Iron Lady: Rust In Peace

Margaret Hilda Thatcher (1925-2013) once famously said, in an interview to Woman’s Own of 31 October 1987, that "There is no such a thing as society. There are individual men and women, and there are families”. Naturally she was often reviled for such a proposition, including by me as I repeatedly quoted her and criticised her vigorously for it in lectures and seminars.

Taken literally such a proposition is patently false. Clearly the collection of individuals and their families are interconnected in a vast and thick mesh of relationships – through economic, political and social institutions – known as “the fabric of society”. The total is infinitely larger than the sum of its individual parts.

But what Thatcher actually meant is that society is all of us, and is not an external entity distinct from the collection of all individuals and their families, so much so that she went on to say: "And no government can do anything except through people, and people must look after themselves first.” A perfectly simple and innocent call for self-help, and for restraint in the reliance on government transfers from a budget to which in the end we all have to contribute. Sure, she was neglecting the fact that welfare transfers are not necessarily always a disincentive to create income and wealth, that they also represent a stimulation of demand and therefore may generate employment and income, and that a more equal and cohesive society may be worth attaining - at least up to a point - even if re-distribution had a net cost in terms of efficiency. But even these omissions and reservations are legitimate though possibly misguided opinions, for which Thatcher did not deserve to be reviled. Therefore belated but sincere apologies are due and are here unreservedly made.

Nevertheless, there are still many exceedingly serious reasons to revile her. The general principle, that one "not speak ill of the dead", does not apply to influential public figures (as we are reminded by Glenn Greenvald, Guardian 8 April): noblesse oblige. I lived in England throughout most of her political career, from 1962-1982, and intermittently until after her downfall in 1990, and disliked her passionately. Mrs Thatcher - for I could never bring myself to call her a Lady - to me was forever Thatcher-the-milk-snatcher (as in 1971, while Minister for Education in the Heath government, she abolished free milk for school children aged 7-11 years). Never mind the destruction of the British coalmining industry: coalmining is an attractive occupation and culture only in the morbid, romantic literary sickness à la D.H. Lawrence, and miners should have been retired gradually by Labour governments over the previous thirty years, instead of being kept employed artificially as a reserve army of Labour voters. But there was no reason to confront them as Thatcher did and unleash riot police on horseback assaulting them: she could have easily bribed them instead with the proceeds of North Sea Gas.

Nor was there any need to start a class war using a regressive and odious poll tax, or to deny Irish hunger strikers in the Maze prison their political status thus leading to their death. She lowered taxes and cut welfare expenditure and industrial subsidies, promoting de-industrialization and unemployment (that rose to a record of nearly 13 per cent under her watch); she privatized council houses without building new ones, and sold off all kinds of public assets, including public infrastructure (steel, airways, etc.) and utilities such as water, telecoms, gas and electricity, transferring massive public wealth to the private sector. She de-regulated economic activities, especially finance, and shrunk the size of the state. In doing this she somewhat revived competition - which she could have done if she had wanted to even without privatization - but did not promote economic growth in the UK, as she is widely credited to have done.

Thatcher never understood any macroeconomics - or she would not have written (in her Path To Power, 1995): "There is no better course for understanding free-market economics than life in a corner shop." With infinitely greater confidence than that applicable to her assertion about society, we could say that "There is no such a thing as a market system". For in order to substantiate the naïf, oversimplified market vision of her mentors (Milton Friedmann and Friederich von Hayek, Alan Walters and Keith Joseph and the whole of the Mount Pelerin Society) as a system of self regulating equilibria we would need a system of complete markets, i.e. of exclusive, spot and inter-temporal, instantaneous and non-sequential markets, for all dated and contingent goods and services. Instead of which we only have a relatively small number of spot markets, a handful of forward markets except for labour and mostly for homogeneous primary commodities as well as money, all sequential and rarely contingent on the states of the world. In the market system as we know it economic agents act on the basis of expectations as well as prices in a typical, incontrovertibly Keynesian world of inadequate and unstable effective demand and involuntary unemployment.  

Policies based on such hyper-liberal (then labelled monetarist) approach, which she shared with Ronald Reagan who gained power in 1980, had massive adverse consequences over time and space. They contaminated and corrupted the New Labour approach of Tony Blair and Gordon Brown, they deeply affected the transition path of the Soviet Bloc from central planning to market economies and caused its immense unnecessary costs, and they paved the way for the global Great Recession of 2008 which is still causing our misery to date. 

Internationally, she strengthened her failing domestic support by declaring war on Argentina over Britain colonial possession of the Malvinas, instead of conducting political negotiations; her tears over the accompanying loss of lives, revealed by recently published War Cabinet papers, are only evidence of hypocrisy. She played a key role in bringing about the first Gulf War, and advocated the 2003 attack on Iraq. She denounced Nelson Mandela and the ANC as "terrorist", while she befriended dictators like Augusto Pinochet, Saddam Hussein and General Sukharto ("One of our very best and most valuable friends"). She opposed German re-unification and the euro but fortunately she was defeated by Germany and France trading one for the other.

