sunspots paper. Because we cannot trade in financial markets that open before we are born, most of the movements in financial markets are Pareto inefficient. Financial markets go up. Financial markets go down. If you are lucky enough to enter the labor market in a boom; you will have a happy and prosperous future. If your first job occurs in the wake of a financial crisis: tough luck.

A bottle of Beaujolais is not the same as a Collateralized Debt Obligation. Why? Because trades in CDOs affect the welfare of the unborn: and the unborn are not around to trade in the CDO market. Stay tuned. I have much more to say about this idea in my forthcoming book ‘Prosperity for All’, to be published by Oxford University Press in 2016.