Market economies are unpredictable and chaotic—and that is why we should value themby John Kay / August 21, 2013 / Leave a comment
“A Russian bureaucrat once asked: ‘who is in charge of the supply of bread to New York?’ The answer, of course, is no one.” (© Sylvain Sonnet)
Capitalism is a misleading term that encourages misapprehensions. One such misapprehension is that economic power rests with the owners of capital. When, during the Industrial Revolution, people went to work in places such as Arkwright’s Mill, the mill was, indeed, Arkwright’s, a tyrannical figure who owned the mill and the machines in it, and brooked no insubordination.
Modern business is not like that. Consider the people we would regard as possessing economic power today: financiers such as Jamie Dimon of JP Morgan, central bankers like Ben Bernanke, business leaders like Steve Jobs. In none of these cases does an individual’s economic power have anything to do with their ownership of capital; it arises from the position they hold within a hierarchy. They do not derive their authority from their capital: rather they derive capital from their authority.
Opponents of capitalism traditionally sought to transfer ownership of the means of production to workers, or to the state. But no one owns JP Morgan or Apple, in any ordinary sense of the term. The Apple store in Regent Street is owned jointly by the Queen and the Norwegian sovereign wealth fund. I doubt if many of the people who work there know who owns the means of exchange (the principal owners of the means of production are Foxconn, headquartered in Taiwan, and the Korean company Samsung), and they don’t know because it doesn’t matter. As for shareholders, there are many ways of asking who the owner of a share is—whose name is on the share register? Who decides to buy or sell? Who benefits from the economic interest in a share?—and each has a different answer. As the management theorist Charles Handy suggested, the concept of ownership simply gets in the way.
Another misconception is that securities markets are the means by which businesses obtain capital for investment. Large companies today generate more than sufficient funds from operations to meet their investment needs. Small and medium sized enterprises, meanwhile, do not have meaningful access to securities markets. If companies do seek to list on the stock exchange—and in Britain few now do—the purpose is generally to provide an opportunity for realisation by employees and early stage investors. Facebook raised $16bn of new capital in its flotation but disarmingly admitted it had no idea what it would do with it. Apple announced a $17bn bond issue, not because it needed the money but because the accounts in which its cash is placed are offshore and it wished to pay a dividend to its predominantly American shareholders. Companies use capital markets for financial engineering rather than to fund capital in their business.
But here my focus is not on capitalism but on the market economy. The markets to which I refer are markets for goods and services, not securities markets. I define the market economy as an economic system that makes extensive use of the price mechanism and allows a good deal of freedom to establish businesses, develop new products and implement new business models. There are no examples of sustained successful economic development in societies which have not adopted some version of that. Further, all countries at or close to the technological frontier—countries which achieve the levels of output and prospects that we know are possible with existing productive capabilities and business methods—are, in the sense I have just described, market economies.
These claims are both strong and weak. They represent a powerful assertion of the superiority of market organisation over other systems of resource allocation. But they stop a long way short of concluding that markets give rise to efficient outcomes in all cases, and a very long way short of any claim that market outcomes are equitable or in any sense morally justified. My enthusiasm for markets is akin to the enthusiasm that EM Forster and Winston Churchill shared for democracy: Churchill allegedly observed that democracy was the worst system of government except for all the others that had been tried, while Forster gave it two cheers rather than three. But if the market system has the moderate virtues I have claimed for it, we need to understand why.
Consider first the role of prices as signals. This is the story we tell in Economics 101, when students encounter the concept of “general equilibrium.” The price mechanism enables fairly good decisions about resource allocation to be made without it being necessary either to obtain or to process very large amounts of information. This informational efficiency of the market system is neatly encapsulated in the perhaps apocryphal story of the Russian bureaucrat who, when taken to the United States, asked: “So who is in charge of the supply of bread to New York?” No one is, of course. Yet New York is supplied more reliably, and with bread of better quality and variety, than cities where someone is in charge. Coordination is better accomplished without a coordinator.
Since the 1930s, some have seen the informational problem of resource allocation as primarily computational. The recent fashion for “big data” is the latest example of this type of misconception. But soft—qualitative—data is vitally important, and computers still struggle to judge the quality of a management team or the trustworthiness of a financial adviser. More fundamental still is what economists call “incentive compatibility”: how to induce people accurately to reveal their preferences and capabilities in a world in which efficiency depends on the matching of preferences and capabilities.
