Fantasy economics

I thought about calling this post "Santa Claus Economics" but choose the more general term.

If I said I was going to solve the nation's economic problems by harnessing the productive might of Santa Claus and his ability to determine good from bad, you'd try to lock me up.

But most people who answer to the rallying cry of "free market economics" basically are believing in something just as fantastic.

In a famous passage, Smith invoked the idea of "an invisible hand" leading the capitalist to an end that is good for both the individual and society. And invisible hand. No shit. But they don't lock you up for professing to believe in free market economics.

Smith did not actually mean that there would be an invisible hand, of course. Smith actually described a whole system of how goods are exchanged, how people behave, etc., all of which lead to the good social result. Smith's work describes the mechanism by which socially good ends are going to be achieved through the selfish agency of the actors.

This whole system that Smith describes is complex and depends on many different notions of how the world works.

Some of the premises on which Smith builds--I'm thinking specifically of the idea of the rational actor which underlies Smith's descriptions of the decision-making processes of people--have been shown to be false. Nobel-prize winning work by psychologists Daniel Kahneman and Amos Tversky shows that people don't make rational decisions at least if we define rational in a classical sense of using Bayesian probabilistic reasoning and logic. But I don't want to go there now--I just want to note how the larger scheme of an economic theory is dependent on many different ideas, some of which are problematic.

The work as a whole describes a manner of functioning. Is is this operation of the market which is supposed to lead to optimal solutions--but the operation of the market to be optimal really needs to meet certain criteria.

Current free market theories as they appear in political debate, however, don't include any of the discussion of the mechanism that has to operate; the debate is generally boiled down to "We need less regulation; regulation is what is destroying the market" as if, once all regulation were removed, the markets would somehow automatically lead to the optimal result. This is the fantasy. It's not as if some invisible hand is waiting for the regulators to say "OK, go do whatever you want now" before it then leads producers to the betterment of society. The invisible hand doesn't exist. If the market isn't functioning in the way that it is supposed to, then it won't lead to good results.

This is clear in Adam Smith's work.
The basic premise of Smith's social betterment is based on the idea that supply and demand will operate to force market prices to match what he called the "natural price"--which we might interpret as what things are really worth. This leads to an efficient allocation of resources, and is one of the underpinnings of what helps the market produce good outcomes. And then, in addition to efficient allocation, there is the possibility for innovation to lead to more efficient use of resources, and the innovator, by being able to produce more efficiently, will reap a profit by virtue of having a more efficient system. Thus, basically, the free market promotes the general good by leading to efficient allocation of resources and by encouraging innovation. This basic premise is, I believe, generally sound, even given problematic assumptions like the non-rationality of people. Or if not generally sound, at least pragmatically sound.

But it is a basic premise in Smith's work, as well, that there are many market conditions under which this efficient allocation of resources does not occur, and in which innovation is squelched. It is clear from Smith's work that one sort of condition that will lead to this inefficient market operation is concentration of power in the hands of a monopoly who can then set the price however it wishes, with no regard for the "natural price". This basic premise was generally accepted until recently. In the 1890s Republicans wrote the Sherman AntiTrust Act, which assumed--as did Smith--that competition was necessary to make the market work.

But in the last decade or two, at least in the political debate, the importance of competition has been completely ignored. The fantasy now is that if there is no regulation, then the market will naturally lead to the best solutions, even though in most markets there is a small number of very large firms that can essentially set the prices as they will to maximize their profits.

If one is going to believe in a theory like laissez-faire economics, then one should at least have some idea about how it works, otherwise you've got nothing but a fantasy. And other people can use that fantasy for their own gain.

In the unregulated markets of the US, what we have is a small number of firms making huge profits, but the efficient (and equitable) allocation of resources that would occur in competitive markets does not occur because the markets are not competitive, but rather are characterized by monopoly or oligopoly power. Thus things are not being sold for what Smith would have considered their "natural price"--for example the wages of laborers have not increased, even though the productivity of labor (which would determine the "natural price") has. And innovation is squelched, too (look at how US technology which was the unquestioned world leader 40 years ago no longer has nearly the same dominance).

The big firms, who are well-represented in the government, use the idea of the "free market" as a rallying cry (and a point of loyalty--because questioning the free market means you must be a marxist), all the while they are doing their best to keep the markets from ever being freed from the power of their firms.

Wouldn't it be great if people stopped believing in some fantastic invisible hand? Wouldn't it be great if people understood how markets work, so that they could see that currently markets aren't working that way?