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Changing the Paradigm of Being, Part 5: Limitations of markets

Did you miss previous parts?

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EquilibriumLibertarians, and others who believe that a truly free market could solve virtually any problem, are generally in favor of laissez-faire capitalism. Merriam-Webster dictionary defines laissez-faire as “a doctrine opposing governmental interference in economic affairs beyond the minimum necessary for the maintenance of peace and property rights.”

The idea is that “demand and supply” principle of a free market is better at allocating resources and satisfying human needs than any other alternative, such as centrally-planned economy.

In a free market, individuals have an incentive to find a way to satisfy the needs of others, because they will be rewarded for that, while competition ensures that the needs of consumers are satisfied in the cheapest way possible. The price mechanism balances demand and supply: when a particular good is in high demand, a producer can charge more and therefore make a higher profit. Higher prices will attract more production, until eventually the supply matches the demand again. At that point the price will go down and a new equilibrium will be found. The free market also leads to efficient division of labor, because it rewards producers who have specialized and can compete better in a niche market.

Market mechanisms are basically collective trial-and-error processes that ensure that production is matched to the needs of consumers, even though no single person involved in this process might know how to do this. Market system itself will produce the solution, even though all participants are only following their narrow self-interest and have limited knowledge about the workings of the system. That’s why market is usually far superior to planned economy.

This is the theory of the free market in a nutshell. It looks great on paper and even works in practice quite well, but it also leads to all sorts of problems when confronted with complexities of the real world.

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In his book Evolution’s arrow* John Stewart offers conclusive arguments that a free market is not always the best option. Chapter 16 of this book, titled “Limitations of Markets”, is a brilliant summary of problems with a free market. The following text will explore some of the ideas presented in that chapter, together with my commentary.

The most important thing that Stewart points out in his study of markets is the observation that markets will work properly only to the extent that individuals and corporations capture full effects of their actions on others. In his words:

“If individuals are not rewarded for all the beneficial effects of a particular action, the action will not be as profitable as other actions that are less beneficial, […] and if individuals do not bear the full cost of their harmful actions, they will not be deterred from doing things that harm others.”

In situations where this is the case, a free market produces detrimental outcomes for the society as a whole. Let’s explore now this argument in greater detail.

Goods such as home appliances, clothes and cars are normally used solely by the purchaser and cannot be enjoyed for free by anyone else. The same goes for services such as air travel, tickets for concerts and mowing your lawn. In all of these cases the full benefits of goods and services go exclusively to the purchaser, and as a result producers can obtain payment for all the benefits they create for others. In these cases a free market will provide the products and satisfy the demand.

However, a number of products are different in one important aspect:

“Some goods and services have collective effects that cannot be targeted only at those who pay for them. They have effects on many others, and it is impossible to prevent people from enjoying these effects even though they have not paid for them. It will be in the interests of individuals to free ride on these goods and services by taking them without paying. As a result, the producer will not be able to capture payment for all the beneficial effects on others of his goods or services. Goods and services that would have been profitable if all their effects were captured will not be profitable, and will not be produced in a society that relies only on markets.”

Stewart lists defense of a country as a classical example of a service with collective effects, as territory can only be defended on a continuum. Since free market would be unable to provide an adequate defense system, a government is needed to impose taxes and fund defense.

Another example of a service that free market will not provide to a satisfactory level is education. This is because good education doesn’t benefit only those people who got it, but has broader social implications. Stewart writes that specific professional education doesn’t benefit only the individual who can do his work better because of it, but also his co-workers who will be more productive, simply because they are working with and learning from someone with better skills. (Of course, it is usually much better to learn a particular skill from a professional teacher). More importantly, the society as a whole will function much better if everybody – no matter of financial status – is well educated about the common issues and can participate in democratic process.

Some other examples of services that are not handled well by a free market are “policing, the provision of safe and well-planned public areas such as parks and streets, and programs that reduce crime by rehabilitating drug addicts or by providing satisfying activities for teenagers.” All of these programs and services have “beneficial collective effects that cannot be targeted only at those who are willing to pay for them. No matter how beneficial these sorts of programs may be to a community, a free market will not provide them.”

When confronted with this failure of markets to solve certain social issues, libertarians usually invoke charity and voluntary work. Charitable contributions certainly can make a big difference in the world, but in my opinion this is not an adequate solution. And it doesn’t solve the free rider problem described above – some people will always choose to contribute disproportionately less to charity than others (or not at all), even though they could afford to be more generous, and even though they may benefit indirectly from charitable actions of others. Of course, the essence of charity is that it’s voluntary, so you cannot do anything about this.

