All Commentary
Tuesday, May 15, 2012

JPMorgan’s Blunder Is No Market Failure

Imperfect knowledge is not an argument for government oversight.

I am not going to try to defend JPMorgan Chase for its recent, widely reported financial blunders.  I certainly don’t know all of the relevant details behind its $2 billion loss. What I would like to point out is an invalid inference in arguments I’ve heard by those who would take this enormous loss as evidence itself of the need for greater bank regulation.

It isn’t.

There have been a lot of articles saying something like the following:

After reporting a surprise $2 billion trading loss, JPMorgan Chase lost $15 billion in market value and its credit rating was downgraded. Perhaps more significantly though, it reignited calls for stricter oversight of the banking industry, reports Reuters. The Washington Post says lawmakers have been suggesting that JPMorgan’s charismatic chief executive Jamie Dimon was facing a type of “poetic justice” after he led the fight against stricter regulation of the financial market. The loss was also a big personal hit for Dimon, whose reputation had turned him into the country’s most influential banker.

Where Was Dodd-Frank?

Some have argued that had all the rules called for by the Dodd-Frank financial overhaul been in place, the actions that led to the loss would have been prevented.  They may be right, but for my purposes it’s beside the point.  It’s always easy after the fact to see how a prior intervention, by government or anyone, might have avoided a fiasco.

Standard economics supplies some arguments for government regulation of voluntary trade.  One of them is that sometimes unhampered trading produces systematic inefficiencies.  The term for this is “market failure.”  If people in government have better knowledge about how to make those trades more efficient and have the incentive to apply that knowledge effectively, then government intervention is said to be justified.  (If people in government don’t have better knowledge or incentives–if public authorities would make even worse mistakes in the market than private persons–it’s called “government failure,” but I won’t pursue that line of thought here.)

Now, I won’t pretend to understand the financial and regulatory complexities of the JPMorgan case, but I do understand this: a huge loss, even a business failure, does not in itself constitute “market failure” in the economic sense–that is, systematic inefficiency.

JPMorgan Chase took too big a risk and lost $2 billion. (Again, we only know that it was too big after the fact, because we can now see the huge losses that resulted.)  But that’s what’s supposed to happen in the market process when such a bank blunders.  The bank loses big time, and everyone involved–from those who were responsible for making the poor decisions to those who trusted the judgment of the bank–suffer the loss.

Profit and Loss

The free market has been called a profit and loss system.  In the real world all investments involve imperfect knowledge. No one knows with certainty in advance how much risk is too much in a given investment, and no one knows with certainty when one is throwing good money after bad.  After all, sometimes losses are indeed temporary, and sticking with it until things turn around may be the prudent thing to do.

Before the fact, estimated profits and losses help us (imperfectly) to tell good choices from bad.  After the fact, actual profits and losses tell us whether we were right.

When JPMorgan has done well in the past, and evidently until this recent episode it had been doing well relative to other banks, it made profits.  But in this last instance it appears that it chose poorly and that it and its investors are suffering the consequences.  The fallout for some of JPMorgan’s executives seems to have begun.  And as reported, the firm has already lost a $15 billion chunk of its market value.  Again, that’s what’s supposed to happen.

The financial industry in the United States is far from a free market.  Contrary to the impression you might get from the popular press, it’s not a playground for freewheeling capitalist buckaroos.  But to the extent that free-market principles apply, neither losses from error nor profits from good decisions are in themselves grounds for “tighter regulation.”  Rather, those are precisely the means by which people who trade in the free market regulate one another.

In a free market, failure is always an “option”.

  • Sanford Ikeda is a Professor and the Coordinator of the Economics Program at Purchase College of the State University of New York and a Visiting Scholar and Research Associate at New York University. He is a member of the FEE Faculty Network.