Flaw in Free Markets: Humans

In the September 12, 2009 New York Times article "Flaw in Free Markets: Humans," Robert H. Frank suggests that untempered devotion to free markets is flawed because human behavior is not always rational:

THERE is broad agreement that Alan Greenspan, the former Fed chairman, was wrong to have believed that market forces alone would insulate society from excessive financial risk. But Mr. Greenspan was wrong for reasons very different from those offered by his most vocal critics.

Those critics fault Mr. Greenspan for having overestimated the strength of competitive forces, a point he essentially conceded in Congressional testimony last fall. But the financial crisis was not caused by a shortfall in competition. On the contrary, it was fueled by competition’s growing strength.

Adam Smith’s theory of the invisible hand, which says that market forces harness self-serving behavior for the common good, assumes that markets are competitive, and most markets have in fact become more competitive over time. Today, if an opportunity exists anywhere in the world, information-age entrepreneurs can seize it more quickly than ever.

The invisible hand, however, requires not just strong competition but also two other preconditions. The economic models that spawned Mr. Greenspan’s former optimism simply assume those conditions, despite compelling evidence of their absence.

First, those models assume that rewards depend only on absolute performance, but in the real world, payoffs are often tightly linked to relative performance. When a valuable new piece of information becomes available to the investment community, for example, the lion’s share of the gain goes to whoever trades on it first. For an individual firm like Goldman Sachs, it is thus completely rational to invest millions of dollars in computer systems that can execute stock trades even a few seconds faster than others. But rivals inevitably respond with similar investments. Taken together, these expenditures are wasteful in the same way that military arms races are.

A second problematic assumption of standard economic models is that people are properly attentive to all relevant costs and benefits, even those that are uncertain, or that occur in the distant future. In fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift.

Given the conditions under which human nervous systems evolved, these aspects of our behavior are unsurprising. Because immediate threats to survival were pervasive, those who didn’t seize short-term advantage often didn’t survive.

Such nervous systems provide an erratic guidance system for the invisible hand. Consider, for example, the difference between actual investor responses to the housing bubble and those predicted by standard economic models.

When house prices are rising steadily, mortgage loans are safe, but relatively low-yielding, investments. During the recent bubble, unregulated wealth managers created mortgage-backed securities that enabled investors to magnify their returns through financial leverage — that is, by enabling them to invest money borrowed from others.

Many experienced analysts had warned for years that those derivative securities were vastly overpriced, but Mr. Greenspan assumed that prudent concerns about the future would prevent investors from taking foolish risks. Real investors faced a tough choice: continue earning high returns from mortgage-backed securities, or move their money to safer vehicles and watch their friends and neighbors pass them by.

Wealth managers faced a tough choice of their own, since they knew that many customers would desert them if they failed to offer the higher-paying, but riskier, investments. Managers also knew that if markets turned against them, penalties would be limited by the fact that almost everyone had been following the same strategy. The resulting collapse was all but inevitable.

Memories are short. Immediately after a severe flood, most people are reluctant to build on a flood plain. But land on flood plains is cheaper, and the prospect of short-term advantage quickly lures many to abandon their caution. That is why many jurisdictions adopt strict regulations against building on flood plains.

The same logic dictates regulation to limit the damage caused by financial bubbles. The list of financial practices that merit regulatory scrutiny is long. But the most important first step is to limit leverage. Existing regulations prohibit banks from leveraging their investments by more than 10 to 1. Other financial institutions, however, are exempt from such regulation. Before the bubble burst, much higher leverage ratios became common in those institutions, which were aggressively marketing mortgage-backed securities. That loophole cries out to be closed.

Is it practical to limit leverage in a global capital market? If other countries don’t take similar steps, Americans could simply move their money abroad. But we could limit the leverage of the domestic financial institutions that provide the capital on which American businesses and consumers depend. If American investors wanted to achieve greater leverage abroad, they would have to do it with money borrowed elsewhere. Such a restriction would be enough to deprive asset bubbles of the fuel they require to threaten stability.