For somebody so opposed to the state taking care of its citizens "from cradle to grave", it is ironical that she should be given a lavish “ceremonial funeral with military honours” yesterday in St. Paul’s Cathedral at an estimated cost of £10-12mn. It is only fair that Ken Loach should have suggested that her funeral should have been "privatized": "Put it out to competitive tender and accept the cheapest bid. It's what she would have wanted".

Global Policy Forum, Yaroslavl 8-10 September

Global economic integration, as measured by the ratio between world exports and world GDP, regressed slightly in 2009 only to resume its course immediately at an even faster rate. Globalisation, however, has not been matched at all - for better or worse - by the progress of global governance institutions. This is why the feeble and fragmented powers of international economic institutions - over 2,000 of them - are accompanied only by ad hoc arrangements from G-n groupings (from the G-1, i.e. the USA, to the G-24 of most advanced countries or the recently emerging G-20 including large less developed actors) to various Global Forums with the participation of some world politicians, businessmen and intellectuals. The Davos World Economic Forum was first and remains the foremost, but others have arisen in equally desirable locations. The millenary town of Yaroslavl - an ancient, former temporary capital of Russia - is hosting its second Global Policy Forum on 8-10 September, with prospective participants including the Russian President Dmitry Medvedev, the Spanish Premier José Luis Rodriguez Zapatero and the French Premier Francois Fillon. it is devoted to the general theme “The Modern State: Standards of Democracy and Criteria of Efficiency”.

Having accepted an invitation to join the Yaroslavl Forum, I was asked by the editor of the Conference website http://en.gpf-yaroslavl.ru/, Dr Dmitry Uzlaner, a number of interesting questions, listed below with my answers.

You are going to take part in the section 'The State as an Instrument of Technological Modernization'. What are your expectations about it? What problems seem to you most topical in this context?

Technological modernisation should not be understood as the introduction, at the fastest rate and on the largest possible scale, of the latest technique available, or the most productive in a physical sense. Modernisation is desirable only if

1) it introduces the best-practice technique, i.e. that which minimises total production costs calculated at the competitive market prices of all inputs, and

2) on the scale determined by total costs not exceeding the operating costs of production on already existing plant, whose historical capital cost is sunk and therefore irrelevant.

When input prices change, or some costs formerly neglected are included in production accounting, the best-practice technique also may change. The technique that is best for oil at $10 a barrel is not the same for oil at $150. The technique that is best when producers do not pay for the pollution generated in the production or consumption of their products is not that which is best when they do pay for it. A significant rise in the price of oil, or taking into account pollution costs previously unaccounted for, can require not only a technological change but possibly a “regression” to older and/or less productive techniques. This problem is well understood by economists and businessmen, but is all too often neglected by politicians and the general public.

The role of the State is paramount in: funding fundamental research and general technical education; enforcing market competition (for imperfect competition will distort the incentives to modernize and adversely affect the scale though not necessarily the occurrence of modernization; generally creating an economic environment favourable to modernization, for instance striking a balance between the production of new technology via patents protection, and the diffusion of technology. But there is no case for the State to have a direct hand in the choice of particular techniques in particular sectors let alone enterprises.

Which economic systems are doing better in the modern world? What factors determine success and failure of the system?

The collapse of the Soviet-type system in 1990-91 has led to a widespread conviction of the superiority of the capitalist system: the combination of market efficiency and the private appropriation of efficiency gains is a major stimulus to technical progress and innovation. For instance, Janos Kornai (Innovation and Dynamism, WIDER Working Paper No. 2010/33) argues that capitalism provides a strong incentive to dynamism, enterprise and the innovation process, and that every revolutionary new product for civilian use - such as information technology, the computer, the mobile phone and internet - has been brought about by the capitalist system. However, we should take into account the role of state-initiated and state-funded research, in this case space research, and its impact on such technical developments. It is true that Silicon Valley could not have developed in a centrally planned economy, but what seems indispensable is not necessarily a capitalist system, but a competitive market environment. Managers of private enterprises are already more motivated by profits than their shareholders, and equivalent incentives can be replicated in state-owned enterprises. China today, for instance, displays more dynamism, enterprise and innovation - and more resilience to economic crisis - than the traditional capitalist system, though this has far reaching implications for democracy.

Today Russia strives for the creation of modern high-tech infrastructure and technological renovation of the entire production sector. What to your mind are the best development strategies for countries like Russia? Which post-communist states were most successful in economic and political modernization? What factors determined their success?

In its current situation Russia, having suffered from decades of central planning inefficiencies, cannot go wrong by upgrading infrastructure and production; the question really is at which point such policy should be subjected to a strict analysis of economic efficiency. Russia has been blessed by an abundance of natural resources, notably oil and gas, which is an opportunity to be exploited. But the development of a diversified industrial basis is essential in the medium-to-long run.

