Are Markets Free?

Effective markets are underpinned by the government. The interventions may be sophisticated and well-thought through or they may be clumsy and ineffective. The neoliberal rhetoric of ‘free markets’ leads to the latter.

In a recent Metro article, Matthew Hooton wrote ‘globalisation combined with free markets has been the most successful economic and social system of the world’. I do not propose to discuss whether we can describe as successful a social system which is riven with mental health and addiction problems or whether we can attribute them to globalisation and free markets. As a previous French prime minister, Lionel Jospin, said (in French) ‘Yes to market economy, no to market society.’

Nor am I going to spend much time discussing globalisation in this context. Adam Smith argued that specialisation (with its economies of scale and learning-by-doing) were crucial to economic development. Globalisation facilitates this, but never forget it has its downsides.

This column focuses on the pernicious rhetoric of ‘free markets’. Whatever the expression sounds like, markets are not typically ‘free’ but are regulated by a host of laws (imposed by governments) and other interventions.

It is unfortunate that the usual introductory economics course pays little attention to the government regulation of markets. Apparently neoliberals having struggled through Economics I (in a famous case obtaining a C pass) miss the point and end up using uncritically the idea of a ‘free market’.

The amount of government regulation varies. In the typical Economics I example, say apples, the transaction is repeated, you soon find out if you made a bad decision, and the loss from one mistake is small. Even so, you might contemplate when you next purchase some apples, how you are protected by the Fair Trading Act (among other interventions). You make the purchase with a degree of confidence in the quality of supply and that knowing there are remedies in the unlikely event that something goes wrong.

Compare that with purchasing a house. As the leaky buildings saga illustrates, you make the decision rarely and it may take considerable time – years – to find out if there is a defect, which may be very expensive and extraordinarily costly to remedy (but very profitable to lawyers). The failure arose in a period when belief in free markets was strong under the slogan of ‘light-handed regulation’. As a result, we have moved to much more heavy (local) government regulation; I am not sure we have got it right.

For once we move away from the naive neoliberal slogan, things get very tricky. I illustrate this with the ‘open bank resolution’ policy. It arises because it is possible – many would judge unlikely – that your bank may fail. There are a number of ways it can, but for these purposes consider the possibility that it has difficulties paying all its depositors either immediately or ever. You don’t think a lot about this when you place some of your savings in a bank but, golly, you would get angry if it were to happen.

Who covers any financial deficit? The easy response is ‘not me’; a slightly more sophisticated version is ‘the government’ which means the taxpayer – in effect someone else.

Why should the government worry?. Aside from the political pressures, the banking system is key in the economy’s payments system so a bank failure could compromise the very basis of an effective market economy. (There are some splendid examples of responses. One of my favourites is that when one happened in Ireland, the local hostelries ran a credit system for their customers; it would not work here because most New Zealanders do not have such an intimate relationship with their pubs.)

The open bank resolution policy states how the government would deal with the situation. It reserves the right to suspend, for a period, depositors’ access to their funds during a temporary crisis and to haircut (that is reduce the value of individual deposits) if there is a permanent deficit. It is only a policy framework, because no one knows the details of an actual incident – the devil is always in the details.

At the same time the Reserve Bank has instituted a number of requirements for the banks which aim to reduce the likelihood of a bank collapsing and that, if it does, buffers – shareholders’ funds and other sorts of investment contributions – will be used first if there is a deficit. This gives greater protection (a lower likelihood of the haircut) to ordinary depositors.

New Zealand is not alone is such strategies. The Global Financial Crisis exposed the failure of the light-handed regulation that had existed throughout the world’s financial system. When things got strained it was the taxpayer who bailed it out by. literally, billions of dollars.

Chief financial neoliberal in the era preceding the GFC was Alan Greenspan, Chairman of the American Federal Reserve (i.e. their central bank). Questioned afterwards by a congressional committee after the collapse, he said, referring to his free-market ideology, ‘I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.’

A congressman responded, ‘In other words, you found that your view of the world, your ideology, was not right, it was not working.’ Greenspan replied, ‘Absolutely, precisely.’

So much for the ‘free market’ in practice. This will be water off a neo-liberal duck’s back, but I want to draw another conclusion. It is one thing to criticise the shallowness of the free market ideology, it is a far greater challenge to design effective interventions.

I have illustrated this column with the open bank resolution policy and the other measures the Reserve Bank has instituted (and is instituting) because they seem very well-designed. (Of course there is grumbling from those who have to respond to the measures. Following the next financial crisis they will not apologise as Greenspan did; by then they will be retired on handsome incomes.) On the other hand, I see intervention frameworks in other markets which would be struggling to justify a C grade.

An unfortunate consequence of the free market and light-handed (I almost wrote ‘light-hearted’) regulation rhetoric has been to destroy our capacity to design quality interventions. A few exceptions aside, we may be drifting back to a Muldoon era regime of poor-quality market regulation.