Alligators in Nirvana: Smart Regulation and the Future of Financial Services-Public Policy Conference

Commissioner Hester M. Peirce

George Mason University Antonin Scalia Law School, Arlington, Virginia

May 16, 2019

Thank you, Tom, for that kind introduction. I am honored to have the opportunity to be with you at today’s conference.[1] It is wonderful to be back on this side of the river, even if only for a few hours. Thank you to the Law and Economics Center and the Program on Financial Regulation & Technology for putting on this conference. I must begin with my disclaimer that the views that I represent are my own and not necessarily those of the Commission or my fellow Commissioners.

I am drawn to events centered on law and economics because I once dreamt of becoming an economist. At the undergraduate level, economics opened my eyes to a whole new way of thinking about things. Although I did not go on to graduate school in economics, my appreciation for the discipline has persisted. In all of life, including in the legal and policy spheres, economic thinking has an important role to play. A variety of perspectives makes for richer conversation, more precise identification of problems, and better solutions.

The careful analysis that economists offer is, therefore, valuable, but it is not easy. Economist and first head of the Congressional Budget Office, Alice Rivlin, who passed away this week, explained that:

The early apostles of policy analysis sometimes sounded as though they had a magic wand—array the options, pick the most cost effective, and make it happen. . . . Realistically, since there's no absolutely "right" answer to most policy problems, what good analysis does is raise the quality of policy debate and decision making. It provokes counteranalysis, it exposes positions built on bad analysis or no analysis. It gradually works its way into policy.[2]

Dr. Rivlin, first director of the Congressional Budget Office and director of the Office of Management and Budget, knew whereof she spoke.

I

Our financial markets are, of course, extraordinarily complex, which makes economic analysis of them exceedingly difficult. Add the intricate web of financial markets regulation promulgated by our agency and others, and disentangling market-driven phenomena from those attributable to policy choices by one or more regulators can become nearly impossible. It is not surprising, then, that research seeking to assess possible solutions to problems we observe in the markets can be equivocal and provisional. I suppose that it is not surprising that economists—and particularly economists working in public policy—are the subject of so much humor, going back to the first decades of the last century. We find George Bernard Shaw supposedly expressing his view that "if all economists were laid end to end, they would not reach a conclusion."[3] Winston Churchill also apparently complained that "if you put two economists in a room, you get two opinions. Unless one of them is Lord Keynes, in which case you get three."[4] As a lawyer, I delight that another profession finds itself the butt of a few jokes.

As a policymaker, I can appreciate the frustration underlying this type of humor. When faced with a regulatory or market failure, we would love nothing more than to have the definitive, "right" answer. At the same time, the issues are complex, and we should encourage economists not to minimize this complexity for the sake of offering us simple, or simplistic, answers that justify politically expedient regulatory solutions. In fact, one of the most important things that economists can do for policymakers is to help us recognize the complexity of the market phenomena we are seeking to regulate, the uncertain results of any attempt to implement regulation, and the trade-offs involved. In other words, notwithstanding the complaints of Shaw and Churchill, it may be that a key role for economists engaging with matters of public policy is reminding regulators that humility is an absolute prerequisite for effective regulation. Given that many regulators are lawyers, I will tell you that the humility does not come to us naturally, so economists have their job cut out for them.

I would like to spend some time this afternoon reflecting on two economists whose work is particularly valuable in helping us to think about the limits on our ability to use policymaking tools to solve complex social or market problems. The American economist Harold Demsetz and the Hungarian economist and political theorist Anthony de Jasay, both of whom died in January of this year, teach us the importance of being brutally realistic about what we can hope to achieve through government policy, particularly given the inherently flawed and conflicted people and tools we have at hand to create and implement that policy. Jasay, who was also a successful trader and banker, remarked that "finance has very little to do with economics."[5] However, the lessons in realistic humility and humanity that these two scholars offer are perhaps particularly relevant to the work of the Securities and Exchange Commission given the intricate complexity of our regulatory space.

