Beyond Mechanical Markets

"This book has had a very big impact on the economics profession since it was published 18 months ago, and justifiably so. It takes apart in a detailed and academic way – without being too technical – the economic assumptions which are at the root of all the issues discussed by all the other authors I have picked. Take Europe, which we have just been discussing. The biggest mistake Germany is now making is trying to build the future of Europe on an outdated economic theory. Namely, the doctrine that monetary management must be – and can be – completely separated from politics. This is expressed by Merkel’s quasi-religious obsession with “protecting the political independence” of the European Central Bank. This doctrine is founded on an intellectual revolution that occurred in academic economics in the 1970s – to put it in tabloid terms, the victory of monetarism over Keynesian economics. This was a revolution based on two key phrases: “Efficient markets” and “rational expectations”. The idea was that if you had markets that were efficient and competitive – if there was no cheating or insider trading, and if all traders behaved rationally in their own self-interest – not only would this system create profitable businesses, but it would also create a national or global economy that was automatically self-stabilising. In contrast to the Keynesian view, a fully deregulated and competitive economy would need no government intervention to moderate business cycles and ensure full employment. The only role for the central banks would be to focus on inflation and keep prices stable – the market would take care of everything else. This “neo-classical” monetarist economic theory, which claimed to refute the conclusions of Keynesian economics, was absolutely fundamental to the political transformation that occurred from 1979 onwards with Thatcherism and Reaganomics. All the slogans – “You can’t buck the market”, “The market is always right”, “Government shouldn’t pick winners” – ultimately came back to the theories of efficient markets and rational expectations. Frydman and Goldberg demolish that theory in a more fundamental way than anybody has done since Keynes. The main new element they bring to the demolition of neo-classical theory is uncertainty, and the impossibility of perfect knowledge. If you go back to the roots of the monetarist revolution in the 1970s, you find that all its conclusions depend on the assumption that profit-motivated individuals operating in free and competitive markets will make the best possible decisions about the allocation of resources. Frydman and Goldberg explain that this claim of optimal decisions by the markets is simply untrue, unless we also assume that perfect knowledge of reality is possible, at least in theory – and not just about the present, but about the forces shaping the future. If such perfect knowledge does not exist, even in theory, then the claims about self-stabilising markets at root of most economic policy since the early 1980s are false. And if perfect knowledge did exist, then ironically Communist central planning would work as well as a market system. All you would need is a computer large enough to take into account all this knowledge, and it would be able to plan the economy. The reason you need markets is precisely because it’s impossible to know what the future will hold. Therefore, markets are a system of experimentation – and they will only work properly if non-market decisions, made by regulators and ultimately by politicians, set some bounds within which market prices can be allowed to freely fluctuate. This is a very important and profound insight which will ultimately undermine not just the structure of academic economics, but also the way in which people think about the relationship between markets and government. That’s right. What this analysis emphasises is that the very idea of perfect, efficient markets is logically incoherent. The problem lies not in any particular imperfection – like insider trading, or lack of competition – but in the fact that markets process information that is too complex to be judged as right or wrong, and must make predictions about the future which can never be objectively predicted, even in terms of probabilities. This means that booms and busts that appear irrational with hindsight are usually quite rational at the time – a point I also make in my book. Moreover, there is nothing irrational or undesirable about financial speculation. Speculation is a necessary part of competitive markets. If you eliminate speculation completely, you get the dead world of Soviet central planning. Price volatility and financial speculation are necessary features of the market system. But politics needs to step in, to prevent this volatility and speculation from getting too far out of hand. It was not greed and irrationality that turned the routine financial bubble of the last decade into a global disaster. It was the quasi-religious belief among politicians that “the market is always right”. This market fundamentalist doctrine rested on academic theories that took economics by storm in the 1980s. Frydman and Goldberg show that these theories were not just empirically false and dangerous in political practice – they were logically incoherent too. December 24, 2009. Updated: September 12, 2018 Five Books aims to keep its book recommendations and interviews up to date. If you are the interviewee and would like to update your choice of books (or even just what you say about them) please email us at [email protected] Support Five Books Five Books interviews are expensive to produce. If you've enjoyed this interview, please support us by donating a small amount ."