Of course, periodic asset bubbles occurred even when markets were less competitive. But people in earlier times were less aware of the high returns being earned by highly leveraged investors. Relaxed regulation and increased competition now confront investors with temptations that growing numbers of them are ill-equipped to resist.

Alan Greenspan’s erstwhile faith in the invisible hand notwithstanding, it was never reasonable to have expected market forces to protect society from the consequences of this risky behavior.

Robert H. Frank, an economist at Cornell University, is also co-director of the Paduano Seminar in Business Ethics at the Stern School of Business at New York University.

Capitalism and Free Markets

Capitalism is an economic system in which the means of production and distribution are privately or corporately owned.
Socialism, by contrast, is an economic system in which the means of production and distribution are collectively owned.

A free market occurs when the purchases and sales of goods and services occur without interference, intervention, regulation, or subsidization by the government.

What many advocates of capitalism and free markets fail to acknowledge is that they do not exist - at least not in a pure form.

Every society in the world is a combination of capitalism, socialism, and tradition. Every economy allocates its resources and products through tradition, command, and markets.

Under pure capitalism, the government does not produce or distribute anything. It provides no national defense, police and fire protection, public health, education, roads, highways, bridges, or garbage collection.

And when markets are unregulated by government, they create many socially undesirable outcomes, such as excessive amounts of pollution, poverty, and market power.

Many advocates of capitalism and free markets seem to imply there are only two options: capitalism or socialism. The reality is that there is a whole spectrum of ways to produce and distributes goods and services. Societies vary in the degree to which they rely on the government to improve market outcomes. It is deceptive to imply any increase in government involvement in the economy is a leap from one extreme to another. Instead, it may be a slight move along a broad continuum.

Stossel Continues to Push the Free Market Mantra

In a July 15, 2009 syndicated column "Health-Care Competition," John Stossel argues:

The statist establishment would love a single-payer health-care system like Canada’s if it were politically achievable. Barack Obama said that if we were starting from scratch, single payer is what he’d back. But, thankfully, Americans are still libertarian enough to cringe at turning the medical system entirely over to government.

So with single payer out of reach, the fans of government control have grabbed for second best: the “public option.” This would be government-run health insurance that would “compete” with private insurance. (It wouldn’t compete fairly because it could do something no private firm can do: milk the captive taxpayers.) But the public option is proving hard to get. Even some Democrats are nervous about it.

What’s a statist to do?

Leading Democrats in the Senate say the answer might be nonprofit health cooperatives. Sen. Charles Schumer wants some method “to keep the companies honest,” and if the “public competitor” can “do those things in a co-op form, I think we’re open to it” (http://tinyurl.com/l55gyh).

One sign that this may be the way things are heading is that the New York Times, the mouthpiece of the statist establishment, ran a front-page article last week that begins with glowing praise for a co-op where doctors have lots of time to spend with patients because of its “collaborative model of primary care.” Among the media it’s an article of faith that the “collaborative model” is more consumer friendly than a profit-seeking business.

The Times connects the dots in case anyone missed the point. “On Capitol Hill, those innovations have made Group Health a prototype for a political compromise that could unclog health care negotiations in the Senate and lead to a bipartisan deal. … [T]he Senate Finance Committee seems poised to propose private-sector insurance cooperatives … as its primary mechanism for stoking competition and slowing the growth of medical costs.”

Give me a break. Since when is government needed to stoke competition? Competition is what happens when government lets people alone. I defy anyone to give me an example of lack of competition that doesn’t have its roots in government intervention.

Since co-ops are nonprofit organizations owned by their members, the Times’ story subtly implies that the profit motive is responsible for the absence of competition and higher medical costs. But that’s ridiculous. In a free market without government barriers to entry, it’s the quest for profit that produces competition and lower costs.

