Thursday, 9 October 2008

Markets are stupid

Now is the time to be saying loudly, clearly and as often as we can that markets are not, never were, and never will be, efficient nor rational. One look at the present mess belies that central claim of markets and their proponents, that markets are efficient at allocating resources. We have been told ad nauseam that things must be "left up to the market". It is time to debunk this central myth of market economics.

The "rational" thing for investors to do just now would be to hold their nerve and not sell. If everyone did so the market would not fall. But that would require the co-operation of others and market operations, with their unequal, often winner-takes-all structures lead to competition not co-operation. That barrier to co-operation is in the mind.

Social psychologists have known for 40 years that the structure of a situation can determine people's attitudes, how they see others and their willingness to co-operate. Too many economic actors have been brought up on prisoners' dilemmas, game theory, and the belief that everyone should pursue their own individual self-interest (because that is how the market operates most efficiently and produce social good in this best of all possible worlds). Worse still, these economic actors assume everyone else thinks as they do and will be have selfishly, and so the chance of getting a co-operative effort started is reduced even further.

We have known from the start that banks needed to start lending to one another again, and that the same banks will suffer if the banking system fails (and the banks themselves seem to have understood this), yet they stubbornly declined to do so. They believed "we just can't until conditions change" but conditions never were going to change for as long as they took this attitude. This is what social scientists call a social trap. The better-known tragedy of the commons (whereby individuals selfishly take more than is sustainable from the common pot until that pot is used up) is a social trap, things people fall into because they do not realise what is going on or cannot see overall outcomes.

In a true market there are just individual decisions and we only realise there is a problem after it is happened because no one is looking out for society as a whole.

Then there are social fences - things that require an effort or cost, for example, trusting others, but no one is prepared to take the first step. "Someone will always default" is the objection, which becomes a self-fulfilling prophecy. How people behave depends on how they think others will behave. If everyone has the selfish, individualist mindset, then they assume others will default and want to get there first.

Judged even by the goals of economic actors (rather than society as a whole) the market is incapable of producing rational outcomes even when its own life depends on it. Judged by society's goals it fails further still and it does so because it is the perfect breeding ground for social traps, because it prevents co-operation and because society's values cannot be represented in monetary exchanges directed by selfish individualism and the profit motive. The idea that the common good will somehow magically arise from the unco-ordinated actions of selfish actors is a myth.


  1. "The idea that the common good will somehow magically arise from the unco-ordinated actions of selfish actors is a myth."

    Firstly, define "common good". I don't know of any economists who would claim that unrestricted markets would produce greater 'equality', if that's your primary concern, but if you're talking about world income and/or the aggregate happiness of the world's population, about 250 years of history proves that your lack of faith in individual human interaction (self-interest is not the same as selfishness) is dead wrong. You really should re-read "The Wealth of Nations".


    Essentially, you're talking about asymmetric information - market participants having different levels of knowledge about a transaction, or about each other - though by fighting the straw-man of zero-regulation and zero-intervention, you're doing so in a rather unreasonable way.

    On a small scale the consequences of such differences may be minor, but that rational behaviour may not be efficient (what I think you mean to say), and that the consequences may be distract, has been known for a long time. That's not a fault with 'markets', per se, just in the way that particular market was framed. The right kind of regulation can allow information to be pooled to improve decision-making, and, by introducing a pricing mechanism, force people to pay for public goods that could only previously be priced 'socially', not in fact. Authorities can allow markets to work and to be efficient, if they are not already so, but the thrust of your argument is that markets can never work. That strikes me as an absurd thing for an economist to say: every time a shopper buys a good that's an example of a 'dumb' market at work, and every time a shopper buys from a black-marketeer that's a sign of markets working better, and quicker, than command economics, even if administered by the best-intentioned, economics-trained bureaucrat.

    So, in a sense, markets are stupid, but what are markets anyway, but an agreement between individuals backed by a legal framework? Two individuals can trade to mutual advantage in a matter of moments, something that no 'intelligence' on Earth has yet been able to recreate.

    Supporting free markets is not all incompatible with social protection far more ample than our current 'safety-net'. Moreover, free-market co-operative and socialist set-ups are well worthy of your study, but such systems won't exist if propaganda takes the place of economics...

  2. "every time a shopper buys from a black-marketeer that's a sign of markets working better, and quicker, than command economics, even if administered by the best-intentioned, economics-trained bureaucrat."

    So I suppose that during World War II , the Government shouldn't have introduced rationing. Now, that is absurd.

  3. Why do you have to reduce things to either/or? If a country's food supply is drastically threatened and existing patterns of consumption unsustainable, it's quite right for Governments to intervene to ensure everyone has enough. The point is not that markets would have failed to work efficiently, but that we believe in having a minimum standard of living, come what may.

    As you know, while this benevolent rationing was accepted until 1945, it carried on for years afterwards and became intensely unpopular. Without markets, that state of affairs would be the norm, not the exception.

  4. That's the most reductionist thing I've read yet, B4L. Food rationing is not the only alternative to markets!

  5. Duncan: that's exactly what Andrew is saying, in response to the argument above his.

  6. Tom: no it isn't. Read it again.

  7. I must say you confused me too, Duncan, that's why I didn't reply. Yes, I should have said.

    I don't want to attach myself too strongly to the argument that food rationing is an inevitable consequence of a drastic curtailment of markets, if that's what you thought I meant, but I don't think it's an unreasonable suggestion.

    The key point, that Rosamund didn't/wouldn't even touch on, is - as plenty of others have posted recently - that markets can work, and that, by small interventions, States can allow them to work better (creating new ones where necessary), without betraying the welfarist/socialist ideals that this State might (peculiarly!?) be pursuing.