Tuesday, 16 February 2010

Why the market is still a force for good

Next Left's report on last week's South Bank Think-Tank Clash was critical of the defence of the market argued by Policy Exchange.

In this guest post, Andrew Lilico of Policy Exchange responds that the moral power of the market ideal remains as strong as ever, challenges the bank bailout as an exercise in double standards which could endanger the future of capitalism itself, and sets out how a pro-market agenda should respond now.


At the recent think-tank clash, I was asked to put the case for the market against the state, and I used my two minutes speech to set out the classical case:

A Market is not a state of nature, the result of no government, but instead the product of free interaction between individuals and groups against a backdrop typically provided by a government of secure (and enduring) property and contract rights, and a secure medium of exchange.

Not everything is, of course, determined in markets. Families do not allocate food at the dinner table via trade. Within businesses, people are allocated tasks by managers, rather than trading over those tasks. Furthermore, much activity in society is driven by philanthropy or faith.

So the question of how best an economy is to be run is not one of whether markets should do everything, but, rather, whether the Market should be the centrepiece of the economic order, the main way in which goods are allocated, preferences are revealed, economic choices are made – and in particular to what extent we should accept the results of the Market rather than subvert them.

Markets are splendid mechanisms. They encourage innovation, imagination and creativity, by allowing new and effective ideas to be greatly rewarded, and by matching those with ideas with those with money to fund the ideas. They encourage efficiency and oppose stagnation and vested power, by providing a means by which those able to do things more attractively and at lower cost can flourish. They are environmentally friendly, facilitating the greatest output from the least use of resources.

Markets allow a society of great diversity and tolerance. There are a few market virtues that are needed – trustworthiness, respect for property, the idea that a deal should be to the interests of both parties. But the list is short. As a consequence, markets are the economic order of the most orderly liberal societies – you don’t need all to have the same religion or same morality or same worldview for a market to work.

Similarly, markets are the enemies of misguided prejudice. If you are foolish enough to believe that those from poor backgrounds or women or members of certain races or the elderly cannot be productive, the market will test your belief and find it wanting – businesses based on ill-founded prejudice will go bust and those that embrace talent from any background will flourish.

So, overall we see that a society that places markets at the centre of the economic order – recognising the key role of governments in sustaining them – will be prosperous, progressive, richly diverse, imaginative, tolerant, and free.

Such is the classical case. One might wonder how I can maintain this position given the widespread view that the credit crunch shows that markets are fundamentally unstable and drive periodic episodes of market collapse, recession and unemployment. I deny that this is the correct diagnosis of the crisis.

In my view the crisis was the result of a vicious interaction between over-pricing of genuinely valuable financial innovations; systemic coordination of errors through the replacement of individual responsibility for investment decisions with an elaborate system of regulatory badging; regulatory get-arounds; moral hazard in respect of housing (governments took too much responsibility for house price rises); a flaw in inflation targeting; and markets awaiting bailouts. (I have published in more detail on this here.

I didn’t recommend a laissez-faire approach to dealing with the banks, but I did oppose the bailouts.

I had many technical objections to the way the bailouts were done, but I often emphasize the immorality and double standards involved. In the 1980s and 1990s we allowed coals mines, steel mills, shipyards, car companies, and many others to shut. At the time, many economists argued that allowing such firms to shut would generate systemic effects, imposing blight upon the regions affected. And indeed this happened. When these industries shut, of course the workers and their families were affected. And so were companies that provided direct services to the industries – the car components firms, the logistics firms, and so on. But the effects went much wider. There were indeed systemic effects. With the loss of demand from these major employers, many unrelated firms went under – clothes companies, restaurants, electronics shops, and so on.

I never denied that there would be such systemic effects. But it was right and necessary that these industries be allowed to shut despite them. And when we read now the reports from the time about how it would be much cheaper, once one took account of unemployment benefits etc., to subsidize these industries’ continuation rather than allow them to shut, we smile at the blatant self-interest and fundamental implausibility of the claim.

But in 2008, once it was not Northern towns that would be blighted but the City of London and the South-East, and once it was not coal-miners and investors in coal-mines that would lose out but bankers and the wealthy pension-holders that lent the banks their money, suddenly, as if by magic, we rediscovered systemic risk and how it was so much cheaper to bail firms out than to impose losses on their bondholders. And it never occurred to most people to question whether this was really anything more than a modern form of corporatism – the country’s allegedly strategic and important industry capturing the ears of policy-makers and spinning them the yarn that public money should be used to spare them from the consequences of their mistakes.

(A common joke in regulatory circles is that the key doctrine of financial regulation is neither “too big to fail” nor “too connected to fail” but, rather, “too connected (to Goldman Sachs) to fail”.)

But so what? Sunder argues that it is naive to make policy based on the premise that we wouldn’t start from here. The reality is that policymakers did bail out the banks and future policymaking must recognise that.

I certainly agree, indeed many, many, times over.

Everything must change from here. Our current economic order is unstable, indeed dangerous. At the core of the private capitalist order, in the banks that are central to the flow of funds, we have created an appalling instability. For fractional reserve banking is an intrinsically risky activity, but at present the key (the overwhelming) providers of capital for fractional reserve banking – the bondholders and depositors – are insured by the state. The consequence is that at the heart of the system there are powerful incentives for excessive innovation and excessive risk-taking, with excess remuneration attached to these.

I would go so far as to say that this instability is so damaging that it is by no means obvious that private capitalism is a desirable economic order at all.

This must change. But how? There are three routes forward.

Either (a) we abolish fractional reserve banking altogether, as proposed by Laurence Kotlikoff and by the Austrian School;

or (b) we make the state explicitly the key provider of capital for banks (e.g. by nationalising the retail banking system altogether, as was common in much of Europe during the 20th century);

or (c) we devise ways to allow banks to fail in the future.

Route (c) is the route I favour and is also supported by, for example, Bank of England.

What might help us choose?

Well, we might note that although private capitalist economies are more volatile than those with nationalised banks, they ought to have higher average growth rates (though whether they should be expected to do so in practice is an interesting further question).

But for me the key argument is not the efficiency-prosperity one. It is the moral case I set out at the beginning. It is because of the moral/politico-philosophical benefits of markets that, although sometimes we must change tack sharply, we should always in the end be aiming to steer back to a market-based system.

* Guest post from Andrew Lilico, who is Chief Economist of Policy Exchange. You can read more from him on the Policy Exchange website and his commentaries in response to the financial crisis and recession for ConservativeHome.

1 comment:

Letters From A Tory said...

"credit crunch shows that markets are fundamentally unstable"

Not so. As I understand it, the market was perfectly stable until the US government started pushing banks into sub-prime lending many years ago, which made them take risks that they would not normally have gone anywhere near.