Among post-communist states, economic success has not always gone hand in hand with democratic progress (from Poland to Belarus and to some extent Russia itself), but democracy must be regarded as a necessary pre-condition of long-term sustainable economic development.

What trends in modern economic theory you find most interesting and percective?

The global financial crisis of 2007-2010 has led to a considerable re-assessment and down-grading of the hyper-liberal economic theories of the 1990s and most of the 2000s. Markets are often non-competitive; in any case they are incomplete, given the lack of inter-temporal and contingent markets, leading agents to act on the basis not only of current prices and quantities of today’s goods, but also of their expectations of future prices and quantities. This is why higher savings might lead to a depression, and a global lowering of wages might increase unemployment. We live in a Keynesian world. Not only are markets somewhat inefficient and unstable, they are also patently unfair as demonstrated by rising national and global inequality.

Having said that, we must recognize that markets - with strong qualifications for at least some financial markets like derivatives - are absolutely indispensable in any economic system, for they provide automatic mechanisms of economic adjustment: of enterprise production to prices, of prices to excess or deficit demand, of actual to desired capital through capital stock adjustment via investment, of inputs supplies to actual outputs. We cannot live without markets.

What, to your mind, are the main problems of interaction between the intellectual community and policy makers? What form of communication is urgently needed? Is it just financing of intellectual think-tanks by some governmental bodies, or a kind of intellectual intercourse like forums in Davos, St. Petersburg, or Yaroslavl, etc.?

The decisions taken by policy-makers reflect mostly their own interests and values and those of their clients, and are rarely purely technical decisions that might be influenced by arguments developed by the intellectual community which, moreover, itself might not be representative of the people. Therefore problems of communication and interaction arise only in the narrow range of decisions open to a technical/intellectual argument; such is the natural limited area of operation of both think-tanks and forums. The real problem is that of democratic formulation and implementation of the public interest, and in a global dimension - though think-tanks and forums such as that of Yaroslavl can indeed have positive effects.

Markets can be expensive

In Central Eastern Europe and the Former Soviet Union the transition to an open market economy was accompanied by the rise and persistence of unemployment, the rise of inequality and of poverty. These phenomena were particularly serious because they meant a drastic reversal of earlier conditions of full employment, greater equality and low poverty incidence. Moreover higher inequality could not be justified as the reward for efficiency, as in normal market economies, but – particularly in Russia – was mostly the result of unrestrained pillage by privileged operators.

Before the Fall

The traditional, pre-Transition, Soviet-type system was characterized by full employment of labour, indeed by over-full employment: excess demand for labour at the prevailing wage rate. While full employment was obviously desirable, it was not the result of a specific policy but the by-product of persistent repressed inflation, i.e. excess demand for commodities at artificially low prices below equilibrium, which translated into excess demand for labour. Of course there was nothing positive about over-full employment, which was only a cause of high labour turnover and inflationary wage drift, which in turn contributed to the perpetuation of a state of excess demand for goods.

Wealth was almost entirely in public hands (in Albania even private ownership of cars was forbidden); the little that remained private was a source of direct satisfaction rather than income. By itself, this made distribution of income among the population more equal than in a market economy where income is derived also from private wealth (which is always more unequally distributed than labour incomes). There were also factors making for greater equality across Soviet republics and countries within the bloc: the emphasis on industrial development in every country, regardless of efficiency considerations; the socialization of enterprise profits and their re-distribution via the state budget; large scale subsidies via the All-Union Soviet budget, and via the under-pricing of raw materials and oil within the USSR and Comecon.

By World Bank standards of poverty – equivalent to $2.15 per head per day at 1996 Purchasing Power – in the socialist countries of Europe and Central Asia in 1988 on average fewer than 4% of the population lived in such absolute poverty.[1]

Unemployment

The initial prolonged recession of the early 1990s was naturally accompanied by shrinking employment and the rapid emergence of labour unemployment, converging to similar average values and dispersion typical of European Union countries. The many queues for goods typical of the old, typical shortage economy were replaced by a single but much longer queue for jobs. In the CIS, however, there were lower rates of job loss and limited job creation, leading to an increase in under-employment and reductions in real wages.[2]

Table 1 provides data for unemployment rates and employment ratios for 1998–2006. While unemployment remained high in Central and Eastern Europe, it tended to decrease in the rest of the area. Employment ratios did not have a clear trend, with several countries remaining under 60% and only a few being close to the Lisbon target of 70% for the EU member states. Employment rates tended to be higher in the CIS countries than in CEE countries, but this partly reflect higher under-employment and lower unemployment benefits.
The global economic crisis of 2008–2009 has already raised unemployment and reduced demand for migrant labour.

