Failure in markets and politics

At the core of my new book, Robust Political Economy: Classical Liberalism and the Future of Public Policy, is a very basic but oft neglected idea – ‘failure’ is endemic to all social institutions because human beings are imperfect. By far the most important imperfection is that people are cognitively limited and thus they make mistakes. Robust institutions, therefore, are not those that eliminate failure, but those that reduce the consequences of inevitable human errors. Before we determine that a particular set of institutions ‘fail’ meanwhile, we must explain how and why an alternative set of institutions can do better.

Basic as this insight may appear, most public policy discussion assumes that government action is necessary to ‘correct’ for ‘failure’ in markets and civil society without adequate consideration of equivalent if not worse failures in politics. Nowhere has this tendency been more apparent than in the claim that the financial Armageddon of 2008 was a ‘systemic failure’ of ‘capitalism’ and that moves to regulate the operation of markets are now required to reduce the prospect of similar failures in the future. What such arguments neglect to explain is why the prospect of ‘systemic failure’ in the process of regulating capitalism is considered any less likely than the market failure it is supposed to cure.

Contrary to fashionable commentary, the classical liberal tradition has never claimed that markets are ‘perfect’ institutions populated by fully rational agents. Neither has it denied the possibility of ‘systemic’ market failure. In a world where learning via imitation is crucial for transmitting knowledge and where ‘herding’ behaviour may be prevalent it is entirely possible that many actors may learn the wrong things and simultaneously invest in mistaken ventures – as the sub-prime bubble so clearly demonstrated. The great advantage of markets, however, is that they reduce the possibility of such failure because potentially erroneous decisions are not backed by the force of law – private property affords those who dissent from the way the crowd is behaving the liberty to act differently.

By contrast the regulatory process which so many are now demanding should discipline markets, is not subject to an equivalent process of competitive testing. It is in the very nature of regulation that decisions are imposed on society as a whole in order to reduce behavioural heterogeneity. But if regulators are no more omniscient or rational than anybody else – and there is no reason to suppose that they are – then the consequences of any errors they make will be more far-reaching precisely because their decisions are backed by coercive authority…

Read the full article on the Pileus blog.

Mark Pennington’s new book, Robust Political Economy: Classical Liberalism and the Future of Public Policy, will be launched at the IEA on 20 January 2011. Click here for details of the event.

IEA Fellow of Political Economy

Professor Mark Pennington is a fellow in Political Economy at the Institute of Economic Affairs and is also a lecturer in Political Economy at King's College, London. Mark holds a PhD from the London School of Economics, has been published in a number of publications and is co-editor of The Review of Austrian Economics.

7 thoughts on “Failure in markets and politics”

  1. Posted 10/01/2011 at 16:54 | Permalink

    Excellent (short) piece- I’d like to hear more about Dr Pennington’s book. I’ve tried making this argument myself – i.e. that the force of law is different to the ‘force’ which producers or market makers in a free market can exert, even if they are monopolists (legitimate monopolists, not government constructed ones). The interventionist riposte seems to be that there is some sort of compulsory power which non-state and non-violent entities (say, a large or monopolistical/oligarchical corporation) can exert and which ought to be checked by government action. Wage or price-setting companies will, they believe, exert this ‘power’ over employees/consumers. This belief seems to lie at the root of much interventionism – the view that markets cannot be left to run themselves. This view is also held where markets exhibit large externalities as well, especially positive ones where interest groups wish the state will provide more of the good in question. I hope that these are the sort of arguments Dr Pennington addresses?

  2. Posted 10/01/2011 at 20:07 | Permalink

    Mark is not a Christian (or even a theist) but I just thought i would point out that I often make these sorts of arguments (in slightly different language) to Christian audiences and the Christian socialists find them very difficult to refute. Human imperfection is a core Christian belief and we need to have an economic order that takes that fact into account. Both the last pope and Hayek traced the grave errors of the twentieth century back to Descartes.

    On a minor point, I would not agree with Mark that sub prime shows problems of herding in markets (though there may be such problems). It shows people reacting rationally when they are shletered from the consequences of their own decisions as both banks and the securitisation institutions were.

  3. Posted 10/01/2011 at 22:50 | Permalink

    Dear Whig,
    Many thanks for your comment – and yes several chapters in the book deal explicitly with the question of externalities both in the context of ‘public services’ and in the domain of environmental protection. A couple of my other posts in the next week or so will touch on these issues – though they are set out at much fuller length in the book.
    Thanks again
    Mark P.

  4. Posted 11/01/2011 at 11:56 | Permalink

    After reading the blogpost, I’d already decided to buy Mark Pennington’s book, but at the risk of wandering slightly off topic, I’d like to thank him for drawing my attention, via the full post on the Pileus blog, to Jeffrey Friedman’s essay “A Crisis of Politics, not Economics – Complexity, Ignorance and Policy Failure”. An intended mere quick glance for future reference at approx last night turned into reading it all the way through until, such was its quality and clarity.

    As a former (until my late-2009 retirement) regulatory and corporate governance practitioner in the banking sector, and a reasonably knowledgeable (but strictly amateur) aficionado of political economy, I’ve spent much time in the past two years trying to convince friends who really should know better that one-dimensional, simplistic explanations for the crisis that serve, primarily, superficial political expediency, are wholly incomplete.

    At times I’ve struggled to convey the concepts that liberal capitalism is not predicated exclusively on the presumed omniscience of all economic actors but admits and adjusts for the effects of imperfect knowledge and markets: that the inevitability of human fallibility actually makes heterogeneity among business models and risk assessment theory within a competitive market a better preventive and mitigator of systemic failure: and that homogeneity across governmental monetary and regulatory policy makes it no less immune to potentially catastrophic error.

    So it’s a pleasure to be introduced to two works which articulate these ideas so clearly and accessibly. They will be joining Gillian Tett’s “Fools Gold”, Kevin Dowd & Martin Hutchinson’s “Alchemists of Loss” and Thomas Woods’ “Meltdown” as the principal authorities on my bookshelf.

  5. Posted 11/01/2011 at 14:41 | Permalink

    Many thanks for buying the book! I couldn’t agree more – the Jeff Frideman piece should be essential reading for both market liberals and social democratic critics – it lays out the terms of where the debate should be rather than the superficial nonsense that passes for commentary on this subject. If you are interested in his earlier work I recommend an essay, also in Critical Review, entitled ‘Prophets of Ignorance: Popper, Weber and Hayek. I have an article in the latest issue of the journal entitled ‘Democracy and the Deliberative Conceit’, which is on a similar theme. Thanks again. Mark P.

  6. Posted 11/01/2011 at 23:17 | Permalink

    Dear Mark, many thanks for the pointers towards both your article in the latest issue of CR and Jeffrey Friedman’s earlier pieces – I’m very interested indeed. [On the latter, I assume you mean the one entitled “Popper, Weber and Hayek: The Epistemology and Politics of Ignorance” (CR Vol 17, Issues 1-2, 2005) rather than the later “Ignorance as a Starting Point – From Modest Epistemology to Realistic Political Theory” (CR Vol 19, Issue 1, Jan 2007)]. Michael St G.

  7. Posted 12/01/2011 at 13:41 | Permalink

    That’s right Michael – its a long piece, but a very good one. In fact I’d recommend just about anything Jeff has written on this subject in the last 5 years. MP

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