Properly functioning markets require careful regulation. Yet much intervention is often injudicious
ASKED why the Federal Reserve had failed to anticipate the lax bank lending that ultimately led to the global financial crisis, Alan Greenspan, the Fed’s former chairman, said he had the wrong model. He had assumed that bankers, acting in their self-interest, could not blow up their own banks. He was wrong, and the regulation of banks has since become far stricter. Indeed partly as a consequence of the crisis, and the political upsets (Brexit, Donald Trump’s electoral victory) that it helped give rise to, the bias against intervening in markets (for credit, for internationally traded goods, and much else) has greatly weakened. The question for policymakers no longer seems to be “How can markets be liberated?” Rather it is, “Can markets be too free?”
Given the now-general disdain for free markets, it is easy to forget the economic miracles they conjure. In his book, “The Company of Strangers”, Paul Seabright, an economist, uses a purchase of a shirt as an example. His shirt is made in Malaysia using German machines out of Indian cotton grown from seeds developed in America. Millions of shirts of different sizes and colours are sold every day. The wonder, he notes, is that no one is in charge of supplying shirts. Were there such an agency, the complexity of the task would defeat it. The enterprises that make up the many links in the chain supplying Mr Seabright’s shirt are responding to price signals from various markets all along that chain. The great merit of market prices is that they convey information about what people want to buy and what others want to sell. A branch of economics, called general-equilibrium theory, captures this formally. It says that in a competitive market, prices are a signal of the marginal value of goods to consumers as well as the marginal cost of goods to producers. Indeed it goes further. When prices (and wages) are set in free and competitive markets, the economy’s resources are allocated “efficiently”. In other words, no person can be made better off without making someone else worse off. In this theoretical Utopia, markets cannot be too free.
The theory is beautiful, and thus seductive. But it does not reflect any world that real people live in or might live in. There are several big objections to the free-market-as-nirvana view of economics. One is that some firms inevitably have market power. General-equilibrium theory assumes perfectly competitive markets made up of businesses that all set prices at marginal cost. In reality some industries will have a few number of large firms, either because of economies of scale or because of “network effects”, which mean the more customers flock to a platform, such as Facebook, the more useful it is to others. Such firms have enough muscle in the marketplace to sell above their marginal cost; the can also pay below-market wages (so-called “monopsony” power). Such sand in the wheels is fatal to the socially efficient outcome of general-equilibrium theory. And where there is market power, there is often also inequality. Another problem is that an atomised free market would systematically under-provide certain goods and services that society nonetheless values, because it is hard for suppliers to charge enough to cover their costs. One example is so-called “public goods”, like national defence. Another is research and development. In a competitive market, there is too little incentive to innovate (hence drug patents). And the full social costs of goods are not reflected in market prices wherever their production leads to economic “bads” such as pollution, congestion, urban blight and so on.
Dealing with such “market-failure” problems requires judicious regulation. Minimum standards of business practice are required in industries for markets to work tolerably well: think of capital requirements in banking of food-safety in the catering business. Free-marketeers rightly point out that intervention is often injudicious and ends up tilting the scales not towards consumers but to vested business interests. But the intellectual momentum now is with the interventionists.
Today's explainer was suggested by Chayut Setboonsarng. This is the first in a series of five. Other explainers in this series include:
Tuesday: What makes something a commodity?
Wednesday: What is the point of spam e-mail?
Thursday: What do think-tanks do?
Friday: What makes a work of art valuable?