Table 1. Unemployment rates and employment ratios in CEE/CIS


Source: UNICEF (2006), TransMONEE data bank, updated 2009, Florence.
Note: Results from national Labour Force Surveys, except for Albania, Belarus, Armenia, Azerbaijan, Kazakhstan (2004 and 2005), Kyrgyzstan, Tajikistan and Uzbekistan, which are official data. The different sources may use different criteria, for example for registering unemployment, working activities in the informal sectors, temporary jobs.

Inequality


Egalitarian ideals associated with socialist ideology should not be exaggerated. First, there was significant residual real inequality due not so much to monetary income differentials but to privileged access to goods for the Party nomenklatura: this was no small matter, as it affected access to housing, motorcars, holiday facilities, health and education, foreign travel, imported and luxury goods as well as simple items of daily consumption which were in scarce supply for the ordinary citizen. Second, in 1931 Josef Stalin in person had condemned the “leftist leveling of wages” (uravnilovka), and urged the introduction of sharp wages differentials between skilled and unskilled and between difficult and easy jobs. And there were prizes for managers for plan-fulfilment and over-fulfilment, discretionary prizes for workers, money to be made by mediators (tolkach) in the informal semi-legal exchange of materials among enterprises, in the black and grey markets among consumers, the reliance on "pull" (blat’) through "acquaintances" (znakomstvo) to obtain scarce goods and services; a few legal markets, such as kolkhozian food markets and flea markets (barakholki). Bribes and large gifts (prinoshenie) were also common. All these factors distorted the significance of the degree of inequality as measured through official monetary incomes.



Subject to these qualifications, pre-transition measures of inequality, such as the Gini coefficient (=0 for absolute equality; 1 for absolute inequality, a situation in which one subject takes all) were impressively low in the Soviet Union and Central Eastern Europe, about 0.25-0.30. From 1989 to 2004 Gini coefficients increased significantly nearly everywhere in the transition, to around 0.35-0.40. Indeed, in many countries especially in the CIS they soon surpassed the degree of income inequality normally found in western market economies. The exceptions are the Czech Republic, where the Gini coefficient was and still is lower, though rising from 0.198 to 0.235; Belarus, with a similar trend; and Slovenia where it fell slightly from 0.265 to 0.243 between 1991 and 2004 (see UNICEF 2006).

“In recent years inequality has either increased at a much slower rate, or – in some cases – even declined. For example, in those CIS countries, where levels shot up in the mid-to-late 1990s, there have been signs of reductions; while in the Central European countries, where levels increased less dramatically in the 1990s, rates of increase have continued to be slow but steady. However, in most of the region, levels of inequality have remained high in the period of economic recovery, suggesting that growth has not always been inclusive in nature” (UNICEF, 2009).


An apparently similar degree of income inequality – Russia in 2007 had a Gini coefficient of 42%, i.e. a more equal income distribution than China’s 47% – can conceal a profound diversity. In China, and in “normal” capitalism, income inequality depends mostly on entrepreneurial success and is the price to be paid for efficiency; in Russia it depends primarily on the pillage of national resources during the transition and therefore it is a form of inefficient inequality.

Table 2. Trends in disposable income inequality, selected countries, 1989-2006

Figure 1. Gini coefficient of income distribution in China and Russia, 1978-2006[3]
Source: Popov (2009).

Poverty

Post-socialist transition, by itself and together with the associated deep and protracted recession, brought about a drastic increase in poverty. By 1998 it was estimated that, in the transition countries of Europe and Central Asia, one out of every five people survived on less than $2.15 per day (at 1996 Purchasing Power), whereas a decade earlier “fewer than one out of twenty-five lived in such absolute poverty” (World Bank, 2000). “There is little doubt that poverty has increased dramatically in the region. Moreover, the increase in poverty is much larger and more persistent than many would have expected at the start of the process.” By 1998 the people living in poverty had reached 20%. Poverty began to fall after 1998, with the generalized resumption of economic growth; by 2003 the poor represented only 12% of the population.[4]

With respect to the predicament of the poor in developing countries, the material hardship associated with poverty in the transition was made much worse by the drop from earlier achieved levels and expectations, and the loss of security. Sudden large scale unemployment, prolonged nonpayment of salaries, unpaid or decimated pensions, hyperinflation and loss of savings, the loss of free or subsidized social services “made people feel unusually vulnerable, powerless, and unable to plan for the future.” For most of the new poor, transition brought “the destruction of "normal" life and accustomed social patterns.”[5]

“The highest levels of absolute poverty are in poor countries of Central Asia”: Tajikistan (70 percent), and the South Caucasus (with Georgia with a poverty rate of 50 percent in 2003). “Yet most of the poor and vulnerable in the transition countries of the Region are in large middle-income countries such as Kazakhstan, Poland, Russia, and Ukraine.” Those most at risk are “the young, residents in rural areas and in secondary cities. The unemployed, people with little education, and those belonging to underprivileged minorities, such as the Roma are also at great risk. Most of the poor are working poor”.[6]

