clever people

Robert Shiller has long been a fan of increasing the "completeness" of markets, creating more and more derivatives to require that "the market" be explicit about its beliefs; for example, in his 2000 book Irrational Exuberance, he proposed long-dated S&P dividend futures so as to require a market forecast of future dividends and their growth, after which one could see whether anyone really bought the implications of the levels of stock prices. In principle, there are all kinds of problems of both self-delusion and private information that could be solved by more and more derivatives.

Of course, in the last few years it has become clear that relatively simple derivatives, like MBS tranches (or even credit default swaps), seem to have befuddled people well smarter than the median. It's not that a large number of people who do understand the derivatives is necessarily needed for them to have their benign effect — up to some solvency limits, some people out there can arbitrage really bad mispricings and should keep things grossly in-line. The problem, though, is the amount of damage people seem to be able to do to themselves and then, transitively, to their creditors, or to people whose reputation may be tied up with theirs, that is on some level independent of the good these things do. Mortgage credit derivatives did create a market price for mortgage credit risk, and even did help spread and diversify it, and yet some people got themselves into a lot of trouble taking on too much risk that they didn't understand, and a lot of other people got in trouble.

It's possible the mispriced supersenior mortgage tranches would have been better priced with even more complete markets, but we will never have complete markets (and we wouldn't have the solvency to correct them if we did). I'm a fan of more complete markets in general, but expecting them to solve all of our problems strikes me a bit like some leftist beliefs in government; the problem, we're told, is that our problems haven't been dealt with by sufficiently clever people, and yet neither the government nor the financial markets are populated entirely, or even mostly, by particularly clever people. Mankind is not perfectable, whether by government or by market.