Markets should not be left to run themselves

We should manage the economy the way we manage life, and always be aware that the best-laid plans might go awry.

Markets are powerful. They promote innovation. As Hayek observed, they allow vast amounts of information to be processed, facilitating the economic process. However, competitive markets also eliminate competitors and sometimes they drive destructive booms and crashes.

With the election of a Coalition government there has been the usual surge of talk about freeing up markets, and Australia being ''open for business''. On the other hand, the entry of a giant foreign competitor into our grain market has been blocked by the government, presumably at the behest of the Nationals.

Although there is evidently some range in mainstream views, it has become almost embedded in our culture that free markets are generally a good thing. But is this view justifiable?

The little-recognised truth is this: there is no sound basis at all, in economic theory or in practice, for expecting free markets to be beneficial, or harmful for that matter. We simply cannot say anything general about free markets, we can only observe and respond to individual cases.

In practice, the free-market era, since 1980, has never measured up to the success of the postwar economy. The common claim of a postwar bounce because of pent-up demand might apply for five or 10 years, but would be hard to justify for 25 years.

In any case there was widespread concern at the time the economy would return to depression, pent-up demand or not. It seems the economy was just well managed by the much more ''interventionist'' postwar governments. This clearly contradicts the claim that government involvement is necessarily bad.


The claimed theoretical basis for the superiority of free markets is the so-called neoclassical theory. This theory concludes that, under severely restrictive assumptions, markets are self-stabilising, and at equilibrium they make the most efficient use of resources. Unfortunately, the neoclassical theory applies in a fictional world so abstract it has no useful relevance to real modern economies.

For example, in the neoclassical world we are all supposed to be able to accurately assess the probabilities of all future events. We are also supposed to be rational calculators, or what I have called calculating reptiles, with no social nature at all. In this fictional world we are not influenced by social or psychological forces, so marketing and advertising would be largely ineffectual. Also there must be no economies of scale.

The central prediction of the neoclassical theory is a ''general equilibrium'', in which all supplies balance all demands. If this were true, market crashes could be induced only by external forces. Yet the October 1987 financial market crash was clearly driven internally. There were no wars or calamities that suddenly disrupted the real, productive economy. Similarly, the 2007-08 crash was driven by excessive piles of debt, that collapsed under their own weight.

The reason the mainstream economics profession failed to see the 2007 crash coming was its adherence to this abstract equilibrium theory, and to computer models that even fail to include the obvious (to others) effects of debt and money.

More realistic assumptions yield radically different theoretical results, in which instabilities of many kinds permeate the economy. For example, economies of scale allowed Henry Ford and Microsoft to grow exponentially, eliminate competitors and dominate their industries. Globally, many industries are dominated by a few giant corporations with immense market power.

Our social nature leads to destabilising herd behaviours, manifest as consumer fads and financial market stampedes. Market psychologists manipulate our fears and lusts with ridiculous ease to sell masses of useless or shonky goods, despoiling the planet in the process.

Systems scientists can recognise a modern economy, full of such instabilities, as a far-from-equilibrium self-organising system. The tidy neoclassical equilibrium theory does not even begin to be a useful approximation to such an economy.

Such self-organising systems are rather messier, and not everything about them is predictable. Nevertheless they typically have some regularities, and a recognisable character. In this respect they resemble living systems, which is no coincidence, because living systems are the best exemplars of self-organising systems.

So we should deal with an economy the way we deal with life. Understand the general character of the economy, use its regularities to help with planning and guidance, but always be aware our best-laid plans might go awry.

In this kind of economy there is no general equilibrium, no assurance of optimality. A free market might yield good results, or not, and it might be efficient, or not. We have to look at individual cases and judge as best we can.

If a market is behaving badly, we can manage it by adjusting the incentives that apply. If a resource is being over-exploited, we might add a charge on its use. If a new and beneficial technology is struggling, we might subsidise it until it is established.

There are many existing perverse incentives, intentional or inadvertent, so we pay extra to make things worse. If we only eliminated them the economy might already dramatically increase the efficiency with which it improves our lives.

We already manage incentives, but incoherently. We also regulate hazardous activities. There is nothing sinister or magic about managing markets. We just need to learn to do it more systematically and without the baggage of an old and irrelevant meme that says managing markets is bad.

Geoff Davies is a scientist, author and commentator. His most recent book is Sack the Economists and Disband Their Departments.