Russian $-Billionaires

Conversely, in the early 2000s Russia saw a spectacular increase in the number of dollar billionaires. In the Soviet era there might have been, at most, a dozen dollar-millionaires in the shadow economy. In 1995 there were no billionaires in Russia. In 2007, according to Forbes, Russia had 53 dollar-billionaires, in third place after the US (415) and Germany (55), but in second place in terms of their wealth, which in Russia totaled $282 billion ($37 billion more than Germany’s billionaires). In 2008 the number of billionaires in Russia increased to 86, with a total wealth of over $500 billion, corresponding to one third of a year’s GDP. Russia’s “primitive accumulation” took the form of privileged access to natural resources at prices lower than in the world market, to subsidized credit and to privatized assets also on privileged terms.


Trends in the current recession


In a recession such as that of 2008-2009 it is plausible to conjecture that initially inequality falls – because the rich lose proportionally more than those who have less to lose – and poverty rises because the poor cannot afford to lose what they have (viceversa in a boom). This is probably what has been happening in transition economies, though it is too early to tell. If the crisis lasts, losses among the poor – primarily through unemployment – become more substantial, and inequality as well as poverty may increase.

Lack of markets can be expensive. But so can the operation of markets. Is this an integral part of the human condition?

[1] World Bank (2000), Making Transition Work for Everyone: Poverty and Inequality in Europe and Central Asia, Washington D.C.
[2] UNICEF (2009), Innocenti Social Monitor 2009, Florence.
[3] Popov Vladimir (2009), “The long road to normalcy: where Russia now stands”, Conference Paper, UNU-WIDER, Helsinki, 18-19 September 2009.
[4] Alam Asad, Mamta Murthi, Ruslan Yemtsov, Edmundo Murrugarra, Nora Dudwick, Ellen Hamilton, and Erwin Tiongson (2005), Growth, poverty and inequality – Eastern Europe and the FSU, World Bank, Washington.
[5] World Bank 2000.
[6] Alam et al., 2005.

Markets: Incomplete, Inefficient, Self-Fulfilling – But Irreplaceable

A major review of “The state of Economics” was published by The Economist of 18 July 2009 (printed version; online version 16 July). It consisted of a general introduction on What went wrong with economics – And how the discipline should change to avoid the mistakes of the past, and two articles on “The turmoil among macroeconomists”, The other-worldly philosophers and on the foundations of financial economics: Efficiency and beyond, (all three pieces unsigned).

The review has both the merit and the demerit of being non-partisan, trying to be impartial and, therefore, being doomed to inconclusiveness. For instance, while it begins by defining Robert Lucas as “one of the greatest macroeconomists of his generation” it reports on many of the telling criticisms to which Lucas has been subjected. On The Economist‘s Blog (16 July), maxreuter soberly but most effectively commented on Lucas:

“Surely you jest. A more accurate description would be ‘successful economist’ or perhaps ‘leading economist’ of his generation. Remember, this is the gentleman who claims that there is no such thing as ‘involuntary unemployment’ – that all unemployment is purely voluntary. No doubt he believes that what happened during the Great Depression, and what is going on now is really an epidemic of laziness.”

“As the article points out: ‘...economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out’. To refer to an economist whose theories were in large part responsible for much of the above as 'great' is a somewhat unorthodox use of the word indeed.”

“Finally a memorable quote from the 'great' Mr Lucas: ‘...the central problem of depression-prevention has been solved, for all practical purposes...’ – Robert Lucas, Presidential Address to the American Economic Association 2003. Perhaps we should leave it to history to judge the greatness of Mr Lucas and the usefulness, if any, of his contributions to economics.”

In spite of inconclusiveness, by and large The Economist’s review is useful and timely. There is no point in trying to summarise it, as it is already dense and condensed, it is available online and has been subjected to various commentaries in the press and on the blogs.

Three comments are offered here instead, on the importance of markets incompleteness and sequentiality, on the implausibility of the so-called Efficient Markets Hypothesis (EMH), and the frequent self-fulfilling nature of expectations. While these arguments amount to a strong criticism of any market system and its efficiency, in the end it must be emphasised that markets – for all their incompleteness, inefficiency, self-fulfilling nature – are the irreplaceable engines that keep an economic system moving. When these engines are running, a government can try and steer the economic machine. This machine may get out of control on its own, or the government itself may drive it off the road, or crush it. But when the markets/engines are not running, the whole economic system grinds to a halt. However, financial markets are different and do not deserve the same positive appreciation and the consequent free reins.

Incompleteness

The Economist‘s review rightly criticises those economists who conveniently “assume that markets are ‘complete’ – that a price exists today, for every good, at every date, in every contingency”. These are the followers of the modern general equilibrium approach developed after Léon Walras by Kenneth Arrow and Gérard Debreu (Econometrica, vol. XXII, 265-90; Debreu’s Theory of Value 1960, etc).

