NEIL REYNOLDS

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January 7, 2009

Ottawa -- Vernon Smith, the American economist who won a Nobel Prize in 2002 for his laboratory scrutiny of abstract economic theory, demonstrated that you can't end market crashes by imposing more government regulations. Born to a poor Kansas farm family on Jan. 1, 1927, he turned 82 last week. His early life was inextricably shaped by the Great Depression - by hardships that provided an enduring incentive to succeed. (As a child, one of his chores was to keep the woodstove in the kitchen supplied with dried corncobs and dried cow chips.) "Like many of my generation," he says in his unassuming autobiography, posted on Nobelprize.org, "I am a product of strange circumstances of survival and of successes built on tragedy."

Like many of his generation, too, he was "born socialist." His mother's first vote was for Eugene V. Debs, the socialist candidate for president, in 1912. His own first vote was for Norman Thomas, the socialist candidate for president, in 1948. Well into his adult years, he believed that the best society, economically and politically, would be a society mostly governed "by a few wise men."

In later years, in the lab, things looked different. Obsessed with the task of determining why people act as they do in market decision making, Prof. Smith developed ways to observe them doing comparable things in controlled and simulated settings. He conducted his first experiment in 1956; it lasted six minutes. Subsequently, across 50 years, he conducted thousands of experiments, using tens of thousands of subjects from all backgrounds - from school kids to business tycoons. As he studied the results, he came to believe that people are, in fact, "born traders," inherently savvy in marketplace transactions regardless of education or professional status.

"I think that people are natural traders," Prof. Smith told Reason magazine in 2002. "We're social animals. We're very much into social exchange. We're surprisingly generous. You do something for me and I do something for you. The benefits of market exchange are easy to see in personal interactions. Out there in the markets, though, they are not always clear."

Prof. Smith turned decisively libertarian. People, he concluded, should be left as free as possible to make their own economic decisions. "Whether we're talking about politics, or economics or social interaction," he said, "the best systems maximize the freedom of the individual, subject only to the constraints of others in the system." This is, of course, the definition of classical liberalism, which affirms decentralized decision making.

The formats for Prof. Smith's market experiments vary. In one version, a number of people (traders) are given the same investment opportunity - an investment, say, that pays a 24-cent dividend every four weeks for 60 weeks. The guaranteed return is thus $3.60. In the lab setting, the times get compressed; the dividend is paid every four minutes. The traders engage in the computer-assisted buying and selling of this income stream. The process may be repeated, with variations, 15 times in a single session. Invariably, as Prof. Smith (and other economists) have repeatedly shown, traders bid each other up well beyond the actual worth of the investment. In 90 per cent of the sessions, trading ends in market crashes. Author and editor Virginia Postrel, by the way, has written a lucid and illuminating account of this research ("Pop Psychology") in the December issue of The Atlantic magazine. Experimental economics demonstrates that people don't normally buy and sell assets based on fundamental worth. People normally are momentum traders, trying simply to buy low and to sell high - a process that, repeated enough times, must eventually end in crashes. Laboratory research by Dutch economist Charles Noussair shows that the lab traders who make the most money are not people who determine fundamental worth; they are people who buy a lot of assets at the beginning of a trading cycle and then sell out midway through the game.

Prof. Smith's experiments remain relevant. In his most recent research, published last year in the American Economic Review, Prof. Smith and his associates - he holds academic posts on both the East Coast and the West Coast - tested the theory that easy money, by itself, can cause bubbles. In this experiment, the economists used only experienced, old-pro traders (to eliminate any chance that "newbies," or market novices, might warp the results). Part way through the experiment, the computer abruptly doubled the amount of cash in "the system." The result? The savvy traders took bidding far above fundamental worth and generated a bubble equal to the bubbles regularly produced by novices. In essence, the lab anticipated real life.

In her own analysis, Ms. Postrel offers a couple of fundamental alerts from the economists who work in labs. Beware easy-money markets. Beware novel investments (such as dot-com and bundled-mortgage investments). Beware also savvy investors. Who should you trust? Prof. Smith holds that markets are highly decentralized institutions that can function properly only with highly decentralized decision making - the very opposite of the government-directed markets of the moment.

Comment:

Markets and economies move forward on confidence: confidence that individuals will have a constant flow of monies to spend, save, invest etc; confidence that jobs are available, confidence that everyone around us is prospering as well, etc.

Also, that governments do not lead because they do not know how (they will always take advantage in prosperous times, of that you can be certain).

I wrote the following to our Prime Minister. It is by-no-means, a final solution, as that is too radical for most to face. It would, however, be more positive than any multi-billion dollar bailouts, imo.

To the Honourable Mr. Steven Harper, Prime Minister of Canada,

How do you kick-start an economy that is presently under recession; that will probably last for a minimum of 10 years or longer, and could become a depression if fear really takes hold?

One thing is certain, in a capitalistic society, society must not depend on Governments.

The only thing Governments can do that is positive, and will help, is to get out of the way and reduce taxes.

Money has to start at the bottom (consumer) and work its way up, otherwise any bailouts, infrastructure spending, etc. cannot work. If governments think they can print money, till the "cows come home", what we will eventually see, is a society built on socialism with no incentive to prosper.

Also, any government intervention will take forever to be put into effect, and the effect will be very negative.

The marketplace needs to act NOW.

So what must happen?

Governments need to reduce or eliminate the following taxes, at least here in Canada.

1. Capital Gains - Eliminate immediately. Even make it retro-active. People with money need some incentive to invest. Not paying Capital Gains will put private money to work.

2. GST - reduce or eliminate. This highly visible tax, will keep monies in "joe/jane-six-pack’s" pockets.

3. Payroll Taxes - Reduce. These taxes are very restrictive when companies are thinking of hiring. E.I. has a huge surplus that is doing little and can really help to stimulate hiring.

4. Income tax. - Reduce, especially for lower income people. They WILL spend it if you leave it in their pocket.

5. There are lots of other stupid, cost ineffective taxes that the government must get rid of. They cost money to administer and provide little or no benefit to society other than keeping civil servants employed.

Governments must also get rid of useless self-serving departments. Do not want to offend anyone here but I’m sure we all know which departments I am talking about.

As I see it, something along these lines will stimulate the market, probably reduce or even eliminate any thought of a government deficit, stabilize or even increase employment (which will lead to more revenue), and give people a positive attitude.