Failure of a free market to address certain social problems and inadequacy of relying on charity makes a good case for having a public sector in some parts of the economy.

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Unregulated markets will also lead to poor outcomes when individuals or corporations do not capture all the harmful effects of their actions. Generally, this would happen when the production and/or the use of goods and services have collective effects that go beyond the producer and the consumer – for example, the production may pollute the environment, and consequently be harmful to people in general. If neither the producer nor the consumer pays the price for these harmful effects on others, the market will give them no incentive to change anything. In fact, if the producer wants to stay in business he actually cannot even afford to use more expensive technologies that pollute less, as he would have to charge higher prices and lose competitive advantage of his product. As Stewart puts it:

“The competition that ensures that consumers get goods and services at the cheapest price is a two-edged sword. It destructively ensures that individuals and firms cannot take into account the factors that the market does not, even where it would advantage the community or society greatly if they did so.”

Free market advocates would probably say that consumers have the power to correct this destructive force of markets. They are on the demand side of the equation, so if they started to demand environmentally friendly products, the supply would follow. To some extent this is correct, but I think this seriously underestimates the power of public relations spin and greenwashing. A company that would only appear to be environmentally conscious would be able to outcompete other producers who would make genuine effort to pollute less.

But there are even bigger problems than greenwashing. Some people simply don’t care enough about the environment as they have other priorities, so in a laissez-faire system you would have to accept certain levels of pollution. Then there are people that like to live in a nice and clean local environment, but don’t care much about the environment on the other side of the planet. This is actually much more common and shouldn’t even be judged too much, because it is understandable to a certain degree: if you don’t observe pollution by yourself, you can have hard time comprehending the scope of the problem. Add globalization to the mix and it becomes extremely difficult to force companies to pollute less with market mechanisms: corporations can produce (and pollute) on one continent and ship the goods elsewhere. Consumers don’t see the pollution and people that are most affected by it are not in a position to influence the market.

It’s easy to say that consumers should educate themselves about products they buy and the impact they make on the environment by consuming this or that good or service. While I support the idea of personal responsibility, it is absolutely impossible to educate yourself about everything. Fields of science and technology have become so complex and enormous in scope in the last hundred of years that you have to study them for years to understand even the basics. It is completely unreasonable to expect from the average consumer to research every product he intends to purchase and understand every ramification of his decision.

Because of all these reasons mentioned above, I’m a strong supporter of environmental regulations imposed by the government.

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The important conclusion that Stewart reaches in his chapter on the limitations of markets is that a market system doesn’t make government redundant:

“Markets are unable to ensure that citizens capture all the effects of actions that have collective effects. So ungoverned markets fail to reward and organize activities that have collective social benefits such as defense, education, and programs that build better communities. And they fail to deter pollution and other activities that cause collective harm […] Where markets fail, government action is necessary to ensure participants capture the full effects on others of their actions, and to ensure participants do not capture greater benefits than they should. Government can use taxes, laws, subsidies and other payments to try to organize the behavior and activities that would have arisen if the market was not deficient.”

Stewart makes no idealization of governments, though. He is fully aware that a government has very limited ability to perform its function effectively. Government has to rely on often incompetent and inefficient bureaucracy, and the interests of government officials will never be completely aligned with those of the general public – even in a democratic society.

What’s even worse: special interest groups can capture the government and use its powers for their own benefit. I have already written about that in my previous post (Part 4: Capitalism – A Love Story). When this happens you can kiss free market goodbye.

So, here is our catch-22: to carry out its duties government must be very powerful; it cannot be a paper tiger. But the more power the government has, the greater threat it becomes to society, if and when special interest groups capture its power.

To limit the risk of abuse, government should have no more power than what is strictly necessary to correct market deficiencies and provide services that the market could not. It seems to me that changing society for the better depends on finding this delicate balance between free market and government intervention. As well as between private ownership and collective ownership.

This series of articles will continue with the quest of finding a way toward that balance.

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Continue to Part 6: Principles of balanced governance


*Evolution’s arrow: The Direction of Evolution and the Future of Humanity – I really enjoyed reading this book, yet I remain skeptical of some of its conclusions. Still, I would recommend this book to anyone – if nothing else – for Stewart’s outside-the-box way of thinking that will challenge your existing views on life, evolution, humanity and social systems.

