Andrew Sheng, Distinguished Fellow of Asia Global Institute, says today's markets could be in need of a complex redesign.
One good consequence of the global financial crisis is the rethink of the foundations of economic analysis. Of the thousands of ideas that challenge economic orthodoxy, two stand out. The first is Nassim Taleb's idea of anti-fragility, which undermines the whole basis of conventional risk management. The other is Nobel laureate Alvin Roth's pioneering work on market design.
Roth's new book, Who Gets What - and Why: The New Economics of Matchmaking and Market Design, goes back to the fundamentals of markets. He makes the common-sense argument that free markets can only exist if there are effective rules, effectively enforced. The financial crisis demonstrated how free markets can fail under certain circumstances. Roth's insight is that markets are as old as human behaviour - they evolve and adapt, but we can always design markets to function better. In other words, the state has a key role in markets, though this does not mean it replaces the market as a mechanism to allocate resources and facilitate price discovery.
There are two broad types of market - public and private (or matching) markets. We are all familiar with public markets, which succeed because they are efficient, transparent and generally have high turnover and public confidence.
Roth points out that matching markets exist everywhere, from dating services and kidney exchanges to job placement and college selection, but they are illiquid, opaque and often do not work very well. They match demand and supply, but not always successfully, because of information asymmetry and mistrust between buyers and sellers.
Most markets evolved through history and experience, mostly through failure and reform. Developing economies have more incidences of market failure because of the learning process. For example, stock exchanges were often introduced to developing countries without fully understanding local culture and characteristics. In the 1980s, it was assumed that if a copy of the New York Stock Exchange was put into a developing country, it would work well. But recent experience showed otherwise. The A-share debacle in China showed that market manipulation, margin losses, illiquidity, inadequate regulation and bad corporate governance were a consequence of market design. These were flaws that need to be fixed.
Good market design means that we don't assume all Chinese investors have the same degree of sophistication and experience as traders on the more mature New York exchange.
Markets are of course networks, and a public network, such as a stock exchange, also operates with many co-existing private networks. Furthermore, there are illegal markets, such as syndicates that engage in insider dealing. Proper supervision of public markets needs a good understanding of how these "private" markets operate.
Roth built his theory of market design on common sense. Private markets operate mostly through strategic decision-making or game theory, because the number of participants is limited, with limited information. Public markets are subject to mass behaviour, where common sense may not lead to good common outcomes.
Building sophisticated Asian stock markets requires making the markets simpler for retail investors, which means there must be strong institutional investors with long-term perspective and professional management. It also requires sophisticated regulators and policymakers who understand that, as markets become more complex, it is important to redesign the algorithms to prevent predatory and manipulative behaviour.
Herein lie the contradictions between state and market. The market thrives on mistakes - your loss is my gain - while the state bureaucracy works on asymmetric rewards, where success may not be rewarded and failure is seldom tolerated. Getting the balance between state and market requires careful market design. This is more complex than we imagined before Roth.
This article first appeared in the South China Morning Post on October 1, 2015.
The views expressed in this article are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.