The Problem with Free Markets? Look in the Mirror

Robert H. Frank is an economist at Cornell University and co-director of the Paduano Seminar in Business Ethics at the Stern School of Business at New York University. He has an interesting Op Ed in today's New York Times (here). The title is: "The Flaw in Free Markets: Humans".

Prof. Frank is of the opinion that human motivation is the ultimate defect in the theory of free market economics. The Adam Smith concept of the invisible hand, the collective effect of all self-interests guiding economic activity to societal good is fundamentally flawed. It is not flawed because of assumptions about what humans fundamentally want to do (survive and prosper). It is flawed because the assumptions failed to recognize factors that determine the individual perspectives on what it takes to survive and prosper. These factors are externalities to the generally accepted principles of free markets. (For a discussion of economic externalities, see Wikipedia here.)

There are two factors that relate to the fatal flaws that have brought us to this point in economic time. Both relate to competition. No, not lack of competition, but, Prof. Frank says, too much competition. His words explain what he means, and I'll start with his first flaw:

First, those models assume that rewards depend only on absolute performance, but in the real world, payoffs are often tightly linked to relative performance. When a valuable new piece of information becomes available to the investment community, for example, the lion’s share of the gain goes to whoever trades on it first. For an individual firm like Goldman Sachs, it is thus completely rational to invest millions of dollars in computer systems that can execute stock trades even a few seconds faster than others. But rivals inevitably respond with similar investments. Taken together, these expenditures are wasteful in the same way that military arms races are.

This relates to the observable fact that we are accumulating more and more debt for less and less growth. This was pointed out in a Seeking Alpha article by Faisal Humayun (here) and in my earlier article "The Declining Usefulness of Debt" (here). The entire problem can be visualized with the following graph:

In the example given by Frank, the Goldman investment was very productive, but the money spent by competitors to compete with the Goldman innovation had very poor marginal return. Unbridled competition is the first of Prof. Frank's fatal flaws.

The second factor relates to externalities that are hard wired in our genes, but not considered by Adam Smith and still absent from much economic thought today. Prof. Frank wrote:

A second problematic assumption of standard economic models is that people are properly attentive to all relevant costs and benefits, even those that are uncertain, or that occur in the distant future. In fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift.

Human kind has evolved from a "flight or fight" survival mode, to a hunt, gather and save for the winter survival mode, to a way of living that involves some degree of planning for a lifetime (and beyond). However, we still have the same genetic code that we started with in the caves. Instant gratification can dominate much of human thought.

This brings me to another long standing rant: compensation plans. Is it any wonder that we create bubbles when compensation can be based on quarterly and annual results with no recognition of any detriments five and ten years later? Such compensation plays to the caveman hard wiring: fight today and flight with the money tomorrow. Let next year take care of itself. All of the evolutionary behavior which has contributed so much to societal structure and stability is ignored in such short-sighted compensation plans.

The problem the world has today is that, as opposed to the caveman who found the other side of the mountain to be another world, the other side of the world is now next door. When someone takes the money and runs today, the detritus remaining behind is still next door and effects us all.

This discussion about compensation warping the motivation of individuals to the point that dangerous externalities are ignored, is but the tip of an iceberg called "behavioral economics". The poster child for this field is Prof. Robert Shiller of Yale. Prof. Shiller has been marginalized by mainstream economics thinkers, but the day for his field has come. The reason that the hand was invisible to Adam Smith was that he had a blind spot. Shiller, and other behaviorists, have the insight to peer into that blind spot. The hand may become visible after all.

Comments

[Gavin Kennedy:]

“The Adam Smith concept of the invisible hand, the collective effect of all self-interests guiding economic activity to societal good is fundamentally flawed.”

You attribute to Adam Smith a modern invention about the metaphor of the “invisible hand”. Smith’s was not referring to “all self-interests” in society guiding it to the common good. His sole reference in Wealth Of Nations is in Book IV of Wealth Of Nations and refers to those merchants, but by no mean all, who were discouraged from engaging in foreign trade and shipping because of their perceived risks to the “security” of their capital and therefore preferred to invest locally, which added to domestic employment and output.

In the 1950s the “invisible hand” was re-defined by modern economists to become a general statement applying to all expressions of self-interest through markets and 50 years later it is widely believed, particularly by economists, most of whom have not read Adam Smith’s limited reference in Book IV, chapter 2, paragraphs 1 through 9, Wealth Of Nations.

Hence, any consequences from the modern, not Adam Smith’s, meaning of the “invisible hand” is caused solely by modern, not classical, economic theory. Robert H. Frank has blamed Adam Smith, who on the meaning on "an invisible hand", is in fact entirely innocent man.

Sep 14 04:12 AM

[socrateazz:]

The problem is not so much a blind spot per se. People see what the imediate effect of certain decisions are and assume the same decisions will produce the same result and thus value those similar future decisions the same. The thing is most first decisions which are effective actually move supply or demand toward a greater balance. The subsequent decisions make further movement toward balance until later overshooting balance. If not stopped soon a serious opposite imbalance will occur. The random walk graphs often illustrate those cycles. If you had serious problems in the near past them a quick reversal is probable. If the past imbalances have been minor as with the recent economy then a serious imbalance could hit hard. People do not react to reality until reality has become obvious. Until the US let Leman sink, there were not any adverse reactions. A little reality allowed to escape and serious things happened.