The mechanisms of information handling are complex and fascinating. But I fear students spend too much time on that part of the story and too little learning about other characteristics of a successful market economy, notably the process of experiment and discovery, and the attempt to check rent-seeking through the decentralisation of economic power.
The world is uncertain; not just risky, but uncertain, in the sense used by JM Keynes. Not only do we not know which future outcomes will happen, we are unable to specify what these possible outcomes might be. Market economies do not predict the future, they explore it. That is the fundamental difference between a planned economy and a market one. Friedrich Hayek remains the most eloquent expositor of the concept of the market as a process of discovery, and his argument was vindicated by the failures of the Soviet bloc in the postwar era. These planned economies failed in the development not just of new consumer products but of new business methods. Centralised systems—whether state or corporate bureaucracies—generally experiment too little. Committees find reasons for concluding that new proposals will fail. And they are right to do so: most experiments do not succeed. Market economies thrive on a continued supply of unreasonable optimism. When the innovations of entrepreneurs occasionally succeed, they are quickly imitated.
The first personal computer was produced by Xerox Parc. Apple is the world’s most valuable company today, having come close to bankruptcy twice. The tablet was invented over and over again by Apple, Microsoft and others until, at a particular moment, a version of it caught the tide of history. The personal computer revolution happened because no one was in charge of it. A similar revolution did not take place in the Soviet Union because someone was in charge of the supply of computers to Moscow.
If market economies are better than planned societies at the origination of new ideas, they are also better at disposing of failed ones. Honest feedback is rarely welcome in any large bureaucracy. In authoritarian regimes, it can be fatal to the person who delivers it; in less draconian contexts, fatal to careers. Disruptive innovations most often come to market through new entrants—Google, EasyJet or Amazon, for example. The health of the market economy depends on constant replenishment of the business sector by new entry.
The third element in the superiority of the market economy is the diffusion of power. Prosperity and growth require that entrepreneurial energy be focused on the creation of wealth, rather than the appropriation of the wealth of others. “Rent-seeking” is the process by which the ambitious find it more rewarding to do the latter than the former. It takes many forms: awarding yourself control over former state assets; seeking protection from foreign competition; winning sinecures or overpaid positions by ingratiating oneself with public servants or corporate employees. Whilst it is ineradicable, there can be more or less of it. The ability of a system to resist it depends on the degree of economic decentralisation. Wherever there are concentrations of economic power, individuals will try to appropriate the rents derived from them. The wider the range of opportunities thus created, the greater the tendency for individuals to do so.
A central theme common to all explanations of the success of market economies is the power of disciplined pluralism. Pluralism requires a good deal of freedom to experiment with the provision of new and differentiated goods and services, methods of production and business organisation. Discipline implies a reasonably rigorous process in which unsuccessful production or organisation is discontinued. The decentralised decisions of businesses and consumers play an important role in both facilitating pluralism and imposing discipline.
If the essence of markets is their pluralist character, then there is an association between the successful market economy and other components of an open society—freedom of expression and democratic institutions. While it is true that authoritarian regimes have operated market economies, the combination is probably not sustainable in the long run, because political freedom is jeopardised by excessive concentrations of economic power.
The “market economy” as I have been describing it is very different from a conception of “free markets” which applauds the aggressive pursuit of self-interest and opposes any legal restriction on the exercise of it. Like socialist planning, this is not an economic model which seems to have been successful anywhere it has been tried. Countries which persist with it, such as Nigeria or Haiti, suffer from endemic opportunism and rent-seeking, and are some of the poorest places on the planet.
There are many different kinds of market economy, with the US, Sweden, Japan and now China succeeding in different ways. All of them are governed by elaborate regulatory codes derived from legal and social institutions. Successful market economies are socially embedded. They accommodate the complex and multi-faceted goals of individuals who mostly do not conform to stereotypes of “rational economic man.” The property rights that such economies protect are social constructs, not endowments fixed by nature. A functioning market economy requires far more cooperation than individualism or merely contractual relationships could provide. Thriving market economies produce complex goods and services which can be safely traded only in the context of reputation and trust relationships.
