Wednesday, December 9, 2015

The best economists know the market is flawed

As almost every economist will tell you, the market economy – the capitalist system, if you prefer – works in a way that's almost miraculous. All of us owe our present prosperity to it.

Think of it: each of us in the marketplace – whether we're buyers or sellers, consumers or producers – is acting in our own interests. A butcher sells us meat not to do us a favour, but to make a living. We, in turn, buy our meat from him not to do him a favour, but to feed ourselves.

That's how market economies work: everyone seeks to advance their own interests without regard for the interests of others. It ought to produce chaos, but doesn't.

Somehow the market's "invisible hand" has taken all our selfish motivations and transformed them into an orderly, smooth-working system from which we all benefit. The butcher makes her living; we get the meat we need.

Heard that story before? It contains much truth. But not the whole truth. Business people, economists and politicians often use it to imply that everything that happens in a market economy is wonderful.

Or they use it to argue that the best way to get the most out of a market economy is to keep it as free as possible from intervention by meddling governments. We should keep government as small as possible and taxes as low as possible.

But market economies aren't always orderly and smooth working. They move through cycles of wonderful booms but terrible busts.

And it's not true that "all things work together for good". A fair bit of the self-seeking behaviour of producers isn't miraculously converted into consumer benefit.

I've been reading a book called Phishing for Phools, a play on the online practice of phishing: posing as a reputable company to trick people into disclosing personal information.

The authors say that "if business people behave in the purely selfish and self-serving way that economic theory assumes, our free-market system tends to spawn manipulation and deception.

"The problem is not that there are a lot of evil people. Most people play by the rules and are just trying to make a good living. But, inevitably, the competitive pressures for businessmen to practice deception and manipulation in free markets lead us to buy, and pay too much for, products that we do not need; to work at jobs that give us little purpose; and to wonder why our lives have gone amiss."

You're probably not terribly surprised to read such sentiments. The surprise is that they're being expressed by two economics professors, George Akerlof, of the University of California, Berkeley (and husband of the chair of the US Federal Reserve), and Robert Shiller, of Yale University, who are held in such high regard by their peers that they're separate winners of the Nobel prize in economics.

They say they wrote the book as admirers of the free-market system, but hoping to help people better find their way in it.

If competition between business people too often induces them to manipulate their customers, why do we so often fall for it? Because though economists assume we always act in our own best interest, psychologists have convincingly demonstrated that people frequently make decisions that aren't in their best interest.

The market often gives people what they think they want rather what they really want. The authors point to common market outcomes that can't possibly be wanted.

One is a high degree of personal financial insecurity. "Most adults, even in rich countries, go to bed at night worried about how to pay the bills," they say. Too many people find it too hard to always resist the blandishments of marketers so as to live easily within their budgets.

It was all the phishing for phools in financial markets – people were sold houses they couldn't afford; people sold securities that weren't as safe as they were professed to be – that led to the global financial crisis and the Great Recession that hurt so many.

Then there's the way processed foods from supermarkets and food sold by fast-food outlets and restaurants come laced with the health-harming things they know we love: salt, fat and sugar.

The authors say a great deal of phishing comes from supplying us with misleading or erroneous information. "There are two ways to make money. The first is the honest way: give customers something they value at $1; produce it for less.

"But another way is to give customers false information or induce them to reach a false conclusion so they think that what they are getting for $1 is worth that, even though it is actually worth less."

Another class of phishing involves playing psychological tricks on us. According to the research of the American psychologist Robert Cialdini, we're phishable because we want to reciprocate gifts and favours, because we want to be nice to people we like, because we don't want to disobey authority, because we tend to follow others in deciding how to behave, because we want our decisions to be internally consistent, and because we are averse to taking losses.

There's no better way to organise an economy than by using markets. But market outcomes are often far from perfect and we need governments to regulate them as well as offset some of their worst effects.