Saturday, 3 October 2009

Is The Free Market Era Over?

Are we moving back to the Keynesian economic approach with all these bailouts around the world, or should we define a new paradigm for economics after the world financial crisis has demonstrated the limits of the free market with its invisible hand?

The failure of economists, businesses and politics to predict and manage the recent catastrophic crash of the world’s financial system has triggered a re-evaluation of the whole basis of current economic theories.

Since the end of the 20th century, economics has been dominated by the classical paradigm based on notions of rational consumers making rational choices in a simple supply/demand world of finite resources, with prices constrained by decreasing returns; all driving the economy to an optimal equilibrium point.

So far, this classical economic approach, initially conceived by Adam Smith, has been working well. Indeed, in normal circumstances people are generally rational. The market automatically allocates resources and controls excesses in an optimum way with minimum oversight or outside regulation required. Under this model, the economy has been working as an equilibrium system; a system that moves from one equilibrium point to another, driven by shocks from external disruptions – technological, political, cultural etc- but always coming to rest in a natural equilibrium state.

But in extreme or complex circumstances, people and the system tend to behave/react differently including consumers, banks, financial institutions, stock market traders and governments. And perhaps the most critically flawed assumption of this classical model has been that economic agents are generally rational. Whereas, we observed recently insolvent households taking mortgages that they could not afford, banks lending to insolvent households without conditions etc. leading us to the subprime crisis …we know the result.

From this flawed assumption, the following question is raised: is it the theory that should be questioned or is it one of its hypotheses (namely the rationality)? Some would argue that questioning the hypothesis is questioning the theory. Anyway…

To tackle this current crisis, Some voices have been suggesting more regulations as this would frame the rationality of economic agents and force them to behave in a more sensible way; some others have been calling for more government intervention in order to set rules and monitor the whole system (with a big bailout here and there when necessary).

Wait a minute, if I am not mistaken, this would mean going back to the Keynesian approach of economics?

Indeed, according to Keynes, Excesses or deficiencies in aggregate demand are the rule and not the exception. Therefore, for Keynes, government intervention is needed to eliminate recessionary and inflationary gaps: laissez faire, laissez passer policies should be replaced with an active interventionist policy by the central government. Keynesians believe that monetary and especially fiscal policies are required; otherwise disasters like the Great Depression that followed the First World War or the crisis that we are facing now would certainly reoccur.

There we are! Was Keynes right? Or should I say, is Keynes right?

Not so sure. If the Keynesian prescription for active government involvement in the economy was warranted after the World War I, in the past few decades, government intervention has become less desirable…and some argue, less necessary. Indeed, since the World War II, we have experienced six decades of growing competition. The once oligopolistic market structures in autos, telecommunications, services, etc. have become very competitive, and government policies increasingly have impact across borders. Furthermore, nowadays, banks, financial institutions, manufacturers, energy suppliers are increasingly internationally managed; following Keynesian policies with their fundamentally collectivist, centralized approach would just lead to more trouble. For instance, if a multinational that has networks over the world is centrally managed in the way Keynes suggests, the collapse of one element of the network in one country would easily make the whole system topple like dominoes around the world as we have just experienced.

In short, if the Keynesian approach was likely to work after the First World War, the crash that we are facing now is far more serious than the Great Depression of 1929 as it can not be contained within borders or so easily solved by mass bailout, mass lending or big government investments/ job creation programs.

The need of an evolutionary or new economic model…

Instead of going back to the Lord Keynes School of thought, maybe we should rather think of a new model that would fit with the globalisation of markets, and that would -to some extent- set some global regulations to frame agent behaviours around the world, but ultimately leave the market free.

This new paradigm should be based on the principle that economies, markets, regulations, globalisation, as well as the internet (a new and very important component), consumers, enterprises and the brain all form complex adaptive systems in which agents dynamically and rationally interact, process information and adapt their behaviour to a constantly changing environment- but always reach a final equilibrium.

In this new model, and unlike the strict distinction between the too much and the too little government approach, the market should rather be a combination of an “invisible hand” and necessary regulatory elements (government that would not impede competition and risk) with the mindset that the market is henceforth a small village that needs to adapt to the constantly changing global environment.

To conclude this paper, I strongly believe that free market still has a future, and markets are still perfectly self-regulating systems. They are only becoming enormously complex adaptive networks – too complex and interdependent for economists and governments to control or even understand.

Ultimately, every individual/company is continually exerting himself to find out the most advantageous employment for whatever capital he / it can command. Therefore, by pursuing our own interest we benefit society more than when we directly attempt to benefit society. According to Adam Smith, we are all led by an “invisible hand” to benefit society even as our intent is to benefit ourselves.

Invisible Hand Theory proposed by Adam Smith in the 18th century, really helps to explain how the market economy works even with its chaotic nature.

Personally, I view the Invisible Hand theory as the economic counterpart of democratic theory. Just as, in a democracy, people are supposed to choose the best leaders for themselves, the Invisible Hand theory presumes that people chose to produce and consume in the most efficient manner when given a free hand.

So in practice, markets may still end up being little bit chaotic due to the irrationality of agents or inadequate information shared within the system, but that is not because the Invisible Hand theory or the free market model is inaccurate.