Sometimes the Economic Beauty Contest Gets Us into an Ugly Mess
King, Stephen, The Independent (London, England)
Given Alan Greenspan's dose of the doubts last week, at what level should we trust markets? The strongest defence is, surely, the idea that markets provide the best single way of allocating the world's scarce resources. Unfettered capitalism, on this view, is desirable because it potentially makes all of us better off.
A weaker defence is that markets are certainly not perfect but they're the best of a bunch of bad systems. While, it would be nice if a better alternative came along, the alternatives tried so far - Communism, Fascism, feudalism and so on - have proved inferior.
Then there's the defence based on faith in individual liberty. On this view, so long as everyone is free to choose, it doesn't matter if the outcome at the level of society as a whole is unattractive, or if individuals lose out. This libertarian view, though, is a matter more for political philosophers than for mere economists.
Markets are truly miraculous, a point well-argued by Adam Smith with his description of the invisible hand. But markets have their weaknesses. They're not very good at dealing with pollution and the other social costs and benefits which stem from private decisions. They're hopeless at dealing with income inequality. And they're particularly weak at dealing with time.
On a day-to-day basis, markets can work rather well. Pop down to your local high street or to the supermarket and, within reason, you're likely to be able to buy all the things on you shopping list. Admittedly, some things are not immediately available - you may have to wait a few weeks for the new sofa to arrive or for the car built precisely to your specifications to turn up - but you never seriously doubt that you will be able to exchange your income for consumption.
Not everyone is in the same boat. Away from the affluent areas of the world, the vast majority of people struggle on a daily basis. For them, markets either don't work well or simply don't exist, the result of, inter alia, an absence of property rights, an ineffective legal system and the mis-appropriation of resources by non- democratic regimes.
In the developed world, though, the biggest problem is time. It's something that was well understood (in their different ways) by John Maynard Keynes and by the so-called Austrian school led by Friedrich Hayek and Ludwig von Mises in the 1920s and the 1930s, but poorly understood by those who have a blind faith in market solutions. Alan Greenspan, the former chairman of the Federal Reserve, was forced to admit in front of a hostile congressional committee that perhaps his faith in markets had been shaken. It's a shame, though, that it took him so long to understand what others had recognised eighty years ago.
Of all the various problems with economic time, two stand out. First, there's the effect of imperfect information. It takes time to evaluate an investment project and time costs money. At the beginning of any evaluation, the businessman may simply not know whether the project is viable. How much time should be spent working out whether the project is worthwhile? The idea that markets can provide a solution to such uncertainties is, of course, nonsense.
Second, within financial markets, beliefs about the beliefs of others are crucial drivers of asset prices. Why were people happy to buy houses two years ago, even though prices were remarkably elevated by historical standards? Why did people buy technology stocks at the end of the 1990s, even though valuations looked remarkably stretched? The answer, surely, comes from people's beliefs that others will pay even more for an asset, even if the price has already risen into the stratosphere.
Keynes famously captured this idea with his beauty contest. "It is not a case of choosing those [faces] which, to the best of one's judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. …