The Trouble with Markets

Every day the media reports movements that have occurred in the stock markets and pundits and commentators explain to the people the reasons for those changes. And every day, millions of viewers, listeners and readers think to themselves “If you’re so smart, why didn’t you tell me before it happened?”

After all, the ‘laws’ of supply and demand are extremely simple and they are all you need to understand how markets work. A rise in demand (or fall in supply) increases the price which increases supply till a new equilibrium is established; conversely a fall in demand (or increase in supply) reduces price which reduces supply till the new equilibrium is settled. Nothing could be simpler. Markets are efficient; markets work; they are inherently stable.

In the case of markets for physical products it seems to work pretty well. The invisible hand of the market organises resources so as to enable supply and demand to be brought into some, no doubt approximate, equilibrium within reasonable time scales. It enables the manufacture, involving hundreds, if not thousands, of sub-contractors and suppliers, to be brought together from all over the globe, with reasonable efficiency, to produce appropriate quantities of the most complex products at a reasonable price. It has been seen to far outperform the achievements of central planning. But it is not perfect.

In the real economy, it takes time to build productive capacity, or to close it down and it takes time to change technologies, or suppliers or find new customers etc. These are frictions which render the market less efficient, damping down the effect of market forces but not preventing them having their ultimate effect.

Economic orthodoxy holds that such forces work for all markets, real and financial alike, but clearly this is wrong. Where supply is fixed it can’t be adjusted in response to increases or reductions in demand. Ricardo noted rare works of art, fine vintage wine and special land which could produce unique outputs. In such cases the prices were dependent to a considerable extent on rarity value, rather than on real fundamental considerations. They could not be moderated by adjustments in supply. The demand for such products and the prices that would be paid, were dependent more on the expectation of future demand and prices. Such markets were speculative rather than efficient.

As well as those items Ricardo identified, the market for company shares, options, futures and various derivative products, all fall into this essentially speculative category. George Cooper (‘The Origin of Financial Crises’) points out that rather than being efficient and stable, such markets are inherently unstable and prone to speculative bubbles. They lack the frictions of real product markets which damp down speculative effect. Investors will continue to invest while ever he believes tomorrow’s price will be higher than today’s, but fear of a fall in price will surely be self fulfilling.

The distinction between banks operating in efficient and those engaged in speculative markets used to be made by legislation (eg in America the Glass-Steagall Act of 1932). Banks investing to support firms and individuals in the real economy were separate from those banks which invested in speculative markets.

After this current bust, it might be expected that governments and central banks will introduce some frictions in these markets, as suggested in ‘The Rise and Fall of Management’. Consideration is also being given to re-imposing the Glass-Steagall type distinction by breaking up those firms which are too big to be allowed to fail.

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