An irrefutable criticism, as futures markets – apart from a handful of currencies, and standardised raw materials over a short time horizon of 3-6 months – are not the rule but the exception, not to speak of contingent markets. But this is the least of those economists’ worries, for they can and do argue – as Christopher Bliss did when I raised this issue with him a long time ago – that markets have a cost, and therefore only those markets will be activated whose expected benefits exceed their costs. Thus in spite of missing markets we remain in the best of all possible worlds.

As a matter of fact the incompleteness of markets cannot be dismissed, for there is one commodity – labour services – for which a forward market could be contemplated only in a society of serfs or slaves, not in a society of free individuals. An irrevocable commitment to deliver one’s labour services in the future to a given master, or a given firm, at a price agreed in the past, would involve a feudal/slave tie inconceivable in a capitalist economy characterised by wage labour (a tenured job involves an option to sell one’s labour at a predetermined wage, but not an obligation to deliver it). Therefore market incompleteness is not a question of costs exceeding benefits of missing markets (unless we tautologically define an institutionally impossible market as infinitely costly), but of the incompatibility between capitalism and feudal institutions in labour relations. It is no accident that Gérard Debreu never speaks of capitalism, but of an unspecified exchange economy. It is not (only) a question of realism, but of which economic system we are talking. One thing are the “parables” often indulged in by neo-classical economists, another thing the science fiction of imaginary planets on which with absolute certainty nobody has ever set foot or ever will.

The lack of future markets for labour services is also why lower wages may not deliver higher labour employment – because those lower wages cannot be guaranteed to continue in the future once unemployment falls – and why a social contract between capital, labour and government may be a superior arrangement with respect to labour market flexibility.

Sequentiality of markets

Nevertheless, the real problem is not so much markets incompleteness but their sequentiality, which is largely ignored. For markets to deliver an efficient resource allocation they should open for the very short time, ideally an instant, that it takes for all economic agents (including representatives of future generations, but let this pass) to express their demands for and supplies of all goods, on the basis of their individual preferences and original “endowments”, thus determining inter-temporal, contingent, equilibrium prices and quantities. Then, once an intertemporal equilibrium is reached for all states of the possible world, markets should shut for ever while all transactors and their successors execute without fail all their transactions to kingdom come. (We leave aside here the thorny issues of existence, uniqueness and stability of such equilibria; complications with externalities, increasing returns, public goods; and the only too often forgotten departures from perfect competition, not because these issues are negligible or unlikely but because they are too large and complex to handle here, and even in their absence there is more than enough to shake anybody’s complacency).

Fortunately for us, and unfortunately for market efficiency, our markets do not function as in this unknown and grotesque economic system. Markets open, shut and reopen incessantly, indeed in the global economy today they seldom shut, for almost invariably you can transact anything at any time of the day and the night somewhere or other on the globe.

In the world as we know it, in order to secure a good’s availability tomorrow, we do not have to express our demand for it today, even if in principle the good could be transacted today in any number of future markets. Therefore all the time, beside taking into account current prices of current goods, we act on the basis not of today’s spot prices of future goods, but of our expectations of their spot prices tomorrow (and of the quantities associated with them). This is the ultimate foundation of the keynesian theory of unemployment due to lack of effective demand; of liquidity preference and of the associated need for fiscal policy. If today’s savers had to express today a demand for future goods, current investment would be activated for their future supply and a generalised excess capacity could only be structural, i.e. due to mismatching of the structure of capacity and of demand. As things are now, whoever saves creates unemployment unless his savings are being spent simultaneously by someone else. It is odd that even critics like Joseph Stiglitz should concentrate on markets incompleteness (as well as asymmetry of information, see his Whither Socialism?, Cambridge Mass, MIT Press, 1994) and neglect their sequentiality.

The trouble is that the Arrow-Debreu model is the only rigorous theory that would support the claim of an efficient market economy. From this viewpoint we can conclude that an efficient market economy is a utopia, in the literal sense that it does not exist, it has never existed and will never be capable of existing anywhere. What had began as an attempt to theorise the efficiency of markets ended up, by the successive tightening of all the conditions necessary to such efficiency, conclusively demonstrating their inefficiency.

Paradoxically the most effective critique of this kind of general equilibrium theory has come from within that same theoretical tradition, from Jacques Drèze and his work on temporary equilibrium. This is a Hicksian concept (from Value and Capital), infinitely more destructive and promising, at the same time, than anything produced by neo-marxian or neo-ricardian or neo-keynesian economists, so much so that it leads straight to keynesian conclusions.

The Efficient Market Hypothesis

In the 1960s Eugene F. Fama at Chicago University and Paul A. Samuelson at MIT independently put forward the Efficient Market Hypothesis, i.e. the proposition that “prices fully reflect all available information” (Fama 1965). The title of Samuelson’s 1965 article, ‘Proof that Properly Anticipated Prices Fluctuate Randomly’ says it all: if markets are informationally efficient, in the sense of prices incorporating the information and expectations of all market participants, price changes cannot be forecast, and viceversa. Everybody will exploit the slightest informational advantage in profitable transactions. As the old story goes, if you see something looking like a $100 bill on the pavement you should leave it where it is, for if it really was a $100 bill someone else would have picked it up already.