II

Harold Demsetz was, of course, a towering figure in American economics in the second half of the twentieth century. Some commentators placed him among those distinguished economists who should have been awarded the Nobel Prize but were not.[6] Demsetz taught at both UCLA and the University of Chicago, and he made significant scholarly contributions in several areas, including property rights, price theory, and the theory of the firm.[7] A famous 1968 paper on the costs of trading on the New York Stock Exchange[8] gave birth to the study of market microstructure.[9] The economist Peter Boettke highlighted how he contributed to the way we think about market competition by emphasizing "conditions of entry and exit rather than . . . market structure" and showing how, even under conditions other than perfect competition, the price system could still "coordinat[e] economic activity."[10] Demsetz raised challenging questions about whether regulation of utilities was necessary, assuming there is competition among potential providers, and about the relationship between competitive behavior and the development of monopolies—and the sustainability of any monopolies that did develop.[11]

Demsetz discussed these complicated issues with a clarity that makes them accessible even to a non-mathematician like me, avoiding complex mathematics or relegating the math, when he did use it, to the end of his papers.[12] His piece on transaction costs on the New York Stock Exchange is an example of his ability to lead his readers in thinking through complicated issues.[13] He deftly explains that characteristics of trading on an exchange that create opportunities for specialists on the exchange floor. He then goes on to walk through the competitive forces that theoretically could discipline the spreads charged by specialists, even when a single specialist is responsible for providing liquidity in any given security. Only in the last pages of his paper does he turn to a short statistical analysis to suggest a possible transaction-cost basis for NYSE’s dominance in trading activity at the end of the 1960s. Consistent with his scholarship more generally, it is elegant, concise, and lucid, and readily accessible—even with its tentative conclusions—to the educated layperson and the policymaker alike.

As evidenced by the papers I have already briefly described above, Demsetz often took contrarian positions in his work. One of the best examples of this is in his article "Information and Efficiency: Another Viewpoint," published in the Journal of Law & Economics in 1969.[14] This paper was a response to an article by Kenneth Arrow (who, unlike Demsetz, would go on to win the Nobel Prize a few years later). In his article, Arrow argued that even conditions of perfect competition would not lead to optimal allocation of resources, particularly for invention, because of the costs of allocating risks and transmitting information. Given these costs, Arrow concluded, optimal allocation of resources to invention would be possible only if "the government or some other agency not governed by profit-and-loss criteria [] financed research and invention."[15]

By 1969, this view, according to Demsetz, had become "the dominant viewpoint" on the question of efficient economic organization. In Demsetz’s opinion, however, it rested on a fundamental mistake, which Demsetz called "the nirvana approach" (and which is now known more generally as the nirvana fallacy)—namely, an approach that presents a choice "between an ideal norm and an existing ‘imperfect’ institutional arrangement."[16] Under this approach, economists "seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient."[17] Economist George Stigler provided us with a nice illustration of this approach: An opera competition was being held in which two singers competed. After the first singer performed her aria not flawlessly, the judge simply declared the second singer the winner without even bothering to listen to her aria, which—had he listened—might have been even worse than the first.[18]

Demsetz contrasted the nirvana approach with the comparative institution approach, which seeks to discover "which alternative real institutional arrangement seems best able to cope with the economic problem."[19] In distinguishing between these two, Demsetz was by no means dismissing the importance of envisioning an ideal state of the world, so long as one used it solely for identifying standards for assessing "practical alternatives of interest" and determining which of those "seems most likely to minimize the divergence" from the ideal.[20]

In expanding on this principle, Demsetz was willing to concede Arrow’s argument that a market economy "does not result in an ideal allocation of resources,"[21] but he argued that this tells us nothing about whether this allocation can be made more efficient. That question requires an empirical analysis of the government or non-profit alternatives that Arrow was suggesting were necessary to achieve a truly efficient system of economic organization—in other words, an analysis not of an ideal alternative but instead an analysis of the "real alternatives."[22] Failing to engage with that admittedly difficult work was, in the end, to produce nothing more than the completely unremarkable conclusion that—to quote Demsetz—"for optimal allocation . . . it would be necessary to remove the nonoptimalities."[23] Well, if you put it that way, it can’t be that hard, right?[24]

Demsetz suggested that the nirvana approach rests on three underlying fallacies: "the grass is always greener fallacy, the fallacy of the free lunch, and the people could be different fallacy."[25] The grass-is-always-greener fallacy he identified with the tendency that I have already touched upon: that of failing to grapple with real alternatives that we see too often in attempts to, as he strikingly put it, "call forth perfection by incantation."[26]

Demsetz illustrates the fallacy of the free lunch by quoting at length Arrow’s argument that, in a market economy, "any unwillingness or inability to bear risks will give rise to a nonoptimal allocation of resources."[27] Demsetz notes that calling an allocation nonoptimal in these circumstances assumes that there are costless ways of bearing or adjusting to risk. But this is to beg the question: If, in fact, risk-shifting is not free, and if the cost of risk-shifting under any actual alternative state of the world is higher than the efficiency gains of shifting risk, describing the resulting allocation as nonoptimal is misleading, as it suggests that some superior alternative must be available.

