Chasing the Invisible Hand

Macroeconomics has become a much maligned field during the last few years and its failures to adequately project and prevent our current “great recession” has put it squarely into disclaim and controversy. Nobel Prize winning Robert M. Solow is the economist probably most responsible for the way we look at modern macroeconomics in this day of models. Solow’s thing is long run growth models and his “Solow” model is one of the first things you study in any intermediate or advanced macroeconomics course. It’s series of time derivatives that looks at things that could possibly create long term value in an economy over time.

Central to this model is the idea that an economy requires capital stock (physical plant, equipment, etc.). Eventually, there are other things that come in to modify those needs like knowledge, methodologies of production, job training and technology. It’s quite mathy so I don’t want to get into the details but just suffice it to say that the model looks for ways to explain why some economies grow and prosper and others just stagnate or experience severe problems. Recently, political and legal systems have entered into the equations and seem to have about as much explanatory power as anything else. To me, it’s a fascinating area and a way we can understand why we can have Asian Tigers or miracle countries like Singapore, South Korea and the like in world where there are also many Burko Fasinos.

Solow has a book review up at The New Republic called “Hedging America” about John Cassidy’s “How Markets Fail: The Logic of Economic Calamities.” Market Failure is an intriguing area that is frequently overlooked by groups and people like the U.S. Chamber of Commerce that find free, unfettered markets to be at the center of all things good. The Market Utopians are not much different to me from the Marxist except the latter are not taken seriously here in the U.S. What the former group does with the invisible hand, to me, is definitely an equivalent form of ideological masturbation.

Perfectly behaved markets and perfectly behaved central planning agencies exist only in the pages of abstract and pristine theoretical economics texts. They are developed as a benchmark, as much as anything, by which we can compare reality and find it lacking. I’ve said this before, but it bears repeating, when you take your first theoretical microeconomics course, your first task is to prove that perfectly competitive markets achieve the same perfect outcome as those managed by an omniscient and beneficent central planner. Technically, you can either have perfect Marxism or perfect market capitalism and you will arrive at the same outcome. In reality, we have blends of both and neither deliver their theoretical outcome.

So, with that small encapsulation of one of the most basic economic principles, I’ll hand the next bit over to the Nobel Prize winner who achieved the prize deservedly through years of study and research (not by aspiration). Solow begins this review by asking a basic rhetorical question to make a point.

The question is “Are you for or against “free” markets?”

Today, of course, no one is against markets. The only legitimate questions are: What are their limitations? Can they go wrong? If so, how can we distinguish the ones that do from the ones that don’t? What can be done to fix the ones that do go wrong? When is some regulation needed, how much, and what kind? More broadly: how to protect the economy and society against specified tendencies to market failure without losing much of either the capacity of a market system to coordinate economic activity efficiently or its ability to stimulate and reward technological and other innovations that lead to economic progress?

The subtitle of John Cassidy’s book illustrates the problem. Most market failures–they occur every day–are not even nearly calamities. They start with the existence of partial monopoly power in this or that industry, with the result that the market price is “too high” and the rate of production “too low” in the precise sense that everyone could be made better off if that error were corrected. They extend to cases where the market does not impose the full costs of their actions on certain producers and consumers, with the result that economic activity is misdirected: the consequences may be minor (a small amount of pollution) or major (fish stocks collapse from overfishing) or potentially catastrophic (climate change from excessive unpenalized emission of greenhouse gases). And what are we to make of the stock-market collapse of October 1987, the largest one-day fall ever on the New York Stock Exchange? It was in one sense a calamity, but it left essentially no trace in the “real” economy of production, employment, consumption, and everyday life. Evidently being for or against “free markets” does not come close to being an adequate response to the problems that arise in a complex modern economy.

Why is it that so many folks want to put ideas into absolute terms instead of the shades of gray and reality they usually exhibit? Solow’s review succinctly explains how looking at the idea of the free market isn’t as easy as the U.S. Chamber of Commerce would like it to be. However, Solow does not employ the lobbying technique of rent-seeking to block trade unions, seek monopoly power, or menace progressive taxation schemes which while touting free markets thus leading to market failure. The agenda of the U.S. Chamber of Commerce is just as likely to create market failure as a poorly designed business or investment tax. Solow isn’t also that type of professor that channels Che and worships at the alter of Lenin. Why isn’t he allowed to critique a market economy with its obvious shortcomings and failures without fear of being labeled a communist or socialist? My guess is that even writing this will label me and Solow ‘commies’ by some blogizens.  Questioning the existence of a free market is like questioning the existence of god.  I freely admit to believing in neither.

Markets fail all the time. Third party payers like Insurance companies cause market failure. The government can cause market failure. The need for huge amounts of infrastructure and customers to pay for it can cause market failure. There are also things like the problem of the commons or the fact that fossil fuels tend to be grouped in various geographic locations that cause market failure. Realization that markets do and frequently fail is not a call for a communist overthrow of capitalism. It’s a call for reasonable regulation and government policy.

