Stephen King: Sometimes the economic beauty contest gets us into an ugly mess
Monday 27 October 2008
Given Alan Greenspan's dose of the doubts last week, at what level should we trust markets? The strongest defence is, surely, the idea that markets provide the best single way of allocating the world's scarce resources. Unfettered capitalism, on this view, is desirable because it potentially makes all of us better off.
A weaker defence is that markets are certainly not perfect but they're the best of a bunch of bad systems. While, it would be nice if a better alternative came along, the alternatives tried so far – Communism, Fascism, feudalism and so on – have proved inferior.
Then there's the defence based on faith in individual liberty. On this view, so long as everyone is free to choose, it doesn't matter if the outcome at the level of society as a whole is unattractive, or if individuals lose out. This libertarian view, though, is a matter more for political philosophers than for mere economists.
Markets are truly miraculous, a point well-argued by Adam Smith with his description of the invisible hand. But markets have their weaknesses. They're not very good at dealing with pollution and the other social costs and benefits which stem from private decisions. They're hopeless at dealing with income inequality. And they're particularly weak at dealing with time.
On a day-to-day basis, markets can work rather well. Pop down to your local high street or to the supermarket and, within reason, you're likely to be able to buy all the things on you shopping list. Admittedly, some things are not immediately available – you may have to wait a few weeks for the new sofa to arrive or for the car built precisely to your specifications to turn up – but you never seriously doubt that you will be able to exchange your income for consumption.
Not everyone is in the same boat. Away from the affluent areas of the world, the vast majority of people struggle on a daily basis. For them, markets either don't work well or simply don't exist, the result of, inter alia, an absence of property rights, an ineffective legal system and the mis-appropriation of resources by non-democratic regimes.
In the developed world, though, the biggest problem is time. It's something that was well understood (in their different ways) by John Maynard Keynes and by the so-called Austrian school led by Friedrich Hayek and Ludwig von Mises in the 1920s and the 1930s, but poorly understood by those who have a blind faith in market solutions. Alan Greenspan, the former chairman of the Federal Reserve, was forced to admit in front of a hostile congressional committee that perhaps his faith in markets had been shaken. It's a shame, though, that it took him so long to understand what others had recognised eighty years ago.
Of all the various problems with economic time, two stand out. First, there's the effect of imperfect information. It takes time to evaluate an investment project and time costs money. At the beginning of any evaluation, the businessman may simply not know whether the project is viable. How much time should be spent working out whether the project is worthwhile? The idea that markets can provide a solution to such uncertainties is, of course, nonsense.
Second, within financial markets, beliefs about the beliefs of others are crucial drivers of asset prices. Why were people happy to buy houses two years ago, even though prices were remarkably elevated by historical standards? Why did people buy technology stocks at the end of the 1990s, even though valuations looked remarkably stretched? The answer, surely, comes from people's beliefs that others will pay even more for an asset, even if the price has already risen into the stratosphere.
Keynes famously captured this idea with his beauty contest. "It is not a case of choosing those [faces] which, to the best of one's judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees." (The General Theory of Employment, Interest and Money, 1936)
Keynes argued that stock markets behave in much the same way. We don't buy a company's shares based on any sense of fundamental value. Instead, we buy a company's shares based on our perception of what others might regard as a company's fundamental value. Others are, of course, doing the same.
This idea works in both directions. It helps to explain bubbles, but it equally helps to explain busts. If I believe everyone else believes stock prices are going to fall, I'd be mad to do anything other than sell. If, though, everyone thinks like this, the market will, inevitably, collapse. Equally, if other companies are laying off staff because they're worried about the future level of demand, I'm not likely to take on staff because I can see that, through the actions of other companies, demand will, indeed, be depressed.
Keynes' brilliant insight was his recognition that, in these circumstances, markets would fail to deliver full employment. His language may have been irritatingly opaque at times, but he understood better than most that markets, left to their own devices, could lead to undesirable macroeconomic consequences. His mistake, perhaps, was to express all this in terms of a "General" theory. Keynes' ideas were specific to only certain moments in time. For the most part, markets have worked well, and Keynes' arguments have all too often fallen by the wayside.
During last week's hearing, Mr Greenspan effectively admitted that Keynes was right, at least as far as the beauty contest was concerned. "I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders." He added: "I had been going for 40 years with considerable evidence that it was working very well."
You have to applaud someone of such experience making such a public admission of error. Yet Mr Greenspan's mea culpa will not be enough to dig us out of the current mess. Knowing that markets have failed is one thing. Knowing how to fix the problem and, indeed, what the problem actually is, is something else altogether.
Looking at how markets have behaved in recent weeks, there is one overriding theme. Investors are desperate for hard international cash. They don't trust stocks, they don't trust corporate bonds, they're expressing doubts about some government bonds and, through the currency markets, they're expressing doubts about the economic outlook in individual countries, from the UK to Iceland, from Hungary to Argentina. All they want is dollars.
As with the beauty contest, each investor believes all others are hoarding dollars. There is a global dollar shortage. This needs to be corrected. It's not just a case of cutting US interest rates. There's also a need to re-boot the economic system by persuading people that there will be no dollar shortfall. This can only be done by turning to the printing press. The US government will have to sell Treasuries to the Fed in exchange for a huge increase in the supply of dollars. Only then will investors begin to think once again about fundamental values in capital market. And only then will John Maynard Keynes be able to rest easily in his grave.
Stephen King is managing director of economics at HSBC
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