Sunday, August 17, 2014

The myth of Free Markets

Up there with Sasquatch, the Loch Ness Monster, and unicorns is the magical and mythical Free Market. 

It doesn’t actually exist in the real world. But why do so many believe in its existence and the apparent powers it has to solve all our problems?

Well, let’s start with Free Market’s co-conspirators: Supply & Demand. Everyone seems to know them. They have an almost Biblical authority over the minds of economists, politicians, and the public. They are the ready answer to every economic question. “How did this happen? Well of course – it’s Supply & Demand.”

The idea behind Supply and Demand is that there is a self-adjusting mechanism in all markets whereby what people will pay for (demand) and what businesses will sell (supply) will always find a happy equilibrium point as prices move up and down. We're all familiar with the X diagram - quantity supplied and quantity demanded move with price, and the point where the lines meet is "equilibrium". It's a law. It's gospel. Right?

Now there is no disputing the fact that there is such a thing as a Supply and Demand curve - i.e. that at various prices, people will buy more or less stuff; likewise, businesses will produce and sell more or less products at various price points. However, the Free Market believers take it a step further. Their claim is that the price is actually determined by the supply and demand, and that it will always reach equilibrium and efficiently utilize all the available resources in the market

What they usually omit from the story is that this only works in a state of market perfection that happens to be conspicuously absent in real life. What does it take for the magical S-D X curve to work and reach our happy equilibrium point where all resources are used efficiently and all people are employed?

  • Perfectly flexible wages
  • Perfectly flexible prices
  • Perfectly flexible interest rates
  • Perfect knowledge of value and risk
  • Perfectly rational behavior by market participants

So here's the catch. In the real world, prices are very rarely set by Supply & Demand and there are a host of dynamics that constantly interfere with the self-adjusting S-D mechanism, sometimes deliberately. 

  • Income levels greatly affect our ability to buy even when prices might be falling
  • Tastes or preferences influence our willingness to buy at any price (this is often the result of the power of marketing to disrupt the "free market" function)
  • If there is limited availability of a substitute or complimentary product, changes in price may have no impact on demand
  • The level of confidence in the future or expectations about pricing or availability or changes in fashion can influence what we buy today and at what price
  • If the market has limited buyers or sellers we may see little movement in prices and quantities
  • Labor skills don't transfer easily from job to job or industry to industry, and loss of work can erode skills and "employability" quickly, meaning even at lower wages, employers may not hire
  • The cost of inputs has a huge impact on what prices businesses can or will charge, along with profit needs and debt levels
  • Laws, regulations, policy goals, social responsibility targets can all influence what is bought, sold, and at what price

Simply put, the "Free Market" never actually materializes in the way proponents claim. The real world is full of a more complex interplay of needs and wants - of private and public and corporate interests - that prevent the simplistic "self-adjusting" mechanism from magically rationalizing all factors. (Of course, we know it really couldn't solve all problems anyway since some human and societal needs cannot be reduced to a price in a market - e.g. clean air and water are usually regional or national challenges.)

Why it matters: this myth leads to bad policy

The religious followers of Free Markets use their mythical, magical S-D X chart to convince us all that if there is unemployment, the government should not intervene, but instead take a hands-off approach, letting the "Free Markets" and the "self-adjusting mechanism" do its work. However, they are quick to add that the government should do things that would help promote the smooth working of the mechanism, such as get rid of regulations.

When we recognize that the mechanism itself doesn't work that simply, and that deregulation, while it might lead to more profits (and possibly lower quality worker conditions and greater risk to the environment), it may not necessarily lead to more employment and increased real wages, we have to reevaluate the problem. 

We saw this dynamic play out during the Great Depression as the self-adjusting mechanism failed to result in a new equilibrium and full employment. And it is also precisely the situation we have been in since 2008, as businesses take advantage of record profits to buy back shares and increase bonuses and stock prices, all while workers' real wages have been declining and unemployment levels remain high. 

So do we live with systemic unemployment believing it is the only choice in our "Free Market" system? Or do we put down our over-simplified economics charts and recognize that if we want to address something as basic as full employment, reading fairy tales won't help. 

Free Market's dirty secret

Businesses actually don't want Free Markets. They want us to believe in the Free Market myth so as to influence policies to favor anti-market and anti-competitive behavior. This may come as a surprise to some of you, but it's not disputed by those involved in industry today. I'm not making a value judgement here - it's just the outflow of how people and companies fight for their interests. 

Many businesses don't want zero regulation - they want to influence the regulatory process to provide a more guaranteed and protected market and profits (just look at the US health care system!) Why is lobbying the most valuable investment of many corporations? It pays!

For those thinking that businesses want free markets, recognize that "Corporations" are actually a legal structure that was established to enable a concentration of market power to limit the influence of competitive market dynamics. Some of the first corporations were monopolies directly supported by their host-nation's navy during colonial times, and the same imperialistic dynamic has continued to play out in more subtle ways today with multinational corporations. Some people don't like the idea of unions and workers negotiating collectively, yet a corporation is really just the same thing - it allows owners to aggregate interests, financial strength and influence while shielding them from personal liability for much of their actions. This is no "Free Market", so let's stop kidding ourselves! 

Think also about how employment contracts and other incentives & threats limit the free exchange of labor; how copyright laws protect high profit margins and stifle innovation. The science of marketing and branding uses sophisticated psychological methods to cause irrational behavior. These are all some of the very deliberate ways businesses seek continuously to make the Supply & Demand curve break down, increasing profits and often squeezing workers.

Back to the real world

We need to stop throwing around mythical terms that have no meaning in the real world. Too many people think that "Free Markets" are threatened whenever someone suggests a role for government or government money in the economy. Mythical creatures are in no danger of extinction! 

Now please note: I am not at all suggesting we should do away with a market-based economy. I am in no way arguing for communism or a government take-over of business. In fact, my bias is to favor market-based solutions whenever possible. I'm simply saying that there is no such thing as a "Free" market that efficiently rationalizes all inputs to maximize resource allocation and create full employment, so we should stop pretending that it exists. There is no pure self-adjusting mechanism that will enable capitalist economies to be fully efficient. They never have been and never will because of all the complex dynamics described above. Markets are not free: they are a set of complex interactions; they are often not efficient; they are not conducive to all economic and societal problems; they can often be manipulated or controlled to various degrees; and they are heavily influenced in a constant tug-of-war between competing interests - some of which gain disproportionate power over the others. That's the real world of capitalism and market-based economies. 

So now that we recognize that "let the market decide" will never adequately address certain dynamics such as unemployment, environmental protection, long-term research, etc., we can see the healthy role for government money to enable a market-based economy to truly flourish and all of society to benefit.

The goal of good economics and the government's use of money (managing interest rates, overseeing and regulating banking, deciding what and how much to tax, prioritizing where to invest and spend, etc.) should be a healthy private sector, market economy, full employment, and the development of the nation's long-term capital needs. It should counteract the growth of oligarchy and ensure that markets and the political process are not becoming unduly influenced by a few wealthy or corporate interests, and that there is equity in opportunity wherever possible. And in the real world, Free Markets have nothing to do with any of this.