Wednesday, June 27, 2012

A market without regulations is like a legal system without laws

The free market liberals, of both the Tea Party-types in the USA, and the Conservative ideologues in the UK, love the idea of markets ruling everything.

They see markets as being the best way of dealing with goods and services. They see government as getting in the way of the private sector, who should be best to be left alone (where the phrase "laissez-faire" comes from).
Their rationale is very simple: markets are the best way of dealing with goods and services because markets are "self-regulating": in other words, prices are controlled by demand (i.e. customers) and supply (i.e. how much of something there is). so a high supply product (like bread) would be cheap, whereas a low supply product (like caviar) would be expensive. Also, there is naturally more demand for bread than caviar.

The same logic works for salaries: commonplace jobs with a large pool of labour offer lower wages than those with a high skills requirement and this have a far small potential employee pool.

Enough of the economics primer. What happens when you put this into practise?

There are plenty of real-life examples of how this unregulated "free-market" works in real life. In the main, though, it doesn't. Here's why.

Look at the property market in the UK. There are those properties that people can mortgage or rent. This all depends on supply and demand. According to the theory, if  customers alter their behaviour (by wanting more of a product), a supplier should naturally react to customer desire: that's how the market works, by suppliers naturally reacting to customers' demand. Does this happen in the UK property market? No.

The housing stock in the UK has remained far below consumer demand for years, decades. It didn't help when the last Conservative government, under Thatcher, sold off thousands of council houses to the private market, without building any sufficient replacement government housing. But that's a separate matter. The question is WHY does the private sector (the market), fail to react to consumers' demands for a large increase in the housing stock? The answer is because of one of the fundamental flaws in the principle of the "free market": short-termism.

The private sector is often terrible at strategic, long-term thinking and looking at wider economic concerns. As businesses are driven by profit, they find it difficult to set aside money for "investments" which take a long time to set up, can be risky, and the financial benefits cannot be seen until some time in the future. Simply, the incentive for businesses to think long-term is too small. As a result, industries that have been privatised see a gradual decline in things like infrastructure and trying to look ahead to future trends.

This is why housing and construction in the UK has shrunk significantly, especially since the onset of the recession: businesses see too much risk and too little potential gain. Even though it's obvious that consumers need more housing, the "free market" is too fearful of risking money on long-term projects. The same thinking is true of the banking sector where it comes to giving out loans to help small businesses and individual entrepreneurs. Even though it can be rationally explained that any risk would be worth it considering the potential wider gain to the economy for encouraging business and wealth generation, banks, like the "free market" in general, are weighed-down by short termism.
George Osborne, the Conservative government's supposed economic heavyweight, has set his reputation on believing that the private sector will create the recovery. But everything tells us the opposite.

Continuing with the housing market, the rise in the cost of rents can be easily explained. Banks are reluctant to give out mortgages, forcing customers onto the rental market. As a result, although the cost of mortgages overall has gone down slightly, the cost of rent has rocketed. This may well result, for the first time in decades, with many younger people being unable to buy a mortgage and stuck in a high rent property. Again, because the private sector is unable plan strategically, this has meant the rental housing stock has remained static while demand has increased. So here is where the market doesn't work: landlords simply see an opportunity to make more money, and with the customer held hostage by the limited number of rental properties (and likely to remain so for the foreseeable future), everyday people are getting shafted. And will continue to do so for years if things stay as they are.

If the private sector is meant to be so risk-averse, why was there a construction boom in Spain? Because they saw no risk. There was a housing boom in the UK too, but not a construction boom on the same scale. What the housing booms in Spain and the UK had in common was the over-valued inflation of prices; but the reasons behind were slightly different.
 In the UK, the boom was fuelled by mortgage lenders losing their previous aversion to risk and giving mortgages to people who were not financially reliable. They forgot one of the basic rules of the market: not to invest in high-risk ventures.
In Spain, the boom was fuelled by construction firms losing their previous understanding of the demand for housing, and creating a huge over-supply. They forgot another basic rule of the market: that as supply increases, price goes down (and will, eventually).

The property market is just one example that quickly comes to my mind. Another one is education.

The introduction of competition was meant to improve secondary educational standards. But how are those educational "standards" measured? By exam results, because that's the easiest way for the "free market" to measure education. The government therefore supported this method when competition was introduced into secondary education.

The result? Schools have turned into exam-preparation centres, concentrating on the exam results the students get at the end of their education, rather than actually how useful or effective that "education" will be in the real world. Students know a great deal about how to pass exams, but not a lot about how to transfer their education into real-world skills useful to the economy.
Another side-effect of this "results" obsession is that schools focus on encouraging subjects that are easier for  students to excel in, in order to improve the schools ranking (and thus attract further revenue). This is a further reason why you have students leaving school with qualifications that may well be of little use. The "free market" has the opposite effect of that intended, because everything becomes a race to reach the lowest common denominator: to maximise results in order to minimise risk.
One last point is the government's introduction of a free market even in examination boards: schools can choose which "testing centre" they think is the best. That was the theory, anyway. The reality has been the opposite: schools, in order to maximise results and minimise risk, have often chosen the exam board that offers the "easiest" set of exams, to give students the best chance of getting a good result, therefore boosting the school's published results.

So what happens when the "free market" is let loose? You usually get a maximisation of profit at the minimisation of risk. If the government wants the private sector to act in a rational, strategic, open-minded way, then they need to read basic economics again.

To trust that the "free market" is the best way of dealing with economy, is to hand over running your economy to people with the mental age of five-year-olds. Unregulated markets, by definition, are, as a general rule, incapable of thinking long-term or strategically. Yes, the market has an important role to play, but it can only be a sane instrument if it is regulated by government.

The "free market", by definition, is an example of anarchy, because no-one is in control of it; it "controls" itself.  It's like having a legal system without anybody to enforce the laws. The "free market" is a system based on blind optimism.

Any government that supports the "free market" is also blind.

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