The Failure Of Free Markets

There is a lot of talk these days about the evils on unrestrained laissez-faire. There have been market meltdowns, business failures and tremendous losses for businesses and individuals. I have to agree that markets have failed. The real failure, however, has been that free markets have failed to exist for many decades.

A free market means that buyers and sellers can trade on any terms that they find mutually beneficial. They can trade whatever they want with whoever, whenever, however and why ever they want to. As long as fraud or coercion is not involved in the transaction, both sides trade because they believe they will be better off after the trade. It is a positive sum game.

The free market is based on property rights. People can use their property and dispose of it in any way that does not infringe on the rights of other people. Property rights are the key to economic progress in any country. Lack of strong property rights and economic freedom is the reason that less developed countries remain less developed.

The economic understanding of market failure is any situation where the allocation of goods and services in an economy is not efficient or optimized. The popular view is that any result in society that we don’t like is caused by market failure. Thus, depressions, pollution, homelessness, and shortages are examples of the infinite variety of things that can be blamed on markets.

There are many cases where the problem is a lack of adequate protection of property rights. In the case of pollution, people who’s property rights are infringed by the polluter should have the right to sue for damages. An appropriate justice system would make it expensive for a business to pollute or do other bad things because of the money it would have to pay to people who’s well being and property they damage.

The main problem with the market failure concept is the belief that benevolent politicians and bureaucrats should save the day. This approach has been energetically followed, but the reality is that the failures of government dwarf any failures of any market. In practically all cases, events that are demonized as market failures are the unforeseen and unintended consequences of prior government intervention in the markets, interventions that are invisible to everyday consumers.

The chain reaction will follow a few well worn paths. One such path is when someone perceives that prices are too high. Government then imposes price controls. The inevitable result of price controls is shortages. That means that rationing must be implemented. Black markets develop to supply the needs of consumers who can’t get what they want. Government programs are implemented to stamp out black markets, which invariably infringe on the rights of everyone. The string of cause and effect can go on for decades.

Another path may be when someone perceives that their income is too low. Government programs, such as the Agricultural Adjustment Act of the 1930’s and its many successors up to today, may destroy product and productive resources to keep prices high, subsidize the non production of crops and livestock, impose high tariffs and other protective measures. The net result is higher prices and a lower standard of living for all those not privileged enough to be in the protected industry. The protections and higher profits draw more people into production or discourage inefficient producers from leaving. The new producers increase production more, requiring further interventions.

These cause and effect chains can be followed in numerous industries, such as oil and gas, housing, banking and finance, agriculture, health care, automobile, and so on. When seen in isolation, an event looks like a random development. When taken together, they display a fairly understandable chain of events, emanating from some original intervention. The sad fact is that, even though this country is nominally free, and is still one of the more free nations , there is not one market that is not subject to massive government intervention at some level, national, state or local.

The current mortgage crisis and market meltdown are the unintended consequences of government induced inflationary credit, artificially low interest rates, lending and housing regulations and, in general, the lack of free markets in banking, housing and money creation. The present interventions of massive liquidity injections to preferred players in the market will have predictable consequences down the road. When those consequences come home to roost, people will forget about the cause of the failure and only blame the markets that failed by not being free.

10 comments to The Failure Of Free Markets

  • Hi Dan,

    You said:

    “Property rights are the key to economic progress in any country. Lack of strong property rights and economic freedom is the reason that less developed countries remain less developed.”

    That is overly simple, since it does not explain why for example GDP-per-capita in norway (which has a very strong public sector and less economic freedom than the USA ) is significantly higher than in the US. More so, since norway started from a lower gdp-per-capita situation vis-a-vis the US after WWII.

    Any advocacy position regardnig free markets really needs to address the issue of market failure in terms of how markets fail to provide goods which fall in the non-excludable catagory ( goods that the producer cannot limit consumption of once it has been produced). Reduction of air pollution that you cite is an example of a non-excludable good, since if multiple people suffer from pollution caused by a factory, yet only one person only sues the factory and wins, then the others who suffered pollution benefit at no risk or cost to themselves. And what if as a sufferer of pollution, I cannot afford to take the polluter to court?

    Also you don’t explain how the market will produce non-rival goods effectively, or how it would limit demerit goods (goods which pay the producer but have negative social affects) such as cigarettes.

    Given that these cases of market failure are well understood, I’m surprised you didn’t try and address them. Essentially it all comes down to transaction costs. If all such non-excludable, non-rival, demerit etc transaction costs are priced in then I agree that free markets will be a good general system. However how are the externalities which arise when the transaction costs are accounted for properly to be priced in? You’d need laws would you not, that are not soley related to price but which are based on some collective, subjective judgement. A carbon credit or a limit on vehicle emissions is an example. Perhaps the biggest theoretical market failure would be that it would tend to increase inequality. This is actually a market failure, since inequality leads to more social instability and more crime regardless of how good ones law enforcement is. I agree that enforcing equality is both doomed and undesirable, however I do maintain that allowing inequality to expand ad infinitum is a nagative externality of markets. Extreme social inequality has caused societal collapse (e.g. the Mayas). Moderate social inequality is beneficial since it provides incentives. However, where to draw the ideal balance?