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Changing the Paradigm of Being, Part 4: Capitalism – A Love Story

Did you miss previous parts?

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Dollar signCapitalism – an economic system based on private ownership of the means of production and the creation of goods and services for profit – has lost some allure in recent years. However, it is important to know that capitalist systems are not all the same – there are substantial differences among them. Furthermore, the term free market is often used interchangeably with capitalism, but this is a mistake. An article Difference Between Capitalism and Free market clears the confusion:

“Free market is mainly concerned with wealth exchange while capitalism leans more on wealth creation. Free markets are a key component of capitalism although they do not fully define what capitalism is. A free market is driven by ‘demand and supply’ leading to free competition without interference while in capitalism, capital owners can at times influence the terms of trade.”

We can recognize two distinct dimensions here, which are present in the economy of every country and each runs separately on a continuum from one extreme to another (thus different combinations are possible in the economy):

  1. Private ownership (capitalism) vs. State & collective ownership (socialism)
  2. “Demand and supply” (free market) vs. State intervention (planned economy)

My position on this is rather complicated: I’m much more in favor of the free market and capitalism than socialism and planned economy. However, I strongly reject free-market capitalism in its purest, libertarian form (even though I have a positive sentiment for some libertarian positions, when not taken to the extreme). I’ll explain my position in detail:

I think that at this stage of human social, spiritual and technological development, free market is simply more efficient than a planned economy, and private ownership gives people better incentives to be productive than socialism would (folks from the Zeitgeist Movement would disagree with me here).

However, there are some parts of an economy where state ownership is perfectly reasonable. I will not discuss here at length about which areas could be defined as key state infrastructure and should therefore be in public sector – I’ll just give one example where privatization is a colossally bad idea: prison system. If you privatize prisons, you give private corporations an incentive to try to influence legislators and judges in such a way that more people would be sent to jail. More prisoners equals bigger profit. Simple. Anyone can see that this would make the whole legal system a joke and would disrupt the very fabric of society. It’s completely unacceptable, even in theory.

A functioning legal system, law enforcement institutions, and reasonable defense capabilities are a necessary part of every society. They should be exclusively in public domain and under tight democratic control. There are many other systems that could be regarded (or not) a public good – such as water resources, fire service, roads, healthcare, education, and social security. I will return to this question later in this series.

On the issue of the second economic dimension (free market vs. state intervention), I also don’t agree with libertarian position. While I’m not in favor of a planned economy, I believe that some regulation of markets is absolutely necessary – especially when public health or safety could be at risk, directly or indirectly (for example via environmental pollution).

Free market alternative seems just absurd to me: under pure free market system, restaurants would follow strict hygienic procedures voluntarily, because they would not want that their customers get sick from food poisoning, as this would lead to losing future customers and possibly get into lawsuits. So, everything is fine, right? Not exactly.

The biggest flaw in libertarian position is that it sees people as entirely rational, all-knowing creatures. But we are not. Some business owners are blinded with short-time gains and don’t even consider long-term consequences. Some are ignorant, because they are preoccupied with other work. Some just like to gamble: if we loosen sanitary measures a little, we can make more money, as probably no one will get sick anyway.

I believe that it’s simply immoral to deregulate markets to such an extent, that people’s health or lives could ever be put in danger because of that.

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One libertarian position that makes sense to me is the notion that there isn’t a problem with capitalism per se, but with the type of capitalism that we currently have – which is often not a free-market capitalism at all: in many countries, the existing economic system is closer to state capitalism, where big private corporations capture the power of the state to generate more demand for their goods and services (government contractors), exclude competitors or subsidize losses (e.g. bailout of banks).

The policy-making relationship between special interest groups (representing corporations), legislature, and executive branch of government, is known as the iron triangle. In essence this means that special interest groups give electoral and political support to certain people within the government, who in turn pay them back with friendly legislation, low regulation and special favors.

The best-known example of the iron triangle is probably the military–industrial complex in the United States, which is defined as: policy and monetary relationship between legislators (Congress), national armed forces (Pentagon), and the military industrial base (defense contractors). The sheer size of U.S. military budget is very inviting to the spread of political corruption, but what’s even more important is that the military–industrial complex is quite literally “armed and dangerous”; which is why president Dwight D. Eisenhower warned America in his farewell speech in 1961: “We must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists, and will persist.”

