23 Things They Don't Tell You About Capitalism

We should leave markets alone, because, essentially, market participants know what they are doing – that is, they are rational. Since individuals (and firms as collections of individuals who share the same interests) have their own best interests in mind and since they know their own circumstances best, attempts by outsiders, especially the government, to restrict the freedom of their actions can only produce inferior results. It is presumptuous of any government to prevent market agents from doing things they find profitable or to force them to do things they do not want to do, when it possesses inferior information.

What they don’t tell you

People do not necessarily know what they are doing, because our ability to comprehend even matters that concern us directly is limited – or, in the jargon, we have ‘bounded rationality’. The world is very complex and our ability to deal with it is severely limited. Therefore, we need to, and usually do, deliberately restrict our freedom of choice in order to reduce the complexity of problems we have to face. Often, government regulation works, especially in complex areas like the modern financial market, not because the government has superior knowledge but because it restricts choices and thus the complexity of the problems at hand, thereby reducing the possibility that things may go wrong.

Markets may fail, but…

As expressed by Adam Smith in the idea of the invisible hand, free-market economists argue that the beauty of the free market is that the decisions of isolated individuals (and firms) get reconciled without anybody consciously trying to do so. What makes this possible is that economic actors are rational, in the sense that they know best their own situations and the ways to improve them. It is possible, it is admitted, that certain individuals are irrational or even that a generally rational individual behaves irrationally on occasion. However, in the long run, the market will weed out irrational behaviours by punishing them – for example, investors who ‘irrationally’ invest in over-priced assets will reap low returns, which forces them either to adjust their behaviour or be wiped out. Given this, free-market economists argue, leaving it up to the individuals to decide what to do is the best way to manage the market economy.

Of course, few people would argue that markets are perfect. Even Milton Friedman admitted that there are instances in which markets fail. Pollution is a classic example. People ‘over-produce’ pollution because they are not paying for the costs of dealing with it. So what are optimal levels of pollution for individuals (or individual firms) add up to a sub-optimal level from the social point of view. However, free-market economists are quick to point out that market failures, while theoretically possible, are rare in reality. Moreover, they argue, often the best solution to market failures is to introduce more market forces. For example, they argue that the way to reduce pollution is to create a market for it – by creating ‘tradable emission rights’, which allow people to sell and buy the rights to pollute according to their needs within a socially optimal maximum. On top of that, free-market economists add, governments also fail (see Thing 12). Governments may lack the necessary information to correct market failures. Or they may be run by politicians and bureaucrats who promote their own interests rather than national interests (see Thing 5). All this means that usually the costs of government failure are greater than the costs of market failure that it is (allegedly) trying to fix. Therefore, free-market economists point out, the presence of market failure does not justify government intervention.

The debate on the relative importance of market failures and government failures still rages on, and I am not going to be able to conclude that debate here. However, in this Thing, I can at least point out that the problem with the free market does not end with the fact that individually rational actions can lead to a collective irrational outcome (that is, market failure). The problem is that we are not even rational to begin with. And when the rationality assumption does not hold, we need to think about the role of the market and of the government in a very different way even from the market failure framework, which after all also assumes that we arerational. Let me explain.

If you’re so smart…

In 1997, Robert Merton and Myron Scholes were awarded the Nobel Prize in economics for their ‘new method to determine the value of derivatives’. Incidentally, the prize is not a realNobel prize but a prize given by the Swedish central bank ‘in memory of Alfred Nobel’. As a matter of fact, several years ago the Nobel family even threatened to deny the prize the use of their ancestor’s name, as it had been mostly given to free-market economists of whom Alfred Nobel would not have approved, but that is another story.