    Finally there remains the very important issue of whether the market actors are actually rational. Is not groupthink (a tendency for humans to copy one another’s behaviour) part of the problem that leads to speculative bubbles?

    I’m not going to disagree that current inter and intra national markets are horribly distorted, by central banks, FRB, unfair global trade subsidies etc etc. I agree that such perversions should be removed.

    However I don’t disagree that having done so, free markets will then magically provide all the answers.

  • Hi Dan W.

    The article is not primarily a justification of free markets, but rather, pointing out that free markets do not exist. Blaming the free market for the results we see is like blaming the umbrella for getting you wet when someone took the umbrella away. The one who took the umbrella is to blame, and it is silly to blame the umbrella.

    With that said, there is always a chorus insisting that anyone who supports free markets address the issues of what some consider “market failure.” While those issues are definitely addressed often and adequately, a severe bias and imbalance is readily apparent. Why is it that those who promote free markets must answer every detail about supposed failure of market systems, while those who support government intervention don’t feel they need to address the many, varied and massive government failures that haunt citizens all over the globe?

    There has never been a system that provided perfectly for every need of every human, and there never will be. It is only utopian dreaming to think there is or even should be. Inequality is not the bad thing that you are implying. It is, rather, an absolutely necessary and totally logical outcome of different geography, culture, abilities and personal inclinations of all participants an a society. Trying to impose equality is trying to undo nature. The countries with the least inequality are destitute nations with little division of labor, little freedom and little trade.

    The GDP or GNP figures that you allude to are very imperfect measures, at best. It is not at all an accurate measure of well being. During World War II, the United States had an unprecedented increase in GNP, because of government spending. It was a period of time when food, fuel, and many other goods were rationed. You could not buy a car or even tires for your car. You could not build a house or buy materials for repairing your house. The reality is that war prosperity is a cruel illusion. The people who lived through it were not prosperous in any real sense. When the GDP fell 46% the year after the war, there was no depression. The economy took off instead, as markets were freed up. Comparisons between countries based on their GDP figures is very weak because the inflation of GDP by government spending does, not in any way, give a significant indication as to the real relative well being of the citizens of those countries.

    Again, when you talk about the lack of rationality of market participants, you imply that the herd mentality affects only market players. The implication is that, once elected to high public office, the anointed ones are touched by God and are suddenly rational and omniscient. Politicians, in fact, are just people, and as such are just as subject to irrationality and error. On top of that, they have power over the lives of others, which magnifies their irrationality so that it touches everyone.

    To the main point, markets are not perfect, nor rational. Nobody I know ever said they were. By the same token, governments are neither rational nor perfect either. They are in fact, even less perfect and less rational, from a citizen’s point of view. Freedom and markets are, the most rational, most fair and most honest way for a society to live in peaceful cooperation.

  • Hi Dan M,

    I agree with what you have said above for the most part. I think you are correct that in most cases free markets are a better way to organise many/most human affairs when compared to government. I certainly agree that current markets are not free and this is one reason for their failure. However the other main reason they have failed is simple greed, which will exist in every and all free markets. Regulations exist to rein in greed, aong other things. What you failed to state in your article is whether you believe markets could and would fail even if they were free of the distortions we currently live with.

    The real problem with market fundamentalism is that it is based on the assumption of a _free_ market. As soon as there is any distortion, intervention, failure of enforcement etc, the whole ideological construct which austrian economics is built on crumbles. It’s human nature to cheat and lie to gain advantage, and this will be true of government officials and market actors.

    Market fundamentalists are happy to apply this will-to-power aspect of human nature to show why central planned (or indeed any other form of) government will always be sub-optimal, but they fail to admit the same human-nature based corruption of the free market would occur.

    Instead they begin with the premise of platonic, perfect, enforcement of property rights, and go on from there to derive the rest of their ideology. Surely you have to admit that as a result, the free markets you speak of can’t actually exist/work in the real world, any more than a perfect communist society can work in the real world. Both ideologies selectively ignore the most fundamental aspects of human nature.

  • Hi Dan W,

    There is a lot of truth to what you said. In the real world, there will be greedy people, those who try to use force and coercion, whether in a market driven economy or a government driven economy. I think the point where we differ most is that I don’t believe there is or could ever be such a thing as a perfect economy or society. Markets will definitely fail, if by failure you mean that everyone is not perfectly and equally cared for. But governments, however, always fail on the same counts.

    What I do believe is that economic laws exist and rule all human action, whether the actors are aware of them or not. I believe that a society that benefits the most people to the highest degree will be the one that does not try to abuse economic laws or restrict the market in any way, other than to prevent people from infringing on the rights of others to their own life, liberty and property.

    I believe that an economy will have more peace and prosperity for all members as it moves closer to individual freedom and self responsibility. I believe that there will be less peace and prosperity for all members of society as it moves toward centralized decision making and less freedom and self responsibility. They are two opposite ends of the spectrum. The state of a society will, in the long run, be determined by where it falls on the spectrum.