If health cooperatives were really more efficient and innovative, wouldn’t they be copied all over the country? That’s how the market works. When someone comes up with an innovative way of doing business, it is quickly imitated and improved on. But buried late in the Times story is the revealing fact that the co-op is “a rare survivor among the hundreds of rural health insurance cooperatives.”

Hello? Don’t the Times editors see the disconnect? If co-ops worked well, today there would be thousands of them. Why should taxpayers fund a method of delivering health care whose success is “rare”?

The newspaper story made another point that is a favorite of the policy elite: Preventive care will save tons of money. If that’s true, there is nothing (but government) to keep people from implementing that principle. But is it true?

This seems to be one of those things we know that isn’t so.

I take Lipitor. The drug may extend my life. But this doesn’t lower my health-care costs. Years of pill-taking increases costs. If the pill works, I may live long enough to get an even more expensive disease. And maybe I, like millions of others, take Lipitor unnecessarily because we would never have had heart attacks. We then spend more, not less, on health care.

Health-care expert John Goodman of the National Center for Policy Analysis (www.ncpa.org) says there are “literally hundreds of studies from over the past 40 years that show preventive medical services usually increase medical spending … Contrary to popular belief, checkups for children and adults do not save the health care system money” (http://tinyurl.com/mc745s).
If the policy elite really wanted cost-cutting competition, they would deregulate medicine. No one has ever found a better way to stimulate competition than freedom.

John Stossel is co-anchor of ABC News’ “20/20″ and the author of “Myth, Lies, and Downright Stupidity.” To find out more about John Stossel and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate Web page at www.creators.com.

Economic Crisis Stirs Free Market Debate

National Public Radio´s Morning Edition program ran a story entitled Economic Crisis Stirs Free-Market Debate on June 23, 2009:

Morning Edition, June 23, 2009 · For months, the U.S. government and financial institutions have been operating in crisis mode, frantically crafting emergency programs designed to forestall a systemic economic collapse.

The steps taken during these times have challenged longstanding assumptions about the operation of modern free-market capitalism and the role of the government in the economy. In the aftermath of the crisis and the inauguration of a new, more activist Democratic administration, U.S. economic thinking seems to be at a historic turning point.

The idea of capitalism as an economic system was explained more than 200 years ago by the Scotsman Adam Smith. In his book The Wealth of Nations, Smith said a free market guides a society to efficiency by bringing buyers and sellers together and stimulating economies to produce more of what's needed and less of what's not.

In the United States, the best known apostle of free-market capitalism was the legendary economist Milton Friedman, who died in 2006. In 1980, Friedman made the case for Adam Smith's capitalism model in a 10-part television series called Free to Choose.

The 'Invisible Hand'

"[Smith's] key idea was that self-interest could produce an orderly society benefiting everybody," Friedman explained. "It was as though there were an invisible hand at work."

In theory, the "invisible hand" of the free market destroys companies that can't compete. But it lifts up companies with good ideas, ones that sell. The Austrian economist Joseph Schumpeter called this "creative destruction."

Free-market true believers say governments generally should stand back and let this process run its course.

The pro-market, laissez-faire philosophy reached a heyday in the 1980s in Britain under Margaret Thatcher and in the United States under Ronald Reagan. In a 1986 message to American farmers, Reagan famously quipped, "I've always felt the nine most terrifying words in the English language are, 'I'm from the government and I'm here to help.' "

President Reagan supported the broad deregulation of the U.S. economy, in order to minimize the government role. In the years that followed, pro-market principles continued to guide U.S. economic policies.

But in 2008, the global economy nearly went into full meltdown. The Bush administration, at the urging of Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, concluded it had no choice but to intervene in the marketplace, to save companies whose failures could have set off dangerous chain reactions: first, the mortgage giants Fannie Mae and Freddie Mac, and then the American Insurance Group (AIG), the largest insurance company in the world.

Adam Smith's Model Outmoded?

The free market had allowed such companies to make bad investments that put institutions around the world at great risk. Many economists, including some from Wall Street, said the lesson was that free-market ideology had been carried too far.