Sep 14 04:49 AM

[Steven Hansen:]

This should be a discussion of diminishing returns and efficiency of motion colliding with innovation. The innovator usually always triumphs, but must continue to innovate on a broad path - and not get bogged down in marginal innovation (marginal improvement).

This is the difference between continuous improvement masquerading as innovation - and true innovation.

While it is true we concentrate on short term goals, it is because the market demands this. the leader who ignores what is demanded will soon not be a leader. this is one reason the better run companies in the world are in private hands.

Sep 14 05:23 AM

[Leftfield:]

In economic discussions, I believe that the importance of the "political" economy is unjustly ignored. That is easily more than half of our total in the "land of the free," far more, if it's coercive influence is accounted for.
As the Constitution mostly recedes as a distant relic, people see political force as a cost-free way to reward themselves and aren't troubled to see long-term consequences, even if they are fairly obvious. Washington is still unjustly seen as a savior by most even after TARP et al. This may go on until there is an event like Lehman and the Wall St. meltdown that reveals it's true squalor to everyone. Unfortunately, because of the nature of government power, the sellout of our freedoms for handouts and advantages may be irreversible at that time.

Sep 14 07:36 AM

[TCK:]

It is difficult to say we really have a free market system. The financial system is highly regulated and performed very poorly. What we have currently is more like "Crony Capitalism" or a rigged market system run by lobbyists and political donors.

Previously failed business went away. Now they are given tax payer dollars and the enablers in Congress play the blame game for political gain.

Sep 14 09:07 AM

[David Van K...:]

Truly free markets are not desirable. There is no "invisible hand" that guides toward the common good. Human behavior over centuries proves that. In a truly free environment, human's worst instincts take over. Would anyone want a free market in traffic (no stop signs, speed limits, or school zones)? Of course not. How about criminal behavior..want a free market there? No. Would you like to watch an NFL game with no rules? Not for long.

There's a reason why humans throughout history have created and accepted "regulations' like the Ten Commandments, Bill of Rights, and the like. The better part of our nature recognizes that such "regulations" are required for a civilized society and to prevent the strongest/meanest/gree... among us from simply overwhelming the rest. The financial markets are no different. They need balanced, fairly enforced regulations to operate in a way that even has a chance to promote the common good.

Sep 14 10:08 AM

[thesheet:]

"This relates to the observable fact that we are accumulating more and more debt for less and less growth".

This makes me think of a book by Donald Coxe. The New Reality of Wall Street. In it he talks about how the market will not leave a bear market until the cause of the crash is removed.

If this is the case, then this bear market has only started. The inefficiencies of using debt on top of debt are building to a climax and the government is trying desperately to keep a system of diminishing returns alive.

Setting us up for a greater crash?

thesheet

Sep 14 10:09 AM

[Tony Petroski:]

From the article:

"The Adam Smith concept of the invisible hand, the collective effect of all self-interests guiding economic activity to societal good is fundamentally flawed. It is not flawed because of assumptions about what humans fundamentally want to do (survive and prosper). It is flawed because the assumptions failed to recognize factors that determine the individual perspectives on what it takes to survive and prosper."

I admire Adam Smith's work and the surest sign of the rigor of that work is in the critiques here displayed.

I never liked the "hidden hand" as an analogy and suspect Mr. Smith would have laughed that it got so much attention.

It's great fun to read how humans get in the way of economic theory.

"Humans" are written of rather than "man," "men" or "mankind." That's all in the game. But "Cavemen?" Shouldn't that be "Cavepersons?"

Professor Frank:

"Taken together, these expenditures are wasteful in the same way that military arms races are."

Yes, but we cavepersons have made it this far.

Sep 14 10:41 AM

[badScooter:]

Fascinating discussion, thanks all.

David Van-, I think the original genius of our system was the recognition that some specific yet widely applicable rules were necessary, but that they should be held to the absolute minimum both in number and in scope.

Wasn't it Rand that said "Free markets are a great idea...too bad nobody has tried them"?

Tony, us cavepersons have made it this far, but absolutely nothing guarantees us the right to continue to make it, as a country, an economic system, or even as a species. One of those "long term blind spots" the author is referring to, I think. I like to imagine what a smart dinosaur would have thought, living through the K-T event...something like, "Hey! No fair!".

Sep 14 11:23 AM

[conceptwizard:]

Free markets are not "free" unless all participants have an equal opportunity. I do not have an HFT at the NYSE, I have to do manual labor to make my decisions the "HUMAN" way. I do not have algorithms to make my decisions in a split second. The fact that these are allowed to exist is an atrocity. I always look at these as the tip of the iceberg, you can see the top but, 90% is undercover.

Obama will make no meaningful changes in these super companies, lest we forget the huge 700 million dollar campaign that was run recently funded by these society caring financial firms, that are paying themselves huge bonuses while America writhes in agony, all this without actually realizing the "mark to market" losses that would still render them insolvent.