Lucas (1978) buttressed this hypothesis with his notion of “rational” expectations, efficiently embodying the sum total of economic information (although really we should call them “successful” expectations, for there is nothing rational or irrational about them). These are the foundations of the denial of the Phillips trade-off between unemployment and inflation; of the presumed ineffectiveness of government policy; and of the theory of Central Bank Independence with sole responsibility for inflation targeting.

This Panglossian view of the efficiency of markets is reminiscent of the parallel claim, by Soviet planners, that their central planning was always necessarily optimal, because if they had known any better they would have made it better. Admittedly it should be easier for countless, decentralised market transactors to recognise mutually advantageous improvements through bilateral exchanges, than for a single central planning agency to spot and implement planning improvements unilaterally; but if plan construction was decentralised, as Oskar Lange had proposed back in 1937, mutatis mutandis the Efficient Market Hypothesis and the Optimum Planning Hypothesis would be equally plausible (or, rather, equally implausible).

The Economist‘s review covers some of the criticisms raised in the literature to this construct. “In 1980 Sanford Grossman and Joseph Stiglitz [AER 70, 393-408], pointed out a paradox. If prices reflect all information, then there is no gain from going to the trouble of gathering it, so no one will. A little inefficiency is necessary to give informed investors an incentive to drive prices towards efficiency.” This is a confusion between the properties of the end-result and those of the process by which that end-result is obtained.

The Economist‘s criticisms of EMH include also the neglect of “institutional frictions” in markets, such as the presence of some less well-informed “noise traders”. But The Economist‘s strongest criticisms rest on the challenge to markets’ inherent rationality raised by behavioural economics in the past decade.

The behavioural approach

Andrew W. Lo (2007), a contributor to the EMH who now seeks its synthesis with behavioural economics, i.e. the Adaptive Markets Hypothesis, characterises the behavioural approach thus:

“Human decision-making under uncertainty” exhibits systematic biases “several of which lead to undesirable outcomes for an individual’s economic welfare – for example, overconfidence (Fischoff and Slovic, 1980; Barber and Odean, 2001; Gervais and Odean, 2001), overreaction (DeBondt and Thaler, 1985), loss aversion (Kahneman and Tversky, 1979; Shefrin and Statman, 1985; Odean, 1998), herding (Huberman and Regev, 2001), psychological accounting (Tversky and Kahneman, 1981), miscalibration of probabilities (Lichtenstein, Fischoff and Phillips, 1982), hyperbolic discounting (Laibson, 1997), and regret (Bell, 1982). These critics of the EMH argue that investors are often – if not always – irrational, exhibiting predictable and financially ruinous behaviour” (see Lo’s references list for bibliographical details).

The latest contribution to this approach is Animal Spirits, by George Akerlof and Robert Shiller, entitled after what Maynard Keynes regarded as the ultimate urge to practice enterprise and to invest[1]. More power to their elbows. But ultimately the strongest criticism of EMH is epistemological, for that hypothesis is based on a peculiar theory of knowledge.

The EMH suffers from what we could call the X-Files Syndrome, “The Truth Is Out There”. Out there is The Truth, some of which is naked and visible to all market participants; some of which is covered in such a way as to be visible only to some of them – either with total certainty or with an attached probability which is the same for all – and the rest of which is unknown but is known with certainty to be unknown. Information available therefore is somewhat limited, but what information is available is true – or likely to be true with equal probability for all those who share it – otherwise its privileged use would not necessarily give an advantage.

Instead of which, in the world as we know it, market participants have different beliefs about the probability of truth of the information they possess; the same “quantum of information” may be viewed as a gold nugget by some and as utter rubbish by others (for instance, the time sequence of numbers generated by a fair roulette to date, with a view to predict future numbers). Otherwise it would not be possible to even talk of “noise traders”; whoever uses this concept should explain what can be relied upon to contain the noise level below a critical, deafening number of decibels, while a bubble inflates up to the point when it bursts. I guess one can belong to the behavioural school without even realising it.

Self fulfilling expectations

If he were to re-write The General Theory – Maynard Keynes wrote in the Introduction to one of its later editions – he would distinguish between economic agents acting on the basis of wrong expectations and of right expectations. He also wrote: “For if we consistently act on the optimistic hypothesis, this hypothesis will tend to be realised; whilst by acting on the pessimistic hypothesis we can keep ourselves forever in the pit of want” (Preface, Essays in Persuasion, 1931). Joan Robinson used to quote Shakespeare to express the possibility of self-fulfilling expectations: “[… for there is nothing either good or bad, but] thinking makes it so”(Hamlet to Rosencrantz, Act 2, scene 2).

