What To Do When Markets Fail?
In the first half of the 20th century, Socialism looked like the way of the future. When Nikita Khrushchev said in 1956, “We will bury you,” he had good reason to be optimistic. The Soviet system had seemingly produced an economic miracle.
We now know better. Socialism failed miserably in just about every way you can think of. Today, virtually every economy is a market economy and the ones that aren’t are basket cases. The central debate of the last century was settled long before this one began.
However, even as market systems have proved triumphant, market failures have become increasingly problematic Crashes have become more frequent and more extreme. Broad market solutions to social problems such as crime and pollution still elude us. To solve today’s problems, we need to seek out new solutions and, increasingly, are finding them.
Booms and Busts
They key function of a market is to provide effective pricing. That, after all, was the point of Adam Smith’s concept of the invisible hand. We don’t have to count on the good will of the butcher or the baker to provide our dinner, because our hunger creates demand, manifests itself into a pricing signal and incentivizes them to provide what we need.
Unfortunately, sometimes our emotions get the best of us. We see housing prices going up, so we want to get in on the action too, which increases prices further and encourages others to pay even more. Soon we are loading ourselves up with debt to pay still higher prices and the cycle continues until the bubble pops and we lose a bundle.
This is nothing new. John Maynard Keynes called the phenomenon animal spirits. Investor George Soros refers to it as reflexivity and has made a large fortune betting against it. Any market is only as good as its participants and we’re not as rational as we’d like to think. Neither are markets.
We have not come close to solving this very basic problem. In fact, it’s getting worse. Since the 1980’s, when market economics had its greatest triumph, crashes have become more frequent and more severe while productivity and incomes have stalled.
Externalities and Adverse Selection
Another problem with markets has to do with externalities, costs and benefits that are external to a transaction and therefore don’t factor into pricing. Sometimes, these are very positive, like the knowledge spillovers that a new invention creates or the network effects that occur when more people buy cellphones.
However, externalities also cause some of our thorniest problems. One is the tragedy of the commons. People who burn dirty coal have no incentive to increase their costs by switching to a cleaner, more expensive alternatives, but we all pay the price of pollution. In a similar vein, mortgage brokers who profit on sub-prime loans increase systemic risk.
While externalities merely ignore costs or benefits, when adverse selection occurs, markets actually make things worse. For instance, when health insurance companies choose only the healthiest customers, they leave a toxic pool of unhealthy ones in the system with no viable market to serve them.
Markets and Corruption
In his book, What Money Can’t Buy, political philosopher Michael Sandel argues that there is still another problem with markets – their corrupting influence. While in some cases, like markets for illicit drugs and human trafficking, the problem is quite obvious, but Sandel points to more subtle and pervasive forms of corruption that degrade community norms.
He calls the phenomenon a “skyboxization” of society where we are creating two classes of people, a privileged class in private boxes and the huddled masses who have to live by different rules. He further points out that the issue is far more widespread than you would think, people paying to skip line, to have someone to carry their baby and so on.
His central point is one of context. For example, when the Pentagon wanted to start a futures market for terrorism in order to increase efficiency of prediction, an uproar ensued and the project was quickly killed.
Markets, we all seem to agree, have their limits. To allow people to pay in order to gain special admission (e.g. to a prestigious university) or receive an award alters the meaning of the good in question. Although markets thrive on valuation, entering money into the equation often degrades moral value.
If you doubt it, try giving your spouse a wad of cash for Valentines Day and see what happens.
Creative Destruction and Brands
One of the problems of classical economics is that, in a perfect market, profits shouldn’t occur. If supply and demand are truly aligned, then all a firm should be able to charge for a product or service is labor plus the cost of capital.
Joseph Schumpeter ultimately solved the quandary by introducing the concept of creative destruction. He pointed out that as long as industries continue to innovate, the market will never reach a true equilibrium, profit stays in the system and business can prosper.
However, the initial point remains. Profit seeking businesses want the market to fail. That, after all, is the point of competitive advantage. Somebody wins and somebody loses. In the final analysis, this is a very positive thing, but it does have it’s uglier rent-seeking side, such as patent abuses and big lobbying budgets.
The Rise and Fall of Market Based Solutions
As the shortcomings of markets have become increasingly apparent, economists have taken notice and much of the research done nowadays is goes beyond strictly market-based solutions. Take a look at the chart below.
In the first three decades that the Nobel Prize for Economics was awarded, a large percentage of the laureates focused on financial innovations like Black-Scholes, CAPM and Gary Becker’s work on applying market-based thinking to social problems. The remaining prizes went to either technical improvements or other areas like game theory.
However, over the past decade none of the prizes were given for explicitly market-based innovations. In fact, there has been a switch in emphasis to the limits of markets, like the 2001 award for asymmetric information or those given in 2002 for behavioral economics and prospect theory.
In truth, this shouldn’t be all that surprising. Most of the really interesting work on markets was done in the 60’s and 70’s, when improvements in information technology made research into markets far more productive. Today, a generation later, the problems markets can solve have largely been solved and the interesting problems lie elsewhere.
The exciting thing is that as we become more aware of how markets fail, we’re also learning a lot more about how to correct for them.
How to Improve Markets
While markets have their problems, the last thing we want to do is reduce their power to do their job. In the vast majority of cases, there is simply no better way to process large quantities of information. However, when the market fails, we need to find alternate solutions. Happily, we seem to be making some progress.
Government Intervention: The most obvious way to correct for markets is with government intervention. Unfortunately, government is prone to all sorts of problems such as bureaucracy, inefficiency and corruption. Not surprisingly, we’ve learned to be skeptical about government involvement.
However, there are signs that government investment can be extremely productive (as I’ve pointed out before, virtually every component in an iPhone has its roots in a government program). Moreover, performance has been improving.
New initiatives like ARPA-e, which gives grants to early stage technologies in energy, are building on previous successes of DARPA, which created the Internet, radar and artificial intelligence. Markets are generally not good judges of new technological areas, so this is an area where the public sector can play a positive role.
There is also some evidence that technology is making government more efficient and less wasteful, along the lines of Tim O’Reilly’s Government 2.0 initiative.
NGO’s: It used to be that when entrepreneurs earned great fortunes, they would leave some to charitable organizations and possibly set up a foundation to spread the wealth when they died. Today, more high-net-worth individuals are getting actively involved and that seems to be making a difference.
The new breed of NGO’s such as the Gates Foundation are much more accountability focused and data driven. It’s not enough just to give anymore, but to do so efficiently and effectively.
Innovation Prizes: Another growing trend is the awarding of large monetary prizes for innovation, such as the X Prize and the US government’s Race to the Top initiative.. These tend to encourage investment many times greater than the value of the prize itself and are proving to be effective in jumpstarting emerging technologies and innovations.
Peer Networks: In Future Perfect, author Steven Johnson proposes another alternative. Peer network approaches like the open-source movement, Crowdfunding, Wikipedia and public service apps such as seeclickfix can often outperform traditional market solutions with non-monetary incentives.
The 20th century was, to a great extent, the era in which markets became triumphant. Over the next century, however, we will increasingly learn how to go beyond markets and augment the basic platform with new technologies that improve overall performance.