Sep 14 01:26 PM

[John Lounsbury:]

Gavin Kennedy - - -

Thanks for an informed comment. I am suitably warned that I should not quote others quoting a third party without going to the source.

Sep 14 02:09 PM

[John Lounsbury:]

Gavin - - -

Is this the quote to which you refer:

“ [An individual is] led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it. ”

If so, I will disagree with your interpretation. I read this to have the merchant represent an example of broader commerce. I think it is restrictive to apply an example of a metaphor to define the boundaries of the metaphor. Perhaps our difference is like that between biblical scholars, one of whom emphasizes the allegorical and the other who emphasizes the literal.

Sep 14 02:56 PM

[Gregman2:]

Very thought provoking and insightful. Thanks for this.

Sep 14 04:06 PM

[rosey99:]

Thanks for an excellent piece. I especially like the graph illustrating lower marginal growth of GDP as a rersult of greater debt. On an intuitive level we all know this, the greater the level of existing debt, the greater the new debt required to mitigate existing debt service. How we have forgotten something so simple (for thirty years no less) is a mystery I struggle to understand. I'm tempted to put this too down to human nature, but that smells like a cop-out.

Perhaps it explains the rationalization of an impending "financial revolution" that complements the agricultural and industrial revolutions, thereby increasing the productivity of financial capital. Too bad it never happened. After all, you can't spell "rationalize" without "rational".

Sep 14 04:17 PM

[untrusting ...:]

David,
Would totally agree with your basic points about the "theory of free markets". There really cannot ever be a totally free market primarily because of human behavior. Humans have demonstrated for over 2,000 years that they can and will exhibit greed, corruption, dishonesty, unethical behavior, manipulation, and virtually any form of advantage to capture wealth, power, control, etc irregardless of the outcomes on anyone or anything else in society. This type of human behavior is repleat throughout history from the Magna Carta, to the Roman Emprie, to the Spanish Inquisition, to Wall Street today.

The problem with regulation is that it is virtually impossible to cross every "t" and dot every "i" and identify every senario to even attempt to regulate even most harmful situations. And even if one could do that, society adapts and evolves so quickly now that new situations are evolving every day. For example, politicans have been trying to close hugh illegal tax dodges for decades. As soon as they close one, it is so profitable that the best and brightest open up several new ones before legislation is even signed to close the old one(s).

There are massive numbers of laws and regulations on the books already. And in the securities area alone, there must be hundreds of thousands of laws and regulations. The bigger problem is many of them are simply not enforced or prosecuted. The simple fact of the matter is that "white collar crime pays" and it pays big time. It seems ironic that the infamous California three stikes law can and will put a petty criminal in jail for serious time for minor property theft such as stealing a bicycle. Yet white collar criminals literally "steal" (misrepresent, fraud, etc) many billions and cause trillions of dollars in harm to hugh numbers of individuals and yet for the most part they get away with it. Even if they do get caught the consequences are relatively trival compared to the wealth they have acquired via the white collar crimes. For example, Pfizer was recently just "convicted" (actually settled) for their 4th instance of fraud and agreed to settle for about $2billion in fines but "admit no guilt". Well what is $2 billion in fines if they made tens of billions in fraudlent profits. Not one single Pfizer employee went to jail or lost all their privileges. This same type of senario of large scale massively profitable white collar crime is carried out over and over and over again. It literally pays BIG TIME to be a large scale crook, but don't even think about small scale crime as it is just not worth it.

The ONLY thing that will reign in large scale fraud and white collar crime is extremely severe penalties and serious prosecution. That is what the RICO laws were enacted for, but they are rarely used except for the mafia and drug dealers. The great thing about the RICO law is it provides for total consfication of all assets and major jail time. Now if 5 or 10 Pfizer executives went to jail and lost 100% of their personal assets, then we just might not have a 5th Pfizer fraud in the next decade. As it is Pfizer will cook up yet another hard to detect fraud and easily recoup the $2billion they settled for. And this is exactly one of our major problems with Wall Street and many public companies today. The amount and scale of money involved is so staggering that we cannot see how this will ever be reigned in.


On Sep 14 10:08 AM David Van Knapp wrote:

> Truly free markets are not desirable. There is no "invisible hand"
> that guides toward the common good. Human behavior over centuries
> proves that. In a truly free environment, human's worst instincts
> take over. Would anyone want a free market in traffic (no stop signs,
> speed limits, or school zones)? Of course not. How about criminal
> behavior..want a free market there? No. Would you like to watch an
> NFL game with no rules? Not for long.
>
> There's a reason why humans throughout history have created and accepted
> "regulations' like the Ten Commandments, Bill of Rights, and the
> like. The better part of our nature recognizes that such "regulations"
> are required for a civilized society and to prevent the strongest/meanest/gree...
> among us from simply overwhelming the rest. The financial markets
> are no different. They need balanced, fairly enforced regulations
> to operate in a way that even has a chance to promote the common
> good.

Sep 14 10:13 PM