The Fallacy of the Rational market

Apr 18, 2010 Editorial

Joseph Stiglitz, once Chief Economist of the World Bank, has in the last decade proven to be one of the most trenchant critics of the “Washington Consensus” medley of measures and the IMF imposed on most of the poorer nations including Guyana.
These measures were based on the premise of the unfettered free-market. His critique proved to be very prescient in the wake of the global financial meltdown that still has us in its throes. Recently, Stiglitz offered his views on that economic premise, which might be of interest to our financial policy makers.
He claims that “while most of the blame for the crisis should reside with those in the financial markets, who did such a poor job both in allocating capital and in managing risk (their key responsibilities), a considerable portion of it lies with the economics profession.
The notion economists pushed – that markets are efficient and self-adjusting – gave comfort to regulators who didn’t believe in regulation in the first place. They provided support for the movement which stripped away the regulations that had provided the basis of financial stability in the decades after the Great Depression.
We should be clear about this: economic theory never provided much support for these free-market views. Theories of imperfect and asymmetric information in markets had undermined every one of the ‘efficient market’ doctrines, even before they became fashionable in the Reagan-Thatcher era. Adam Smith’s hand was not in fact invisible: it wasn’t there.
If markets were as efficient in transmitting information as the free marketeers claimed, no one would have any incentive to gather and process it. Free marketeers, and the special interests that benefited from their doctrines, paid little attention to these inconvenient truths.
While economists who criticised the ruling free-market paradigm often still employed, as a matter of convenience, simple models of ‘rational’ expectations (that is, they assumed that individuals ‘rationally’ used all the information that they had available), they departed from the ruling paradigm in assuming that different individuals had access to different information. Their aim was to show that the standard paradigm was no longer valid when there was even this seemingly small and obviously reasonable change in assumptions.
They showed, for instance, that unfettered markets were not efficient, and could be characterised by persistent unemployment. But if the economy behaves so poorly when such small realistic changes are made to the paradigm, what could we expect if we added further elements of realism, such as bouts of irrational optimism and pessimism, the ‘panics and manias’ that break out repeatedly in markets all over the world?
Of course, one didn’t have to rely on theoretical niceties in order to criticise the faith in unfettered markets. Economic and financial crises have been a regular feature of capitalist economies; only the period of strong financial regulation after the Second World War was almost totally free of them. As financial market regulations were stripped away, crises became more common: we have had more than 100 in the last 30 years.
The present crisis should lay to rest any belief in ‘rational’ markets. The irrationalities evident in mortgage markets, in securitisation, in derivatives and in banking are mind-boggling; our supposed financial wizards have exhibited behaviour which, to use the vernacular, seemed ‘stupid’ even at the time.
If we are to design policies to prevent crises or to deal with them when they occur, it is essential to understand the critical flaws in the standard paradigm.
Standard economic theory – the theory of demand and supply says that if prices (including the price of labour, or wages, and the price of capital, or the interest rate) are fully flexible and markets function as they should, then even with such uncertainty there should be full employment.
Markets in capitalist systems don’t work that way, though, and the question is why? The standard call of conservative economists (including those in Guyana) for more ‘labour market flexibility’, ensuring that the wages of workers will drop even further.
But traditional Keynesian economics argues that what matters is aggregate demand, and that lower wages reduce aggregate demand. The current crisis demonstrates what can happen: countries with stronger systems of social protection and less labour market flexibility have, in many ways, fared better.

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The Fallacy of the Rational market

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