The Economist‘s review states: “… Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.” But in a recent, inspiring article (Economics is in crisis: it is time for a profound revamp, FT 21 July 2009). Paul De Grauwe explains beautifully the self-fulfilling nature not just of expectations but of dominant economic theories.

“Take government budget deficits, which now exceed 10 per cent of gross domestic product in countries such as the US and the UK. One camp of macroeconomists claims that, if not quickly reversed, such deficits will lead to rising interest rates and a crowding out of private investment. Instead of stimulating the economy, the deficits will lead to a new recession coupled with a surge in inflation. Wrong, says the other camp. There is no danger of inflation. These large deficits are necessary to avoid deflation. A clampdown on deficits would intensify the deflationary forces in the economy and would lead to a new and more intense recession.”

“Or take monetary policy. One camp warns that the build-up of massive amounts of liquidity is the surest road to hyperinflation and advises central banks to prepare an ‘exit strategy’ [see our post on “Exit Wounds”, 3 August 2009]. Nonsense, the other camp retorts. The build-up of liquidity just reflects the fact that banks are hoarding funds to improve their balance sheets. They sit on this pile of cash but do not use it to increase credit. Once the economy picks up, central banks can withdraw the liquidity as fast as they injected it. The risk of inflation is zero.”

“Does it matter that economists disagree so much? It does. Take the issue of government deficits. If you want to forecast the long-term interest rate, it matters a great deal in which of the two camps you believe. If you believe the first one, you will fear future inflation and you will sell long-term government bonds. As a result, bond prices will drop and rates will rise. You will have made a reality of the fears of the first camp. But if you believe the story told by the second camp, you will happily buy long-term government bonds, allowing the government to spend without a surge in rates, thereby contributing to a recovery that the second camp predicts will follow from high budget deficits.” …

“This conflict matters not only for market participants, but also for policymakers.” … “The cacophony of analysis helps to explain why policymakers react in different ways to the same crisis and why it is so difficult for them to come up with co-ordinated action.”… “How to resolve this crisis in macro-economics? The field must be revamped fundamentally” (De Grauwe, cited).

Back to the drawing board, then: “We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called ‘animal spirits’ are fundamental forces driving macroeconomic fluctuations” (De Grauwe, cited).

Markets as indispensable homeostatic mechanisms

Well, markets are incomplete, sequential, inefficient, self-fulfilling… So what? All of these considerations taken together do not eliminate the absolute need for markets in resource allocation, for they are irreplaceable homeostatic, self-regulating mechanisms that adjust prices to excess demand (Walras), quantity produced to excess price over cost (Marshall), and actual capital stock to desired capital through investment decisions. Axel Lejonhufvud stressed long ago the markets’ self-regulating role (which should not be confused with self-regulation of their own functioning). More generally, markets also adjust production capacity and production of inputs to those of outputs (Dick Goodwin on the Multiplier as a Matrix).

Sometimes the self-adjustment is too fast, sometimes it is too slow - as it happens with all homeostatic mechanisms, like thermostats - but it is there; the alternative is manual control, i.e. central planning. As I tell my students, there may be special circumstances in which manual control is superior to an automatic mechanism. In Star Wars, when Luke Skywalker targets the heart of the Empire, he disables automatic controls and goes manual, and succeeds. But he only had one target; there were only two alternatives, hit or miss; and … the Force was with him. In Central Eastern Europe, on the contrary, the inability to introduce markets in almost forty years of attempted reforms – primarily because of persistent endemic excess demand, but also for the leadership’s fear of loss of political power and control – was the ultimate economic cause of collapse of centrally planned economies in 1989-91.

We could paraphrase Wiston Churchill’s dictum about democracy, and say that the market economy is the worst economic system except all the others that have been tried. But markets alone do not, on their own, characterise an economic system. We are engaged now, as never before, in an intellectual struggle over what ownership mix, what rules of the game, what share of government expenditure, what social and re-distributive policies, what global governance institutions should prevail in the modern market economy. While economic arguments are used, the choices involved are essentially political, and attempts to control or replace markets as the economy’s engines are always grabs for political power and control.

Except…

… that the markets' homeostatic properties praised above demonstrably do not apply to most credit and financial markets, where products may multiply instead of reducing and spreading risk; securities may go toxic; transactions are more likely to be fraudulent because of lack of transparency; there is a corporative system of rewards masquerading as a market for managerial skills; leveraged bets in derivatives markets can inflict massive damage on innocent bystanders; banking pyramids proliferate; profits are privatised and massive losses are eventually socialised. Here the primacy of markets must give way to effective regulation, first national then global.


[1] “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (The General Theory of Employment, Interest and Money, 1936, pp.161-162). Akerlof and Shiller take “animal spirits” to imply irrationality, but the urge to action rather than inaction could well be a rational survival strategy, instead of the neglect of reason.