Finally, Demsetz sees the people-could-be-different fallacy in Arrow’s argument that risk-shifting is incomplete in part because it can "dull incentives"—in other words, because of the problem of moral hazard.[28] Demsetz suggests that it is a delusion to think about efficiency in risk allocation without accounting for risk-averse, moral-hazard-prone people as we find them. Real people as we find them, including their "taste for risk reduction," must inform how we think about efficiency in the market.[29] Demsetz is willing to entertain the notion that government might step in to allocate resources to invention more efficiently than such people; after all, it may be that government will take "a risk neutral attitude."[30] That view, however, has to be demonstrated, not merely asserted. After all, "government is a group of people" who are all probably risk averse in about the same degree as their fellow citizens (except with respect to political risk, where their tolerance is probably much lower).[31]

To add to the human factor that Demsetz identifies, the policy implementation process involves large bureaucracies. Bringing a policy solution from conception to successful implementation involves more than just dropping it into an agency black box and watching a perfectly functioning program emerge on the other end. Again Dr. Rivlin’s insights are helpful:

The idea that the Federal government just enacts a program, and that federal officials write the regulations, or actually run the program, and then something good automatically happens, is no longer gospel . . . . Unless the Federal government energizes states, localities and the private sector and unless it works in partnership with the people on the ground, visible success is going to be illusory.[32]

In his book Red Plenty, Frances Spufford captures the essence of Demsetz’s nirvana fallacy in an amusing retelling of an anecdote from the period when Soviet economists were trying to solve the problem of prices in a system where market-generated prices were condemned as an artifact of bourgeois ideology. In the 1960s, some of these economists were convinced that cybernetics would solve the pricing problem for them. Early in his book, Spufford puts us inside the head of a computer scientist who is running an experiment to see whether he could optimize the prices—or "objectively-determined valuations"[33] in acceptable Soviet terminology—for potatoes delivered to Moscow consumers. As the computer runs, he ponders the efficiency of the computer as opposed to the apparent inefficiency of the bazaars on the edge of the city where individuals sell produce raised on their private lots. In those bazaars, the market generates a clearing price, but he muses to himself:

The market’s clock speed is laughable. It computes at the rate of a babushka in a headscarf, laboriously breaking a two-rouble note for change and muttering the numbers under her breath. Its stock arrives one sack or basket at a time, clutched on a peasant lap. It calculates its prices on cardboard, with a stub of pencil. No wonder that Oskar Lange over in Warsaw gleefully calls the marketplace a ‘primitive pre-electronic calculator’. In the age of the vacuum tube, it’s an anachronism, good only for adding a small extra source of high-priced supply to the system, for those moments when the modern channels of distribution can’t quite satisfy every consumer need. And now even that function is becoming obsolete. When [this software] reorganises Moscow’s delivery system, the efficiency gains should fill the state shops with enough cheap potatoes for everyone. . . . There has been no time to visit the cold-stores, interview the managers, [or] ride on the delivery trucks[ that make up the distribution chain]. But the [software] should still work. Conditionals, again: it will work, if the figures are reliable. It will work, if it is indeed possible to redirect the flows of potatoes at will in the way that the program decides is efficient. It will work, if the loops by which the program optimises are compatible with the loops in Soviet life that get things done.[34]

Spoiler alert: It did not work. The nirvana promised by cybernetics was revealed as nothing more than an illusion when it encountered the mundane, but very real and very human world of potato production, distribution, and consumption.

The nirvanas that American policymakers pursue are not quite as outlandish, but even so, Demsetz’s criticism of the way we think and talk about policy options persists 50 years after he published his article. Pundits and politicians, and more troublingly, policymakers often suggest that the possessing pure intentions and putting the right government employees to work obviate the need to interrogate assumptions about how policy will work in practice. As we have grown more confident in our ability to collect and process data, perhaps the problem has increased over time. Our attempts to facilitate a national equity market system, for example, have tried to substitute government prescriptions, such as the Order Protection Rule of Regulation NMS, for decision-making by market participants. Non-optimal decisions about which stock exchange to send an order to were replaced with a mandate that orders must be executed at the best displayed price. The result is also not optimal, and likely not any more efficient, for a number of reasons, including because it prohibits traders from taking into account non-price considerations and has created artificial incentives to operate exchanges. As I read Spufford’s description of cybernetic price-setting, I also could not help but think of modern financial regulatory efforts to formulate neat models into which centrally determined risk weights are plugged and from which optimal capital or margin or liquidity formulas emerge. Models have a place in regulation, but we must recognize their limitations.

