The end of free market fundamentalism not of the mixed economy

Capitalism these days does not resemble the “free market” model conceptualised by critics on the left. Economies have substantial public sectors - in Australia, government absorbs one third of output. It is best to refer to “mixed economies” with dominant private sectors but large public sectors providing public goods, redistributing incomes, stabilising the economy and delivering a safety net protecting the vulnerable. Where the boundary should be drawn on public activity lies at the centre of political debate but “mixed economies” not laissez faire are the dominant global economic system.

As such, capitalism has performed well raising many societies from poverty to prosperity. For example, numbers earning less than $1US per day fell by one-half to one-third of their 1970 levels by 2000. Australia experienced continuous, strong growth for 17 years with improving living standards, low inflation and unemployment in 2007 at its lowest level in 34 years.

The success of capitalism is a source of recent problems. With prosperity those aspiring to accumulate wealth have developed optimistic biases borrowing incautiously to purchase assets in the expectation that values would steadily increase with prosperity. Those with longer memories have sounded warnings about “irrational exuberance” but have typically been ignored.

The current crisis has ended the exuberance and raised questions about the staying power of capitalism, the extent of increased government control and the likely regulatory reforms. Some question whether capitalism should be replaced by socialism with party bureaucrats directing investment and consumption. For sane people the question is what are the regulatory lessons? “Free market fundamentalism” (FMF) has a limited role in thinking about how financial markets should operate but capitalism as a whole has not failed.

Indeed, almost no economists subscribe to FMF. Most regard libertarianism as an extreme doctrine akin to the ideology of doctrinaire socialists with their insistence that markets can never work so governments must run everything. For most economists the “mixed economy” with social democracy imposed to “civilise capitalism” and with a preference for liberalising trade and a dislike of “nanny state” paternalism provides a core model.

Most economists I know learnt from a text like Paul Samuelson's Economics. This text - and the imitators which followed it - acknowledged the role of markets but emphasised they often do not work well. Market failures arise with certain public goods best provided by natural monopolies. Monopoly power itself should be regulated. Moreover, Samuelson as an interpreter of Keynes saw the imperative for active macroeconomic management. As Samuelson's students, most of us accept Keynes’ view that the economy cannot be relied on to clear markets implying a need for regulation.

In the 1970s and the 1980s some economists blamed high inflation and unemployment on Keynes. The argument was that governments, by “pump priming” would create inflation which would become built into expectations leading to the need for restrictive monetary policies which would drive unemployment. This largely correct analysis is not an argument for FMF but provides a case for moderate monetary expansion, for targeting inflation and for using monetary policy sparingly.

Since Samuelson wrote his textbook, economists have become more concerned with uncertainty in markets and consequent prospects for market failure. Often these are agency problems where market participants take advantage of private information to engineer good outcomes at society’s expense. Then contrary to Gekko's dictum, greed is not good. It does not drive the social advantage.

Concentrating on the US we can discern conflict-of-interest issues as factors in the current crisis:

1. There have been agency problems in US mortgage markets partly due to brokers who provided mortgages and received a commission based on loans sold not loans successfully repaid. These brokers had incentives to lend to non-credit worthy borrowers because this maximised their advantage but left society exposed to huge risks.

This outcome was fed in part by US attempts to increase home ownership through an attack on underwriting standards http://www.independent.org/pdf/policy_reports/2008-10-03-trainwreck.pdf. Academics applauded this decline in standards as innovatory financing increasing home ownership among poor groups. Resulting foreclosures reflected this misplaced social romanticism. In fact, foreclosures began in 2006 before the dramatic decline in US property prices when the US economy was strong. The surge in foreclosures in 2008 - in prime and subprime markets - increased pressure on property prices and worsened the crisis.

The crisis is not primarily of bankruptcy and bad debts. US mortgage and credit card losses could have been paid for by amounts already contributed to bailouts. The problem is fear that loans may be awarded to those with solvency problems - those seeking loans often have solvency concerns. Hence there has emerged a freeze on lending crippling the economy. This fear can be addressed by restoring confidence through public guarantees and through governments taking equity in institutions to improve market viability.