Stephen King: Central banks have the power to avert another catastrophic depression

One American bank failure and, apparently, we have proof that market economies just don't work. The move towards ever more deregulation is leading us all into another depression. Greedy capitalists, left to their own devices, will suck the blood out of our economies, leaving the rest of us to suffer ongoing economic hardship.

At least, I think that's the argument. It is, of course, total nonsense. Markets are, for the most part, desirable because they respond to our individual wishes. They are, after all, the mechanisms which allow you to buy your Fairtrade coffee in the morning and which enable you to get your hands on the latest Harry Potter on the stroke of midnight. The alternative is to queue up outside GUM for hours on end in the middle of a frozen Moscow winter circa 1975. The invisible hand takes some beating.

The greatest success of markets in recent years, though, is not so much the efficient distribution of the collected works of JK Rowling but surely the increased integration into the world economy of impoverished nations which now appear to be on the road to prosperity. China may not be a market economy, but it's a lot closer to being one now than it was at the time of the Cultural Revolution and, as a result, a lot better off. India has hugely benefited from the technology revolution which has given Indian workers opportunities that might only have been dreamt about twenty or thirty years ago.

State planning may have its supporters but, these days, most of them have surely lost touch with reality. We now know that Stalin's Soviet Union, lauded by many as a credible alternative to capitalism, was built on not much more than terror and slavery. That, I think, is not a credible option. Equally, China's Great Leap Forward under Mao in the 1950s offered an alternative vision – a blast furnace in every garden – but it's not one that most of us would cherish.

The issue, then, is not so much that market-based economies are failures – the evidence suggests clearly that they're not – but, rather, that individual markets occasionally fail. Typically, these failures lead to demands for more regulation. However, while market failures do take place in deregulated "Anglo-Saxon" market economies, they also occur in highly regulated economies. Japan suffered one of the most momentous market failures of the last sixty years following its post-bubble collapse at the beginning of the 1990s, yet was never a shining example of a deregulated market economy. America's housing market is up to its eyeballs in regulation and tacit government support, yet has still managed to collapse after the earlier boom.

Although the world economy has lurched from one financial crisis to the next, these crises need to be seen in the overall context of rising living standards, lower inflation and, over time, smaller oscillations in economic growth. For many countries, these improvements have led to lower and more stable unemployment, a prize not to be sniffed at.

Market failures cannot, however, be treated lightly. They lead to indiscriminate gains and losses. Failures make some people rich and others poor. They can also deliver tremendous instability, economically and politically. The biggest fear of all, though, is that market failures can lead to social catastrophes on the scale of the Great Depression.

Anyone who's read The Grapes of Wrath, John Steinbeck's harrowing account of the 1930s, will know that the Great Depression was extraordinarily destructive. Ultimately, the Depressionwasn't a story about banks, manufacturers and others gong bust, even though many of them did. Instead, the Depression was a story of immense human hardship. The Roaring Twenties were followed by an economic apocalypse. At the beginning of the 1930s, US economic output fell by a total of around 30 per cent, a collapse on a scale nowadays difficult to comprehend. Unemployment soared, reaching an extraordinary 25 per cent of the workforce at its peak in 1933.

Could we be on the verge of another Great Depression? The current situation offers some similarities, notably the idea of market failure. Basic economics textbooks typically assume that markets are efficient, in the sense that they allocate resources in ways that cannot make anyone better off without making someone else worse off. Markets, though, sometimes get things wrong or, even worse, stop functioning altogether. The job of policymakers is to resolve these difficulties where and when they occur. Arguably, the refusal of policymakers to step in following the 1929 Wall Street Crash contributed to the depression which followed. They spent too much time worrying about the evils of capitalism and not enough time thinking about market failure.

John Maynard Keynes' The General Theory of Employment, Interest and Money offers a treatise on market failure. He understood better than most that, on rare occasions, economies could settle down in steady states associated with massive and persistent unemployment.

Unfortunately, Keynes came from the Delphic school of writing, leaving others to misinterpret his ideas to suit their own agendas. In a nutshell, though, his view was that labour and product markets were sometimes unable to co-ordinate in ways which would deliver full employment. Companies wouldn't hire the workers who, ultimately, might provide the demand for the companies' products. Workers would save rather than spend because they feared they might lose their jobs. All in all, there would be a shortage of effective demand.

Keynes' market failure, then, was an economy-wide problem which could be dealt with through, for example, looser fiscal policy. Since then, though, the literature on market failures has grown rapidly to include the remarkable insights of George Akerlof, Michael Spence and Joseph Stiglitz, among others.

Given, then, that we know more about market failures than before, we can afford to be optimistic that we're not facing another Great Depression. Rumours over the weekend that central banks are considering the possibility of buying mortgage-backed securities from the private sector are encouraging in this regard.

There are those who will regard actions of this kind as no more than a bailout of the already filthy rich, but their views completely miss the point. The failure of the mortgage-backed securities market threatens all of us. If banks are unable to raise funds, they won't be able to lend to the likes of you and me. If the market deems mortgage-backed securities worthless, there'll be big holes in pension provision. If banks refuse to lend to each other, fearful of hidden bad debts within the system (whether or not those bad debts actually exist), more and more institutions are in danger of going under. Using taxpayers' money to put a floor under the mortgage-backed securities market is, in effect, a way of bringing the market to its senses again.

There are, though, two problems with the market failure approach. First, those with a pathological dislike of markets will happily put the issue of market failure to one side and, instead, argue that all market systems are bad. For those who've forgotten, it's worth noting that Keynes' views were hijacked by the proponents of big government. They thought his views justified ever bigger budget deficits. Oddly enough, this error was partly Keynes' own doing. He should have called his "General Theory" a "Specific Theory", designed to deal with the rare occasions when markets do, indeed, fail.

Second, although market failures happen in both directions, policymakers typically only step in when there's too much fear, and not when there's too much greed. Market failures are symmetrical. Our policymakers' responses, too often, are not. When we've pulled ourselves out of this latest crisis, much more thought will have to be given to why markets fail on the upside. After all, busts only occur following earlier unsustainable booms.

Stephen King is managing director of economics at HSBC