There are glimmers of hope that Demsetz’s lessons are being absorbed. Just last week, the Commission proposed a rule that would exempt certain companies from the requirement to obtain an auditor attestation of their internal controls.[35] The requirement that companies get an internal control audit assumes that the government can make better decisions than private actors about how much risk transfer is appropriate. It assumes that, left on their own, investors will irresponsibly allow companies to get away with not having an audit of their internal controls. Last week’s proposal recognizes that—for a subset of companies that are small and have low revenues—investors might rationally decide to retain the risk and spare the expense of paying an auditor. If an investor in a biotech company seeking to get its drug approved had the choice between her money going to an internal control audit or a new scientist, she might choose the latter and bear the risk of not having the former. Politically risk averse policymakers might prefer she choose the former, even though hiring a scientist might be better not only for the investor, but for the people who would benefit from the company’s drug coming to market.

III

The second scholar I would like to discuss today, Anthony de Jasay, is perhaps less well known in the United States, but his work provides insights that sharpen Demsetz’s argument. Whereas Demsetz had a fairly conventional academic career, Jasay did most of his significant work outside of academia. Born in Hungary in 1925, he studied agricultural economics for a time in Budapest and then became a journalist.[36] In the late 1940s, after the Communist party had gained control of the country, he soon realized that he needed to find his way out of Hungary. In an interview recorded in 2000, he described an encounter with someone whom he later came to view as the personification of the state, "a newly powerful person—he was a Communist—who had the power of patronage": "And there he was, a sort of powerful, fleshy, muscular man, in a beautifully cut gabardine suit, heavy silk shirt. And there I was, a skinny, miserable person, trembling. . . . He said to me, after a brief conversation, ‘You and your kind will never get a job in this country.’"[37]

Jasay said, "that marked me."[38] Such an experience likely would have done the same to any of us. So he left Hungary for Austria. He found his way to Australia, and then to Oxford, where he studied economics. He served as research fellow at Nuffield College until 1962, seven years after his arrival in Oxford, and then went into finance in Paris.[39] He returned to writing about economics and political philosophy when he retired to Normandy in 1979, where he lived and wrote until his death in January. He wrote trenchant critiques of social contract theory and provided us with novel ways to think about private property.

Jasay was not wedded to any particular school of thought, and great economic minds did not cause him to tremble as he had before the Communist in the gabardine suit. He took issue with Keynes for his macro methodology; Jasay, unlike Keynes, believed that macroeconomics was rooted in micro principles.[40] He took issue with George Mason’s own James Buchanan for what Jasay believed to be the logical flaw in the position that a government enforcement mechanism was a necessary prerequisite for binding private contracts.[41] He took issue with Hayek for emphasizing the anonymity of the market and thus downplaying the disciplining role that being a repeat player with a reputation has on people’s behavior.[42]

Like Demsetz, Jasay encourages us not to idealize government solutions intended to respond to social or economic inefficiencies. Indeed, often government solutions are far from perfect because government itself has a motive to pursue its own ends, namely, increasing its discretionary power.[43] His argument was grounded in the perceptive insight that "in any non-unanimous society with a plurality of interests, the state, no matter how accommodating, cannot possibly pursue ends other than its own."[44] As Pierre Lemieux explained, Jasay saw that "it is impossible to aggregate the preferences of all members of society into a sort of social welfare function."[45]

Absent unanimity among citizens, the state must choose among competing claims. Jasay pointed out how government-speak can obscure the state’s decisions to prefer one group over another. He contrasted two statements: "the state found that increasing group P’s utility and decreasing that of group R would result in a net increase of utility," and "the state chose to favor group P over group R." They are "descriptions of the same reality,"[46] but the former sounds much more scientific. Regardless of how it is marketed, the reality, in Jasay’s assessment, is an unpleasant one; the government almost inevitably ends up favoring the people whose preferences result in an increase in the government’s power and discretion.

