One of the most important models in studying economics is the model of perfect competition. We teach it in Principles of Economics, in Intermediate courses, and in Masters' and Ph.D. graduate courses.
One of the conundrums of the model of perfect competition is as follows. If all economic agents (buyers and sellers; consumers and firms) are acting as "price takers" (the core assumption of the model of perfect competition), how are prices actually set? They can't be set by the buyers and sellers because they are, by the definition above, not able to set prices. Economists close this logical loop of the perfect competition model through an idea made popular by the famous French economist Leon Walras. Economists posit the existence of a professional "auctioneer" (often called the "Walrasian Auctioneer" after Walras) who calls out prices to the buyers and sellers. The price-taking buyers and sellers announce their intended purchases/sales at that price. If supply equals demand, the auctioneer declares that to be the market price. If it doesn't, the auctioneer tries again, raising the price if it was too low (excess demand) or lowering it if it was too high (excess supply). This process (called tatonnement) continues until the market clears.
One of the problems in motivating the Walrasian process is that there are few known examples in the real world. However, for years, the single example that gets cited (or at least asserted) is the London gold auction among European banks (the morning and afternoon "London gold fixings" that you will hear quoted on cable channels). I use this example in my classes, so imagine my surprise when the Wall Street Journal revealed this morning ("U.S. Probes Gold Pricing" page 1, March 14, 2013, but WSJ articles disappear behind a pay-wall) that the U.S. Commodities Futures Trading Commission (CFTC) is investigating the London Waslrasian gold auction for "manipulation".
So what could the CFTC be thinking? I think there are at least three possibilities.
1 ) The CFTC simply doesn't know what it's talking about. I'll explore this in more detail below.
2 ) Perhaps the CFTC believes that the participants were engaging in behavior outside of the auction that would manipulate the price. For example, if auction participants were secretly colluding to coordinate their messages in the auction, that activity would be illegal if carried out in the United States, and there are numerous examples of large and small corporations that have been caught in this type of price-fixing; I assume that this would also be illegal in the U.K.. Full Disclosure: There is nothing in the WSJ article that indicates the existence of any evidence of price fixing in this illegal sense on the part of the participating banks.
3 ) Perhaps the CFTC believes that the London gold market simply has too few participants to capture Walras' idea of competitive price-taking. The late Prof. Leo Hurwicz, a winner of the Nobel Prize in Economics, provided a mathematical model that showed that when the number of participants in a Walrasian auction was small enough and they had enough "market power," they might act in what would seem to be not in their own interest in one round of a Walrasian auction in order to help themselves in future rounds. However, another Nobel Prize winner, Prof. Vernon Smith, demonstrated in his early economics experiments that small numbers of buyers and sellers may not per se be an impediment to the emergence of approximately competitive behavior. It depends, instead, on the circumstances of the economic environment and of the particular economic institution.
Let me return to point 1 ) the possibility that the CFTC may be wasting it's time (and our taxpayer money). We spend a lot of time in economics classes talking about "market failure" but we also need to talk about "government failure," of which this could be a potential example. The economic study of government decision-making is known as "public choice," and I can think of at least two public choice explanations for the CFTC getting it wrong (if indeed they are getting it wrong):
A ) The decision to pursue this case may be made by lawyers, and lawyers think about things differently than economists. In particular, lawyers often reason by analogy. From an economist's point of view, this can lead to some unwelcome economic outcomes. To an economist, one of the most infamous "reasoning by analogy" failures of the legal system was the U.S. courts' comparison of underground oil pools with wild rabbits on British manor lands. This led to the creation of wasteful common pool resource problems in the oil industry which took decades to address successfully. The reason I bring up the analogy argument is that the WSJ article is full of references to the ongoing debate over the LIBOR interest rate process. The entire article, from the CFTC point of view, seems to be about extending the LIBOR problems to London gold, by analogy. [They are both in London; they both involve big banks; ergo ......] But LIBOR was not set by an auction, it was set by averaging process, so to an economist there is no analogy there at all. Price-setting by auction and price setting by averaging are potentially as different as night and day.
B ) Another part of public choice is the belief that government bureaucracies take on a life of their own; their goal becomes self-perpetuation rather than a critical adherence to their actual mission. The WSJ says that
"The CFTC's move is the latest sign of a once-obscure regulator flexing its muscle in the wake of the financial crisis. The agency, headed since 2009 by Gary Gensler, a former Goldman Sachs Group. Inc. executive, has played a leading role in the [LIBOR investigation]."
If you think it Twilight-Zonish that a former executive of "The Goldman-Sachs" is using his newly found government power to portray other bankers as "manipulators," then you might be a ..... oh never mind.
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