Ha Joon Chang: Confused on Bounded Rationality and Economic Regulation

In this third and final of the series on Ha Joon Chang’s critique of ‘free market economics’ I examine his account of ‘bounded rationality’ and the case for greater economic regulation. As in much of his work the policy conclusions which Chang draws simply do not follow from his premises.

In chapters 16 and 19 of 23 Three Things They Don’t Tell You About Capitalism, Chang asserts that free market economics rests on the view that actors are fully rational and that individuals always know what is in their best interests when deciding to buy, sell and invest. Drawing on Herbert Simon he argues that people often do not know what they are doing because the limitations of the human brain make the world too complex to fully understand. Thus, there are often advantages from restricting individual choice in order to reduce the complexity of the problems people face. One way to do this is to rely on administrative hierarchies such as firms, which operate on internal command and control procedures. The existence of corporate firms which ‘plan’ their activities Chang says demonstrates that so called ‘free market economies’ are to a significant extent ‘planned’ – and that the existence of such hierarchies demonstrates that ‘planning’ is often superior to more decentralised structures. Similarly, rules and regulations that limit choice can result in better decisions. Just as consumers who have limited attention spans often adopt routinised decisions – such as buying well known brands rather than risk unknown products – so rules and regulations can reduce the complexity of the choices people face and limit the things that may go wrong. From this Chang concludes that we should see greater government regulation not as an inhibitor of economic growth but as a way of reducing uncertainty. In the specific context of financial markets he argues that to avoid future crises complex financial instruments should be banned ‘unless we fully understand their workings and their effects on the rest of the financial sector and … on the rest of the economy’ (p.177).

Reading Chang’s book you would never know that free market economists such as Coase , Hayek and Vernon Smith have done more than anyone to examine bounded rationality and the role of hierarchy and rules as social ordering mechanisms. Granted, 23 Things is a semi-popular work not a purely academic analysis – but an honest attempt to convey what ‘free market economics’ is about would have made some reference to these writers contribution – assuming Chang understands it.

Hierarchy and rules have a role to play in any economy – but under bounded rationality there is uncertainty about what types and levels of hierarchy and which rules are desirable. Chang seems oblivious to the role that market competition plays in determining how much hierarchy, and what rules we should have. Having cited the extent of organisational hierarchy witnessed in firms he states that, ‘The question is not whether to plan or not. It is what the appropriate levels and forms of planning are for different activities,’ (p:209). True – but these words could have come straight from the mouth of Ronald Coase – a free market economist who won a Nobel Prize for work on the theory of the firm. In his Nobel address Coase notes:

“To have an efficient economic system it is necessary not only to have markets but also areas of planning within organisations of the appropriate size. What this mix should be we find as a result of competition,” (716).*

Unlike Chang, Coase recognises that the type of planning that goes on in markets is categorically different to governmental planning because – unless particular organisations are granted regulatory privileges by the state (of the sort Chang favours) – it is arrived at via voluntary cooperation. Freedom of contract enables people to enter into a range of competing institutional structures and to discover through a process of evolutionary learning which are best suited to different tasks. Big firms, small firms, owner-managed firms, joint stock companies, partnerships, mutuals and cooperatives all compete for workers, sales and investment capital. By contrast, government planning is imposed on all by the force of law. People cannot – save for leaving their particular country- exit from government plans. The scope for organisational learning is thus diminished and the risks of failure should fallible politicians and planners make mistakes, are correspondingly more far-reaching.

A similar argument applies in the case of social rules. Hayek and Vernon Smith argue that people rely on rules in order to overcome the limitations posed by their ignorance. But unlike Chang, they emphasise that these rules should, wherever possible, be voluntarily subscribed to and subject to competition from potentially better adapted alternatives. Voluntary conventions and private codes of conduct are typically enforced through reputation and ostracism rather than direct coercion. Those who wish to challenge a rule can ‘break’ the relevant convention without needing legal approval –and if successful they may provide role models that can be imitated. The role of government, therefore, should be limited to providing the basic protections, such as security of property and contract law, which give the maximum scope for people to experiment with their own private rules of conduct. The greater the extent of centrally imposed regulation the less scope there will be for decentralised evolution, the more difficult it will be to remove maladapted rules, and the greater the danger of a ‘systemic failure’ should the wrong rules be chosen.

Contra Chang the major lesson of the financial crisis is not the need for more regulation- but for greater competition between different forms of regulation in order to reduce the risks arising from the bounded rationality of regulators. As Jeffrey Friedman has shown in some detail the problems that afflicted the financial sector arose in large part from the inability of policy-makers to comprehend the combined effects of the maze of interconnecting regulations which have accumulated over the last fifty years. Regulators are as subject to bounded rationality as anyone else but with their unique powers of coercion and immunity from competition they have the capacity to do enormously more harm. From the decision of monopoly central banks to keep interest rates at excessively low levels; to the regulatory inducement of government-backed mortgage companies to relax lending requirements for low income families; to internationally enforced capital regulations which induced banks to securitize risky mortgages; the creation of legally protected monopolies in the credit rating business which prevented alternative ratings methodologies from arising; and the creation of deposit insurance and implicit bail out guarantees which have reduced incentives to avoid excessive risk, coercive government rules have induced all manner of disastrous unintended consequences.

With his proposals to ban complex financial products Chang seems unable to recognise that given appropriate background incentives boundedly rational actors in markets (whether individuals or institutions) can adopt an easy ‘rule of thumb’ when faced with decision-making complexity – ‘if you don’t understand it, then don’t buy it’. This is not an option they face when dealing with centrally imposed regulations and mandates. If the financial crisis has taught us anything it is that the public needs protection from regulators and central bankers who don’t understand what they are doing. If we are to reduce the risk of future crises then we should limit the scope for governments to impose new rules and regulations unless they can demonstrate what these consequences will be.

* Coase, R.H. (1992) The Institutional Structure of Production, American Economic Review, 82 (4): 713-719.

** Friedman, J. (2009) A Crisis of Politics not of Economics: Complexity, Ignorance and Policy Failure, Critical Review, 21 (2-3): 127-183.

This article has now been re-published in the collection ‘What Caused the Financial Crisis’ (2011): University of Pennsylvania Press.