This central theme in Jasay’s work—"that it is monumental folly to ignore the state’s own interest in any analysis worthy of consideration"[47]—forces his readers to confront difficult questions about what the state can be expected to do, and particularly whether it can be expected to respond well to the conflicting demands of competing interest groups. The state’s less-than-benign motivation to advance its own interest—to increase its discretionary power—must be accounted for when we look to government to solve a problem.[48] Jasay further points out that even failed government attempts to solve problems can advance the state’s interest in increasing its power in the name of fixing the very problems that it has created or exacerbated.[49] As an example, proxy advisory firms gained market power because of a number of regulatory actions by the SEC, and one potential response to their market power is a new regulatory regime for proxy advisors.

Jasay’s message is not wholly negative. He does see a way for conflicting preferences of people in society to be organically reconciled. Jasay reminds us of the power of private arrangements: To quote Jasay, "If two consenting adults close a contract, and there is no independent evidence of duress (i.e. evidence other than the contract looking unfavourable to one party), we accept a prima facie case that they like the terms of this contract better than not entering into a contract with each other."[50] The government need not meddle with two voluntarily contracting people for the benefit of one of the contracting parties and should only rarely step in on behalf of third parties.[51] In fact, government intervention, if it becomes routine, could dull people’s natural inclination to cooperate with one another.[52]

The respect Jasay shows for private agreements is a natural companion of his emphasis on liberty, as opposed to rights. He explains that "[i]f we start from the position that all feasible acts are free unless there is a good reason against them, the burden of proof is on those who affirm such a reason."[53] A respect for contracts and an emphasis on liberty accord well with regulatory humility, as they do not assume the regulator knows best, and they respect people’s expertise about their own lives and preferences. Jasay’s insights are relevant to today’s regulatory debates. Think, for example, of our accredited investor standards, which preclude many Americans from investing in private companies and diminish the funding options for entrepreneurs. Or think of the difficulty cryptocurrency entrepreneurs are having getting the regulatory green light to offer their products and services to an eager marketplace.

IV

Jasay’s argument about the state’s pursuit of its own interests nicely complements—and complicates—Demsetz’s description of the nirvana approach and the related fallacies. Demsetz points out how we have to analyze proposed government solutions in the cold, harsh light of reality, rather than assuming that government involvement will eliminate inefficiencies or that flawed human beings will overcome their flaws when they work for the state. Jasay’s analysis suggests that government solutions may fail because the state is pursuing its own ends—which may not involve solving the problem used to justify the policy. He insists that liberty considerations be part of the analysis.

In reflecting on the work of these two thinkers, it is not my objective to lead you to despondency about policymakers’ ability to effect positive change in the world. Rather, it is to encourage us all to resist the temptation to assume the best about policy responses to real world challenges. We can be better policymakers if we do not sweep reality, including the reality of our own limitations, under the carpet. Demsetz and Jasay, with their eyes-wide-open view of private- and state-based solutions, can help us make better policy choices. Sometimes the best choice will be to leave a problem to the market to solve. In other instances, the best choice will be a government solution that draws on market forces and takes into account government incentives and human tendencies.

These insights should inform the economic analysis that is part of every SEC rulemaking. I always call for our analyses to start with an identification of the problem we are trying to solve. Next, the analysis should describe a baseline against which each alternative solution will be compared. Then the analysis should assess reasonable potential solutions, including market-based solutions, with an honest look at the costs and benefits of each. Our consideration must include a realistic assessment of how any regulatory mandate would work in practice and what its unintended consequences would be. We should incorporate metrics in our analysis to see whether the chosen solution works. A problem in the markets may justify a regulatory solution, but we cannot delude ourselves into presuming that the regulation, which will be administered by human beings of the same variety as those in the marketplace, will itself be without problems. Among the relevant costs of any rulemaking is the cost of depriving individuals of their liberty to enter into contracts with one another voluntarily. As Jasay would remind us, the burden of proof is on us regulators to explain why encroaching upon that liberty to act is appropriate. Whether we are speaking of market or government solutions, we must avoid, to use Demsetz’s words, "call[ing] forth perfection by incantation."

V

Thank you for listening today, especially because I suspect that the lessons of Demsetz and Jasay are better directed at me than at many of you. Just a couple weeks ago a Texas lawyer sent me a photo of a swamp alligator as a gentle reminder to be humble in my policymaking role and wary of my own motives. In this spirit and because we are at a law school, I will close with a joke, this time a lawyer joke: An economist walks into a coffee shop with an alligator. "Do you serve lawyers here?" the economist asked the barista? "Of course, we do!" said the barista. "Great." said the economist. "I’ll have a latte, and my alligator will have a lawyer."[54]