In the years since the 2008 financial meltdown, free markets have suffered a shattering loss of credibility, especially among Americans who have lost their jobs, homes and the money they saved for retirement and college for their children.
Since the days of Adam Smith, more nonsense has been written about free-market capitalism than any subject other than religion.
Beginning in the 1960s, ivory-tower economists started developing a host of “rigorous” quantitative models that claimed to show how markets actually work.
These models (expressed in obscure differential equations rather than clear English) focused primarily on markets for common stocks and other financial securities that were assumed to represent the closest real-world approximation of the free-market ideal.
They were all wrong.
But they still became mainstream thinking among 1980s and ’90s Wall Street rocket scientists and remained so right on into the 2008 collapse. Several of the models’ developers even won the Nobel Prize in economics, with its impressive gold medal and seven-figure check.
It may come as a surprise to some, but markets are by no means artificial entities invented in an ivory tower. They are entirely natural and instinctive products of human pragmatism.
Let’s look at some of the popular myths about markets that have brought us so much grief. The first is that the amount of goods and services consumers are willing to buy at the so-called “market price” always equals the amount producers are willing to sell.
The evidence indicates that real-world buyers and sellers are forever chasing transaction prices that coincide just long enough for them to strike deals. The price agreed upon for one deal may be different from that of a similar one struck at the same instant on the other side of the room.
This should come as no surprise to anyone who’s ever bought a knock-off Rolex wristwatch, Mont Blanc pen or Vuitton handbag at a bargain price from one of the sidewalk stalls that line Manhattan’s Canal Street, where the sweaty reality of free markets truly flourishes.
Another myth is that markets are perfectly efficient because decisions to buy and sell are made by coldly rational androids that seek only to maximize their personal satisfaction in objective ways, possess complete information and have absolute freedom to enter into transactions or to pass on them.
But real-world markets are usually chaotic, with the average buyer or seller trying to guess what every other average buyer and seller thinks is the right price. And what about situations like the one faced by a fisherman forced to sell his fresh fish at the end of the day for whatever price a restaurant chain offers, because it’ll spoil overnight?
Many economists claim that market-price changes are entirely random and independent of each other, like consecutive coin tosses. But normal people instinctively know that prices are determined by human beings who negotiate knowing what the last transaction price was. The real world is like an unbalanced roulette wheel, full of patterns and dependencies.
Still another myth is that markets work best when they’re not subject to any meddling by external institutions like government. But markets need regulation as both President Obama and Governor Romney acknowledged in their first debate.
We can’t rely on the myth that a seller knows his economic success ultimately depends on his reputation among potential buyers. The argument that he has a powerful economic incentive to maintain a reputation for honesty can easily fall prey to natural instincts that may be those of a con artist.
Market myths like these provided justifications for the deregulation mania on Wall Street and elsewhere. If we want to recover from the Great Recession they helped cause and avoid a repeat of it, we’d better learn the difference between myth and reality.
originally published: October 13, 2012