"We sort of morphed from Adam Smith's invisible hand, that markets move things in a very helpful direction, to some notion [that] free markets have an infallible hand," says Robert Barbera, chief economist at the Investment Technology Group (ITG).

The simple capitalism model that Smith described no longer seemed to fit the complicated, highly interconnected global economy of today. In his book The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future, Barbera says it's time to update our economic thinking. Schumpeter's idea that it's good for companies to fail and others to take their place usually makes sense, Barbera says, but not always.

"Wal-Mart appears. It's very innovative, and many, many small retailers over time are put out of business. That's the price of progress," Barbera acknowledges. "That's Schumpeter's 'creative destruction.' Conversely, when you're in a position when a great many financial institutions have lent the wrong way and there's this chance for a dominolike default, there's nothing creative about that destruction. You've got to prevent it. That's the cost of capitalism: Periodically you will have to come to the rescue of the financial system."

The Bush administration, generally conservative and pro-market, came to this very conclusion when it rescued AIG. Clearly, new ground had been broken in economic thinking.

Not Too Big To Fail

Not surprisingly, free-market purists have objected to these moves. They say the government should just let troubled companies go down, no matter how big they are.

"How, going forward, are we going to avoid [another] situation like this, unless we say, in a few cases, 'Look, that's it!' " argues Thomas Woods, a senior fellow at the libertarian Ludwig von Mises Institute in Auburn, Ala.

"I'm telling you that would have more of a salutary effect than all the regulatory tinkering put together," Woods says. "If these guys saw that, just like everybody else, if they don't produce, they fail. They're just like the guy who's a mechanic, the guy who's a plumber. They enjoy no special privileges."

Woods lays out his argument in his book, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse.

A History Of Intervention

Actually, however, there's nothing new about American capitalism changing in response to developments in the economy. When the free-market system allowed monopolies to emerge in the 19th century, the Interstate Commerce Commission was created to control them. And the Great Depression, 70 years ago, brought another layer of government intervention in the U.S. economy.

The free-market champion Milton Friedman, in fact, said the U.S. government erred during the Depression by not intervening quickly enough. In one segment of his Free to Choose TV series, Friedman explained how the failure of one private New York bank in 1931 set in motion a whole series of bank failures around the country. It was, Friedman explained, an emergency situation that demanded an intervention by the Federal Reserve. But the Fed failed to act.

"The Federal Reserve system stood idly by when it had the power and the duty and the responsibility to provide the cash that would have enabled the banks to meet the insistent demands of their depositors without closing their doors," Friedman argued.

It is now widely accepted, even by most pro-market economists, that in a financial crisis, the government needs to intervene, even aggressively. What largely sets economic thinkers apart from each other is their view about what governments should do in addition to rescuing troubled banks.

"Most economists to the left of Friedman will say, 'Well, yes, this is one example where the government should intervene actively, but there are lots of others, too,' " says Brad DeLong, an economist at the University of California, Berkeley.

The Government's Expanding Reach

This is where the debate is now. The U.S. government, last fall under President Bush and then under President Obama, has gone well beyond rescuing banks. The practice of American capitalism has fundamentally changed.

"Remember those days in September when we woke up and found that the U.S. taxpayer now owned two large mortgage companies and an insurance company, AIG?" DeLong asks. "And now we're going for auto companies, and who knows what's going to go next? The U.S. government is taking over an awful lot of things and expanding its role in the economy quite strongly and quite aggressively."

Obama says he does not want the U.S. government's majority ownership of General Motors to mean Washington runs the company, but his administration is demanding more fuel-efficient vehicles. He says he's "a strong believer in the power of the free market," but that statement came even as he proposed regulatory reforms that would bring the biggest government intrusion into the private sector in more than 70 years. And then there are the administration's plans for energy and health care reform, both of which feature major new government roles.

Our free-market capitalist system will survive. But with each new economic crisis the guiding principles get revised.