I do not think it means what you think it means…

November 14, 2010 at 4:10 pm (Tom) (economic theory, economics, Efficient-markets hypothesis, free markets, Market failure)

Instead of staring at my longer, unfinished post about why partisan politics is destroying the usefulness of economics, I thought I’d post a quick one about the misuse of a particular economic theory.

The Free Market

You’ve almost certainly heard of the concept of a “free market”.  Most people chalk this up to one Adam Smith, the father of classical liberal economics; although as far as I can tell, the phrase is actually attributable to John Stuart Mill, writing about 60 years after Smith’s death (and not about economics, either). It describes a situation where individuals have complete power to buy and sell property and services to other individuals at will; bound only by government enforcement of the laws of contract and private property. The advantage of a truly free market, Smith argued, was that the “invisible hand” of the market would set prices at the correct level. Subsequent economists like Ricardo and Cournot cleared up what he meant by this confusing statement, introducing the supply/demand curve and explaining the mechanism behind it.

Simply put, (and in the absence of all other stimulus):

1. People buying in a market will look for the lowest possible price amongst the sellers. If the lowest possible price is above the amount they’re willing to pay, they drop out, and are no longer buyers.

2. Sellers will look for the highest price amongst the buyers. If the highest possible price is less than they’re willing to sell for, they drop out.

3.  Prices will move to the point at which the number of sellers is equal to the number of buyers.

4. At this price, this is neither a surplus nor a shortfall, so it is the most efficient and stable state.

So far, so good. It hangs together, it can be proven logically and by experiment; and from the late 1700’s to today, it’s been a centrepiece of anti- or minimal-government thought. Basically, the wisdom of crowds is superior to the wisdom of bureaucracies.

However, there is a key problem with the theory – it relies on information symmetry. For it to come off without a hitch, every single one of the buyers and sellers needs to have complete knowledge of every other transaction and possible transaction able to take place in the market at any given time. That way, they can compare all the options, and come to the perfect, rational decision. Obviously, this isn’t possible in practice, and where one party has access to better information than the other, they can take advantage of this to get a higher or lower price than the model says. This problem is the source of much of the consumer protection law of the 20th century; which was a project begun by the British common law, and continued by the Liberal party in the UK, the Republicans in the US, and the Menzies-era Liberal Party in Australia.

Efficient-markets Hypothesis

However, where the theory causes real problems is when you’re buying and selling money itself.

The global economy is worth about $61.06 trillion US dollars. That’s an estimate of every single economic transaction taking place all over the world. Of that, the world stock market is now worth $36.6 trillion dollars (measured at one of the lowest points of the financial crisis, it’s picked up since then). So a little more than half the world’s economy is listed on a sharemarket somewhere.

However, average daily turnover of the foreign exchange market alone is $3.98 trillion US dollars; and the total value of derivatives is $791 trillion US dollars. That’s more than 11 times the total value of the world economy.

So the vast bulk of transactions made every day in the finance industry aren’t for tangible things. They’re making and taking bets about what happens in that “real” economy, the tiny little $36.6 trillion dollar nub that deals with the measurable, regulated, material world. They’re buying and selling a chance to make more money.

At the start of the 20th Century, there were two schools of thought that rebelled against this emerging financial capitalism. Broadly, they were called Fascism and Communism, and both seem to have largely died out – but their unifying thread was the complete rejection of speculative earnings. They both argued that this kind of trading was unproductive, parasitic, and, after the 1890 and 1929 stock market crashes, dangerous, too.

The answer from economists was to develop the Efficient-markets Hypothesis. This says that in financial markets (where people are buying a chance at more money, rather than an item they need to consume or trade), the market is actually dealing in information and trading risk. The price someone is willing to buy or sell for is dependent on their knowledge of what’s likely to happen to that price in future; so the market price will move quickly to reflect all available information about the item. So if you’re trading in the market, you don’t really need to know what you’re buying or selling – if you have an idea as to whether the price is going to rise or fall in future, that’s all you need to know, because the market will always get it right. Government, by “regulating” will just slow down the wealth creation process, and add the risk of the market getting it wrong.

You see where this is heading, right? In the leadup to the financial crisis, new types of derivative products flooded the newly deregulated US exchanges – most famously “sub-prime” mortgage bundles, but these weren’t the only culprits – food and fuel futures and foreign exchange bets played a role too. Since a downturn in the US economy in about 2000, the US federal reserve had been giving out loans at near 0% interest – certainly below the rate of inflation, and this free money found a place to go.  A massive bubble built, but because people knew that the market couldn’t get it wrong, there was no reason to check out what they were buying.

And then, disaster. There are plenty of reasons the EMH doesn’t work in practice, but the key problem is that it’s using Adam Smith’s old theory in a context stripped of the things that make it work. Why? Because until the market fails, it makes a lot of people a lot of money. And when it does, it turns out they can shift that failure on to the taxpayer or consumer.

Built-in Market Failure

But even where the market is of a type that Smith could have forseen, the problem of information asymmetry remains strong. The theory argues that where buyers and sellers have differing levels of information, there is an incentive to improve it; so as they do so, the market returns to equilibrium. OK, good answer, but what about  markets where a large number people only buy occasionally; but a small number of producers sell all the time? It’s very much in the interests of those producers to have all the information, but the time and energy involved in collecting it as an individual makes it prohibitive. What if, even better, the producers can invest money to misinform, selectively inform, or otherwise manipulate the buyers? We call this sort of thing “advertising”.

A pretty good example of a free market vs an efficient market is the US pharmaceuticals market and the Australian one. In the US, medicines are sold subject to a check from the US Food and Drug Administration; doctors then have leeway to prescribe whatever drug they wish. Consumers, in addition, are able to request particular brands or drugs from their doctors, and in some states regulation prevents doctors from refusing to prescribe these alternatives, if it’s appropriate to the patients’ condition. There’s public assistance for the poor and the elderly, but everyone else pays full price. Pharmaceutical companies spend billions of dollars a year marketing to and influencing both consumers and doctors; with very little regulation. This is a deregulated market in action, and in 2009 constituted 17.3% of their economy (public + private spend).

Australia, on the other hand, bans direct-to-consumer advertising and severely limits marketing to medical professionals. Doctors can specify what is prescribed by brand, and can refuse to prescribe anything they don’t think is worthwhile. It also operates a subsidy for medicines called the Pharmaceutical Benefits Scheme, which dramatically reduces the prices of drugs considered by an expert panel of scientists to provide good value-for-money. You can still buy the other drugs; but they’ll cost you the full amount, just like in the US. This is a highly regulated market; and in 2009 constituted 9.1% of our economy (public+private spend).

The American market is clearly more free; so why is it more expensive and greatly less effective?

Well, the trick is that the word “free” doesn’t just apply to governments. By limiting the information that the sellers can put into the marketplace, and by adding a major and highly accurate price signal to the matket in the form of the PBS, the Australian system actually corresponds more closely to what liberal economists would term a “free” market.  It’s not the removal of regulation that makes markets work efficiently, it’s the removal or minimisation of market distortion; and business is just as capable as government of distorting a market – in fact, that’s pretty much their job.

So next time someone tells you that free markets are more efficient, check that they actually know what they’re advocating – the strict regulation of corporations, consumer protection, banning advertising or inexpert buyers, government guidance to market participants, the removal of distortionary incentives like yearly executive bonuses and sales commissions and possibly the closure of most of the global financial system.

Inconceivable!