The Hindu Business Line : Free markets: Integrity a necessary condition

The desirability of free markets and their outcomes are based on a number of assumptions, involving perfect competition, rational human beings, no marked inequalities in income, wealth and opportunity and externalities, e.g., pollution, environmental damage, etc.

In a capitalist economy in which investment, production and pricing decisions are made by businessmen, theory tells us how these variables are determined and behave over time.

In socialist economies, all assets are State-owned and all economic and financial decisions are made by the State.

After the collapse of Communism, there are barely any examples of socialist systems, barring perhaps the unfortunate cases of Cuba and North Korea.

Huge success

Capitalism has succeeded beyond its wildest dreams in America, Europe and Japan (although there are significant differences in the quality of life, the latter two scoring much higher on human development indices).

No wonder it was touted as the way to go in the endless advice dished out by the US and institutions such as the World Bank and the IMF to poor countries.

What caused the current, devastating systemic crash in the icons of free markets?

It was not supposed to happen. Markets are self-correcting (and, in the modern belief, self-regulating) and will, left to themselves, reach an ‘equilibrium’ – a sort of economic nirvana in which there is utter peace in product, factor and financial markets.

Savings and investment, demand and supply, are in perfect balance and there is no involuntary unemployment.

Any attempt to disturb the equilibrium is not ‘pareto optimal’, i.e., no one can be made better off except at the expense of another.

For this ideal outcome in exchange of goods and services in free markets, buyers and sellers, apart from being perfectly rational, are equal in bargaining power and access to and understanding information. It seems the fatal flaws lie here.

Fatal flaws

The unfortunate borrowers in mortgages were induced to do so by low starting ‘teaser’ interest rates, downplaying the risk of rates adjusting sharply upward later.

And, of course, they were led to believe that they were buying an ever-appreciating home.

Obliging raters

Playing a catalytic role were obliging credit rating agencies, which enabled original lenders to get the dodgy loans they made, off their books quickly.

It was all so convincing that the financial intermediaries - the biggest commercial and investment banks and hedge funds - decided they wanted all the action for themselves. That became their undoing.

Economic theory takes individuals as the unit of decision-making and presumes they act in their best self interest.

A wrong step, a mistake, has potentially damaging consequences, threatening personal financial well-being.

Asymmetry

But a trader working in a large financial institution exhibits a very different behavioural pattern, thanks to a distorted reward system in which he earns huge bonuses if his trades are right and only loses his job even if he wipes out the balance sheet - an asymmetry widely commented upon much before the current crisis broke out and the consequence of separation of ownership and management in the typical large modern firm.

Economists forgot to add integrity to the list of assumptions for the well-being and functioning of free market economies.

More Stories on : Economy | Financial Markets | Financial Scan

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page