In this book, Cassidy–who is a write for The New Yorker–characterizes these ideologies that worship at the alter of the unfettered invisible hand as “Utopian economics”. How did the Invisible Hand Theorem become a religious tenet? Solow explains the purpose of markets, fettered or not. Again, we point to the most basic economic exercise. That is showing the results or the best economic outcomes can be achieved either by central planning or by a market. Here’s Solow’s explanation.

There is a certain amount of truth in that characterization. By “utopian economics,” Cassidy means, in the first instance, the careful elaboration of the precise scope of Adam Smith’s Invisible Hand. It turns out to be a lot more complicated and attenuated than sloganeering can afford to acknowledge. To begin with, if a market economy is to be advertised as doing an acceptable job, we need a definition of a good economic outcome.

The standard version says that one allocation of goods and services to individuals (call it A) is better than another (B) if everyone is at least as well off (in his or her own estimation) in A as in B, and at least one person is better off. So there is to be no trading off of one person’s well-being against another’s. That sounds fair; but notice that judgments about inequality are ruled out: if everyone is equal but poor in A, and B differs only by making one person fabulously rich, B is better than A. That sounds a little less appetizing, but this extreme case underscores the individualistic nature of the whole exercise: nothing is supposed to matter to anyone but his or her own access to goods and services. Notice also that, by this definition, most As and Bs simply cannot be compared: some people are better off and some worse off in A than in B, so neither is “better” than the other.

The next step is to say that such an allocation is “efficient” if no feasible allocation can leave everybody at least as well off as they were and make somebody better off. In other words, there is no “better” allocation. You would like your economy to lead to an efficient outcome. There are many efficient allocations, some egalitarian and some just the opposite, and none of them is better or worse than any of the others. They cannot be said to be equal either; they are simply not comparable in this language.

There are so many deal breakers in the real world that make both central planning and an unfettered market Utopian that to expect either to function as the basis for policy is to expect some Buddha to show up at your house and hand you a wish fulfilling jewel. The problem is, here in the USA, those that push the idea of unfettered markets are basically preaching that the heavens are about to open up to rain gold down on us all. It’s no different then listening to a Che wannabe talk about the petit bougeouis, the glorious proletariat, and what would’ve happened if Trotsky would’ve really been able to do all he wanted in the U.S.S.R. These things are all the dreams of ideologues.

Here’s just one of the things that has to hold true for the invisible hand to work. It’s the lack of our old friend information asymmetry which sets the ground for the moral hazard problems.

The informational requirements for the validity of the Invisible Hand Theorem are considerable. All buyers and sellers must have access to the same information, preferably complete information, and they must be able to process the relevant information, and they must be willing and able to behave rationally in the light of it. (Unpacking the notion of “rationality” in this context would be tedious: it involves having consistent, non-contradictory preferences about one’s consumption of goods and services, and knowing how to find one’s way to the most preferred among all feasible configurations.)

So, why are Marxists sent off to the Island of Misfit Toys while folks like Ron Paul get elected to Congress? Why do we still have to deal with the acolytes of Ayn Rand but not people that like to quote Lenin? Actually, if you read Lenin now, you’d be surprised at how much his treatise on banking and interlocking directorates sounds like a pretty good explanation of the Wall Street situation of late. The difference between Rand and Lenin is that Lenin actually had some pretty good numerical analysis while Rand writes a fairly interesting novel.

So, the Solow book review is as close to a really discernible lecture on the realities of the markets and the complications of making them work like they should that I’ve seen coming from a theoretical economist for some time. I want to read the book based on his analysis. There appears to be cautionary tales that are worth reading. I’ll leave you with this “Utopian economist” and a quote of his before the recent spate of financial market crises. Then give the last word to Solow.

Cassidy quotes Alan Greenspan:

“Recent regulatory reform coupled with innovative technologies has spawned rapidly growing markets for, among other products, asset-backed securities, collateral loan obligations, and credit derivative default swaps. These increasingly complex financial instruments have contributed, especially over the recent stressful period, to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago.”

Flexible maybe, resilient apparently not, but how about efficient? How much do all those exotic securities, and the institutions that create them, buy them, and sell them, actually contribute to the “real” economy that provides us with goods and services, now and for the future? The main social purpose of the financial system–banks, securities markets, lending institutions, and the rest–is to allocate society’s pool of accumulated savings, its capital, to the most productive available uses. It does a lot of this, beyond doubt.

We would be much poorer without a functioning financial system, and the flow of credit and equity purchases that it permits. If anyone who wanted to start a business–a software company, a biotechnology laboratory, a retail store–had to do so with his or her already saved-up wealth and the help of relatives, many good ideas would go unrealized, and some wealth would lie idle or be wasted. If every time you chose to invest in an existing company it was forever, because there was no way to sell your share and invest somewhere else, it would be much harder for promising enterprises to attract capital and grow.

But those needs were being taken care of a quarter-century ago, and well before that. The real question, to which Greenspan gave such a confident and grandiose answer, is whether anything much was added to the system’s ability to allocate capital efficiently by the advent of naked CDSs and CDOs and the rest of the alphabet. No blanket answer is possible.