Yet another example of how corporations can benefit at the expense of public good is through “loopholes” in the tax code that save them tons of money. Perhaps most of loopholes are due to incompetence of legislators and their advisors, but we can be pretty sure that some are quite deliberate. The problem is only exacerbated with complicated tax code that even senators and representatives barely comprehend. In my opinion, tax code should be as simple as possible – every adult should be able to understand it.

The world increasingly resembles a corporatocracy (an economic and political system controlled by corporations or corporate interests), where money can buy legislation and pervert the free market. Add to the mix crony capitalism (preferential regulation and other favorable government intervention based on personal relationships) and you’ll get a total mess that is our current system. These dishonest practices can lead to concentration of wealth and political power in the hands of a small, well-connected elite, which by itself puts democracy in jeopardy.

As I have said earlier, I support regulation of markets where it makes sense (consumer protection, environmental regulations, etc.), and I can even live with direct government intervention (government subsidies, tariffs, state monopolies…), if it is done in a transparent way and is subject to democratic control.

However, we should fight political corruption of all shapes and sizes. I realize that it’s a fight that cannot be won; corruption will never be eradicated completely, but it can be contained.

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The challenge is twofold: firstly, there are acts that are already illegal (fraudulent business practices, corruption…), but are often – for whatever reason – not being criminally prosecuted, or sentences are inadequate to serve as a deterrent. Secondly, there are acts that are not illegal (in some countries), but should be – the prime example being “institutional corruption”, such as campaign contributions to politicians or political parties.

I believe that the corporate funding of political parties should be completely prohibited. In fact, political parties and candidates should be, for the most part, publicly financed. Private funding should be limited only to political parties’ membership fees and donations from individual citizens, which should be publicly disclosed.

There’s one type of corruption that is particularly insidious, because it’s very hard to fight against it. We can call it an implied payoff. It works like this: lobbyists try to influence a public official to take the action that would benefit a particular corporation or industry sector tremendously; during the conversation they hint, that they would be happy to hire him after he leaves his office. The official then takes the action that was proposed to him. When this official leaves his public office, they hire him for a huge amount of money.

With this type of corruption it doesn’t help much if former public officials are obliged to disclose their income for a number of years after leaving their offices, because all of their income will be earned legally. Yet we have an obvious conflict of interest here. This situation can be described with the metaphor of a revolving door.

I can understand why libertarians are so deeply frustrated with government. However, I don’t share their view that free market can solve every problem. (I will explore limitations of markets in the next part of this series).

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As soon as liberty is complete, it dies in anarchy.

– Will Durant

To resolve the problems associated with political corruption, some schools of thought advocate a society with no state at all. Anarchism has historically been an anti-capitalist movement and thus a radical left-wing ideology. Similarly, the libertarian movement has been the anti-statist wing of the socialist movement, so outside the United States, the term libertarianism is commonly considered to be synonymous with left-wing anarchism.

But in the United States, classical liberalism has largely been renamed to libertarianism, which is now generally associated with advocacy of limited government and free-market economy (as well as civil liberties and political freedom). This kind of right-wing libertarianism is a tamer version of anarcho-capitalism (free market anarchism): a radical libertarian political philosophy that advocates the elimination of the state in favor of individual sovereignty in a free market.

For right-wing libertarians a state is a necessary evil that needs to be reduced to a bare minimum, while anarchists from across the political spectrum want to outright abolish it. They believe that living in a stateless society will bring humanity the ultimate freedom and prosperity. I disagree completely.

I think that some sort of government is absolutely necessary to ensure public order and safety in a large-scale society. Modern societies cannot be compared to pre-state tribal societies where everybody knew each other (and these ancient societies shouldn’t be idealized, either).

If state was to disappear, and no other form of government took its place, we would see a huge rise in crime and civil unrest, as there would be no law enforcement. Chaos and instability would force people to organize armed neighborhood watches for protection from gangs, mafias, and ordinary criminals. Alternatively, people would pay these same gangs and mafias to “protect” them (you can substitute the word mafia with private defense agency if you like – in a world without a government that would regulate these agencies, it doesn’t make any difference). Sooner or later some powerful warlords would emerge in different areas. They would conduct occasional warfare between each other and collect “protection fees” from people living in territories they controlled. Effectively, we would return to feudalism.

That’s just one of the possible scenarios of what could happen if state was to disappear. I’m not saying that this hypothetical example is even the most probable. The point that I want to make is that anarchy is an unstable state (no pun intended) – sooner or later its instability will bring about some sort of government; but it may not be the kind that we would like.

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Continue to Part 5: Limitations of markets.