Slaves to dead economists

By Marcel Côté

The financial crisis of 2008 reminded us how fragile markets could be. The crumbling of the financial markets, and the warts that were discovered as they crumbled, is a sobering lesson. Markets are mechanisms to allocate resources. They work well only under certain conditions. Not only can they fail, but they seldom work as well as the theory would suggest, as some conditions are typically always subpar: insufficient information, market concentration, transaction costs, cost of switching. Anyone who has examined his or her bank statements or telephone bills realizes that under the liberty of the free markets, banks and telephone companies can pass a lot of special charges to their customers.

Unfortunately, markets have become an ideology. Shielded by the mysterious virtues that any ideology drapes itself in, markets are given a free ride by many, allowing the worst excesses to flourish. Questioning the wisdom of unregulated markets is deemed an attack on freedom by these ideologists. Markets can do no wrong and should be left alone. So the awe-inspiring Alan Greenspan let the financial markets evolve and grow, with few regulations. The structured financial product markets, which required trust, transparency and accountability to work well, were allowed to mushroom unfettered into trillion dollar markets, fed by subprime mortgages of dubious quality. “The market will sort it out” was the magic wand thrust at anybody who called for tighter regulations.

But let’s not pick on Greenspan alone. Millions of people share the ideology of “free market,” which finds its roots in the neoclassical model of market economy theory developed in the early part of the 20th century. Its main tenet was that free markets were better than any other system of resource allocation to maximize the collective economic well-being of a society. But the neoclassical model’s theoretical foundations are increasingly called into question. Not only do its assumptions now appear unrealistic, but in real life, price competition has hardly been the driver of equilibrium postulated by the neoclassical model.

The economy is not a system seeking its equilibrium, as the free-market ideologists would believe, but one that is continuously evolving, along the lines of Darwin’s theory. A new model of the economy is indeed emerging, based on the drive of businesses to survive by continually trying to differentiate their products to shield them from competition, fuelling innovation and growth. Disrupted by this drive for differentiation, markets are always out of balance and should be regulated to function well.

This new view does not conclude that markets always operate in the common interest and can efficiently solve all problems.

Markets are never perfect and indeed are easily manipulated by businesses seeking to avoid direct competition. This is why intelligent government intervention is sometimes necessary — to more effectively align markets with the common interest. That does not say that government interventions are always correct, but neither is the behaviour of the markets.

But paradigms endure. Just as many people still do not believe in evolution nearly 150 years after Darwin, there will be ideological support for free markets for years to come. However, as its theoretical foundations are crumbling and crises like the one we just experienced sober us up, the free-market ideology will slowly fade into the sunset.

The great economist John Maynard Keynes made the point that we are unfortunately too often the intellectual slaves of some defunct economist. When a politician says we should leave things up to market forces, you should ask yourself if that person is not stuck in the past, with a bankrupt ideology.

Marcel Côté is founding partner at SECOR Consulting in Montreal