Don’t be too quick to over-regulate

The present global financial situation has seen a plethora of calls for greater government involvement in the functioning of economies and, more specifically, being used as evidence that markets just plain don’t work. An example of such thinking appeared in La Trobe Opinions last month (see Christopher Scanlon, “The Market Delusion”, 13 October 2008). Apparently the events of the last two months have destroyed the “delusions” that markets are simple affairs, markets are natural and function best without government interference and that markets are free of ideology.

As one of the apparently delusional free-marketeers, I’m not entirely sure anyone has actually argued that markets are simple matters. What is more to the point is that markets facilitate an intricate system of exchanges utilising a relatively simple mechanism. This is not to say that the mechanism itself is simple, though. Anyone who doubts that ought to go the nearest university library and look at any book on price theory. It is interesting to note that no suggestions are forthcoming as to what ought to replace markets to determine the allocation of goods and services (including financial services).

The remaining two points still stand, despite recent events and claims from those left of centre. As a social being, it is in people’s nature to want to trade with each other. This has been the case from the advent of even the crudest form of civilisation. Notwithstanding the mistakes that have been made in the United States, from both borrowers as well as creditors, it is still difficult to see how matters are improved by having governments dictate whether and how transactions take place. Focusing on debt financing, the “government interference” railed against includes dictating interest rates (rather than allowing the lender choose), terms on which financing may be provided and minimum lending criteria. This last one ought to focus the minds of the critics of free markets, since minimum lending criteria are likely to exclude those on lower incomes. Unlikely to be an intended result of government interference, but more on that in a later post.

As for whether markets are free from ideology, this one still stands as well. The belief that the free market produces the best possible result may be inextricably linked with a particular ideology, but the markets themselves are not. As with much of the criticism that has come from the left, the argument that the free market is an ideology is a product of a confused mind. The concept of a free market is really a tool for analysis, a benchmark if you will, that enables us to predict as accurately as possible (which is not to say with 100% accuracy 100% of the time) what the effects of certain actions (including regulation) are likely to be. Viewed in this light, free markets are an application of a discipline known as microeconomics. In essence, this all comes down to incentives that people face. And to demonstrate how free from ideology free markets are, the microeconomic principles underpinning this concept correctly predicted the effects of policies in communist jurisdictions (which is about as far from free market “ideology” as one can  get).

Exhibit A: Soviet Russia. Free market analysis essentially comes down a single basic concept derives from two relatively simple notions in their own right: that prices for scarce goods (or services) are ultimately determined by an interaction of supply of with demand. When prices go up, people have an incentive to supply more and people demand less, and vice versa. Whenever this (natural) process is interfered with, outcomes are very predictable. In the case of Russia, the central planners artificially set prices below where they would be in a free market, leading to a predictable rise in demand. It is not entirely clear what happened with the supply side of providing goods in this case, but supply certainly did not rise to clear the market (if it had, it would have meant the Soviets were diverting resources away from other more valuable uses). The predictable outcome is exactly what happened: queues. And not of the inconvenient variety that we occasionally have to put up with at the supermarket.

Exhibit B: Maoist and modern China. Perhaps the last communist state that could remotely be regarded as successful. But it is necessary to ask where did this success come from? Is it because Chinese central planners have so much more foresight, or even just better information than their Soviet ilk? Not likely. It is instructive to note that until Deng Xiaoping decided to experiment with free markets, China never looked even close to breaking into the ranks of being a developed nation. Today, the effects of these policies are still very evident. It is well documented that there is a substantial wealth gap between the Special Economic Zones (e.g. the region around Shanghai) and the rural areas. You don’t need to be an expert in current Chinese affairs to be aware that it is not the rural areas doing better at the moment. And take a shot at which areas are the ones that the Chinese have experimented with free market economics? A similar story can be told about present Vietnam.

If markets have been shown to work in societies that (at least predominantly) embrace collectivist ideology and central planning, then it is difficult to see how they can be regarded as inextricably entwined with ideology. Experience shows they work regardless of the ideology in force at the time.

The current situation has prompted other concerns that, on the face of it, appear to undermine the case that free markets are the best option for running a country. This will have to wait for a later time. Suffice to say, this does not detract from a thing that I have presented here. And we will wait for that later time to consider whether it is not so much free markets but government anyway that has made this mess.

The thought to leave you with for the moment is that, given the political climate and the natural human desire for quick action – to be seen to be doing something – we are going to see more regulation in the short term. The main hope here is that cooler heads dominate the process and this temporary short move away from where things need to be is just that – temporary and short.

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  1. Anonymous says:

    Thanks very interesting blog!


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