What are the implications of all this for public policy? The European centre-left in the post-socialist era has had great difficulty in reconciling its progressive instincts with the pervasive realities of market economics. There have been two principal attempts at such reconciliation, which I call “redistributive market liberalism” and “homeopathic socialism.”
Redistributive market liberalism broadly accepts the market fundamentalist account, espoused by the political right, of how market economies function. It recognises that greed is endemic and that financial incentives are the principal motivation for economic behaviour. It accepts that markets, prima facie, get the right answer to issues of resource allocation. But it seeks to temper market outcomes in two main directions: tax and benefits should be employed to offset the malign distributive consequences of unrestricted markets, and policy interventions are appropriate in a strictly limited group of cases described as “market failures.”
This is the dominant economic philosophy in the UK Treasury. In modern British government, an economic case for state intervention requires an argument from market failure. Distributional issues are dealt with by the Treasury through its control of tax and benefits—we do not acknowledge distributional consequences as a valid reason for intervening in the markets.
Redistributive market liberalism gives far too much away to market fundamentalists. It posits a separation between the economic realm, and the political and social realms. This becomes untenable as soon as one recognises the role played in the economy by trust, cooperation and solidarity, the contestable nature of property rights and the limitations on any knowledge imposed by radical uncertainty.
Homeopathic socialism is state control of industry watered down until its effects are barely discernible. Postwar governments in the UK sought ownership of the means of production and exchange, which proved largely unattainable and was inefficient in the industries in which it was tried. National planning was offered as a substitute in the 1960s, and, when that didn’t work, planning agreements were mooted. By the turn of the century we had “light-touch regulation,” the apotheosis of homeopathic socialism. This progressive dilution of an unpopular and unsuccessful doctrine satisfies no one and created an intellectual vacuum which became evident after the banking crisis in 2008. The left readily acquiesced in the process by which governments provided much of the capital and underwrote all the liabilities of major banks. The Labour government was frightened of being associated with “nationalisation,” yet this was a moment at which many would have accepted that a period of direct public control of banks was the best way of ensuring that they continued to perform essential functions during a period of necessary restructuring.
Simply to assert that there should be “more regulation” is a hopelessly inadequate response to the problems that the modern financial sector poses for the real economy. We do not create financial stability by creating a body to promote financial stability. Despite the evidence of past failure, greatly exaggerated expectations of what regulation might achieve remain widespread. The CEOs and boards of large financial institutions, ludicrously well paid, were unable to understand or control what was happening within them. That was true, a fortiori, of the external regulators.
Regulators have never lacked the relevant powers. They have always had the capacity to apprehend Bernie Madoff or to block the acquisition of ABN Amro by the Royal Bank of Scotland. The issue is that regulators lacked political authority and the technical competence to undertake the job with which they were charged—supervision of the strategy and conduct of large financial conglomerates of almost unfathomable complexity which wielded excessive political influence. This will not change until we begin to address questions of structure rather than attempting to monitor behaviour. Stabilising the structure of the financial services sector was, in 2008, the right thing to do in the short run. In the long run, however, it was precisely the wrong thing to do. Instead of facilitating the winding down of failed business models, we have committed public money to their indefinite continuation.
Policy ought to be pro-market, not pro-business. In the financial services sector we have confused the health of the industry with the health of large firms within it. The transition to a digital economy, for instance, has been slowed dramatically by a perceived need to protect the vested interests of publishing firms who no longer have a role to play.
The experience of the financial sector shows that a combination of ineptly designed regulations and regulatory capture has made outcomes considerably worse. I am frequently asked: “Are you for markets or against them?” That is an absurd question. We should be pragmatic about markets and, when we intervene in them, we should do so not on the basis of putatively universal principles but rather on a detailed understanding of the particular ways in which different markets work.
Markets are less like well-oiled machines than constantly changing adaptive biological systems. Their essence is chaotic, their development inherently uncertain. If we could predict the evolution of markets, we would not need them in the first place. It is with humility, therefore, that we should contemplate the future of the market economy.
Adapted from the Political Quarterly lecture, given at the LSE in June