    Scandinavian countries are often cited as socialist societies that are successful. The fact is that they are suffocating and stagnating under a massive weight of government. They started out as very prosperous capitalist countries with a great deal of accumulated wealth. They are finally depleting that accumulated wealth and will eventually drive their economies over a cliff.

    The United States is no different. It has become a high tax, big government nanny state. The only reason that America is still a world leader is because the governments of all nations seem to be in competition as to how irresponsible they can be. American politicians are driving our economy rapidly toward the cliff, when the tens of trillions of dollars that they have committed us to become due.

    Whether you call it free market fundamentalism or a simple belief in economic laws, there is plenty of evidence in the world over the course of millennia which suggest that the less freedom, the worse off the people will be.

    I appreciate the open discussions with you. I am learning a lot. I look forward to your next installment. of The System Of The World.

  • Dan Wilkinson

    Hi Dan M,

    I do share most of your concerns about government. Given that none of the systems of society are perfect I suspect that the ideal system in the current age of population growth would be where free markets provide all goods which are rival and meritorious, and some form of collective management (not necessarily central governemnt in the form we know it today) provides non-excludable and som non-rival goods and can help make sure markets price external transaction costs. A third institution would need to provide a sound money supply that links the two together, but which also prevents them from distorting one another.

    I don’t see why in principle the two can’t co-exist, my aim would be to aim for the improvement of both as close as possible to the ideal.

    However, I think a lot of the economic laws you refer to may need to be rethought a bit once we leave the current age of population growth and move into the phase of steady or declining population, as I’ll try and show in my next article. At the very least, it should be possible to agree that the application of the key laws will produce different results in situations of rising and declining populations.

    However I’m not sure what exactly your definition of the key economic laws are. Can you state the key laws?

  • Dirk

    It is frustrating when socialists cite Scandanavian countries as examples of success. Norway has an abundance of natural resources and they were developed by private enterprise- there is still a very strong private sector there. Sweden is a great example of a country that vacillates between socialism and greater privatism- and it is the periods where supply side economics and private enterprise are strongest that the economic performance of Sweden is the best.

    It is the mark of civilization that groups of people cooperate and create boundaries. But as these groups make the error of commandeering more profits to support unproductive behaviors (such as welfare mothers and workers without monitoring and rewarding output and innovation) they invariably lead to lower productivity and a lesser standard of living.

  • Actually, I will make the economic laws the subject of my next article. From my perspective, those laws are derived from the inherent logic of human choice and human action. It really won’t matter what the circimstances are in ages to come, just as it didn’t make a difference ages ago.

    We can relate to historical characters of thousands of years ago because they used the same human logic, felt the same human emotions and had the same choices that we do now. The only thing that has changed over the course of history is the technology with which we satisfy our needs.

  • Dan Wilkinson

    Good grief dirk, it should be obvious from what I have said so far I am not a socialist! Not being a market fundamentalist does not automatically make me a socialist for heaven’s sake! There is such a thing as a middle ground.

    Adherents of the austrian school would consider you a socialist since you support fiat money. Labels are pointless, and an outcome of blind ideology.

    What I am interested in is examining facts in the absence of ideaology. For example, the fact that Norway and Sweden have done rather well for themselves.

    Ask the scandinavians what makes them successful and they will reply that it is investment in human capital. Having met a bunch of norweigan and swedish individuals I can attest to the fact that they are some of the best educated, rational, balanced and sensible people I have met.

    I’m inclined to buy this viewpoint, since there are plenty of other countries richly endowed with natural resources that have not done so well (and there are both socialist, capitalist and mixed economies in this not-so-good list).

    .

  • Dan Wilkinson

    Hi Dan M,

    Looking forwards to that article then – the next SoW article is proceeding rather slowly but will be ready soon.

  • anon

    “The sad fact is that, even though this country is nominally free, and is still one of the more free nations , there is not one market that is not subject to massive government intervention at some level, national, state or local.

    The current mortgage crisis and market meltdown are the unintended consequences of government induced inflationary credit, artificially low interest rates, lending and housing regulations and, in general, the lack of free markets in banking, housing and money creation. The present interventions of massive liquidity injections to preferred players in the market will have predictable consequences down the road. When those consequences come home to roost, people will forget about the cause of the failure and only blame the markets that failed by not being free.”
    though i agree i think it is also fair to point out that those interventions where the ones that major players in those industries lobbied for . I simply don’t think blaming only the government for an intervention while letting those that lobby very effectively for it off the hook is fair at all . In my honest opinion the huge amounts of lobbying and campaigning only certain firms, industries and other special interest groups are able to do and allowed to do in the states are what causes a weak democracy and leads to these market failures . The other ongoing market failure in the states in my opinion is the weakened ant-trust division of the doj for the last 30 years has allowed way to much collusion . . after all according to even my limited knowledge of the field(i’m obviously not a real economist or even an econ student) it’s the Free Competitive Market and not simply the free market that can most benefit society . For a market to be free you did need strong regs so that firms don’t engage in anti-competitive behavior . I think even Smith said something along the lines that if you give firms the opportunity to engage in anti-competitive behavior that they most certainly will because in most cases they have every incentive to do so .

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