Sunday, July 11, 2010


Freefall is economist Joseph Stiglitz's book on "America, Free Markets and the Shrinking of the World Economy".  Reading it is deja vu

How so? Over on the liberal Pakistani blogs, there is a small crowd that finds the solution of every problem in the (unspecified) correct implementation of Islam.  Whether it is an issue of women losing custody rights to their children in Pakistani family law, or the bombing of shrines and the persecution of minorities, or it is constitutional problems,  Islam, implemented correctly, will fix it.  Stiglitz seems to be pointing out that the same orthodoxy attends to all of America's problems - financial, economic, and even environmental problems: The unregulated free market will fix the problem.   This even when economics is supposed to be science, not a religion nor an ideology.

There is ample empirical evidence that the markets are imperfect; just the latest, ongoing crisis suffices to show that, and Stiglitz does that in ample measure.

What is very interesting is that the imperfection of the markets is understood theoretically as well; and therefore the outlines of what role the government must play - in order to alleviate these flaws - is also there.  But strong ideological convictions coupled with the political power of the financial and corporate America work to prevent the problems from having an engineering solution.  Just as more and more Islam will save Pakistan more and more free markets will save America.

For my future reference and perhaps for your edification, I want to save one passage here from chapter nine.

The mainstream of theoretical economics for more than a hundred years has been dominated by what is called the Walrasian or general equilibrium model, named after the French mathematician and economist Leon Walras, who first articulated that model in 1874.  He described the economy as an equilibrium - like Newtonian equilibrium in physics - with prices and quantities determined by balancing supply and demand.

One of the great achievements of modern economics was to use that model to assess the efficiency of the market economy.   In the same year that America declared its independence, Adam Smith published his famous treatise, The Wealth of Nations, in which he argued that the pursuit of self-interest would lead to the general well-being of society.  A hundred and seventy-five years later, Kenneth Arow and Gerard Debreu, using the Walrasian model, explained what was required for Smith's insight to be correct.

The economy was efficient, in some sense that no one could be made better off without making someone else worse off, only under very restrictive conditions.   Markets had to be more than just competitive: there had to be a full set of insurance markets (you could buy insurance against every conceivable risk), capital markets had to be perfect (you could borrow as much as you wanted for as long as you wanted at competitive, risk-adjusted, interest rates), there could be no externalities or public goods.  The circumstances under which markets failed to produce efficient outcomes were referred to, quite naturally, as market failures.

As often happens in science, their work inspired vast amounts of research.   The conditions under which they had shown that the economy was efficient were so restrictive as to quesetion the relevance of the view that markets were efficient at all.   Some failures, though important, required only limited government intervention.  Yes, the market by itself would lead to an externality like too much pollution, but the government could restrict pollution or charge the firms for emitting pollution.   Markets could still solve most of society's economic problems.
Quite often in science certain assumptions are so strongly held or are so ingrained in the thinking that no one realizes that they are only assumptions.  When Debreu listed the assumptions under which he had proved the efficiency of the market, he didn't mention the implicit assumption that everyone hada perfect information.  Moreover, he assumed that commodities or goods were uniform, whether houses or cars, a kind of Platonic ideal....Similarly, Debreu treated labor just like any other commodity.  All unskilled workers were identical, for example......Arrow and Debrue had assumed there was no innovation; if there was technological progress, its pace was unaffected by any decision made within the economy......

The answers tot he question about the generality of the results of the Walrasian model - whether they were sensitive to the assumptions of perfect information, imperfect risk markets, no innovation and so forth - were made plain in a series of papers I wrote with several coauthors, most notably my Columbia University colleague Bruce Greenwald.  We showed, in effect, that Arrow and Debreu had established the singular set of conditions under which markets were efficient.  When those conditions were not satisfied, there were always some government interventions that could make everyone better off. Our work also showed that even small information imperfections (and especially information asymmetries - where one person knew information that others didn't) dramatically changed the nature of the market equilibrium. ....It simply wasn't true that a world with almost perfect information was very similar to one in which there was perfect information.   By the same token, while it was true that competition could provide a spur for innovation, it was not true that the markets were efficient in determining the ideal amount of spending or the best direction of research.

Academic economists on the right did not receive these new results with enthusiasm.  At first, they attempted to look for hidden assumptions, mistakes in the mathematics or alternative formulations....These attempts at refutation have all failed: a quarter century after the publication of our work, the results still stand.

Conservative economists were left with two choices.  They could argue that the issues we had raised, such as thoose associated with information imperfections, were theoretical niceties.  They reverted to the old argument that with perfect information (and all the other assumptions) markets are efficient, and they simply asserted that a world with only a limited degree of information imperfection was accordingly almost perfectly efficient.  They ignored analyses that showed that even small information asymmetries could have a very big effect.  They also simply ignored the many aspects of the real economy - including the repeated episodes of massive unemployment - that could not be explained by models with perfect information.  Instead, they focussed on a few facts that were consistent with their models.  Yet that had no way of proving that the market was almost efficient.  It was a theological position, and it soon became clear that no piece of evidence or theoretical research would budge them from it. {emphasis added}

The second approach conceded on the economics but moved on to politics: yes, markets are inefficient, but government is worse.   It was a curious line of thinking: suddenly economists had become political scientiests.  Their economic models and analyses were flawed, and their political models and analyses proved no better.  In all successful countries, the United States included, government has played a key role in that success....

Government has played an especially large role in the highly successful economies of East Asia.  The increases in per capita incomes there during the past three to four decades have been historically unprecedented.  In almost all of these countries, government took an active role in promoting development through market mechanisms.   China has grown at an average rate of 9.7 per cent per year for more than thirty years, and has succeeded in bringing hundreds of millions out of poverty.  Japan's government-led growth spurt was earlier, but Singapore, Korea, Malaysia, and a host of other countries followed and adapted Japan's strategy and saw per capita incomes increase eightfold in a quarter century.

Of course, governments, like markets and humans, are fallible.  But in East Asia, and elsewhere, the success far outweighed the failures.  Enhancing economic performance requires improving both markets and government.   There is no basis to the argument that because governments sometimes fail, they should not intervene in the markets when the markets fail - just as there is no basis to the converse argument, that because markets sometimes fail they should be abandoned.