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Why Markets Fail

........This is a pervasive problem in most human societies, and it’s worth noting that those societies that survive over the long term tend to be the ones that work out ways to keep too much wealth from piling up uselessly in the hands of those with more power than others. This is why hunter-gatherers have customary rules for sharing out the meat from a large kill, why chieftains in so many tribal societies maintain their positions of influence by lavish generosity, and why those nations that got through the last Great Depression intact did so by imposing sensible checks and balances on concentrated wealth – though most of those checks and balances in the United States were scrapped several decades ago, with utterly predictable results.

By neglecting and even arguing against these necessary redistributive processes, neoclassical economics has helped feed economic disparities, and these in turn have played a major role in driving cycles of boom and bust. It’s no accident that the most devastating speculative bubbles happen in places and times when the distribution of wealth is unusually lopsided, as it was in America, for example, in the 1920s and the period from 1990 to 2008. The connection here is simple: when wealth is widely distributed, more of it circulates in the productive economy of wages and consumer purchases; when wealth is concentrated in the hands of a few, more of it moves into the investment economy where the well-to-do keep their wealth, and a buildup of capital in the investment economy is one of the necessary preconditions for a speculative binge.

More broadly, concentrations of wealth can be cashed in for political influence, and political influence can be used to limit the economic choices available to others. Individuals can and do rationally choose to maximize the benefits available to them by exercising influence in this way, but the results can impose destructive inefficiencies on the whole economy. In effect, political manipulation of the economy by the rich for private gain does an end run around normal economic processes by way of the world of politics; what starts in the economic sphere, as a concentration of wealth, and ends there, as a distortion of the economic opportunities available to others, ducks through the political sphere in between.

A similar end run drives speculative bubbles, although here the noneconomic sphere involved is that of crowd psychology rather than politics. Very often, the choices made by participants in a bubble are not rational decisions that weigh costs against benefits; it’s not accidental that the first, and still one of the best, analyses of speculative binges and panics is titled Extraordinary Popular Delusions and the Madness of Crowds. Here again, a speculative bubble starts in the economic sphere, as a buildup of excessive wealth in the hands of investors, which drives the price of some favored class of assets out of its normal relationship with the rest of the economy, and it ends in the economic sphere, with the crater left by the assets in question as their price plunges roughly as far below the mean as it rose above it, dragging the rest of the economy with it. It’s the middle of the trajectory that passes through a particular form of crowd psychology, and since this is outside the economic sphere, neoclassical economics can’t deal with it.

This would be no problem if neoclassical economists by and large recognized these limitations. Unfortunately a great many of them do not, and the result is the classic type of myopia in which theory trumps reality. Since neoclassical theory claims that economic decisions are made by individuals acting freely and rationally to maximize the benefits accruing to them, it’s seemingly all too easy for economists to believe that any economic decision, no matter how harshly constrained by political power or wildly distorted by the delusional psychology of a bubble in full roar, must be a free and rational decision that will allow individuals to maximize their own benefits and benefit society as a whole.

Now of course, as mentioned in an earlier post, those who practice this sort of purblind thinking often find it very lucrative to do so. Economists who urged more free trade on the Third World at a time when “free trade” distorted by inequalities of power between nations was beggaring the Third World, like economists who urged people to buy houses at a time when houses were preposterously overpriced and facing an imminent price collapse, not uncommonly prospered by giving such appallingly bad advice. Still, it seems unreasonable to claim that all economists are motivated by greed, when the potent force of a fundamentally flawed economic paradigm also pushes them in the same direction.

That same pressure, with the same financial incentives to back it up, also drives the equally bad advice so many neoclassical economists are offering governments and businesses about the future of fossil fuels. The geological and thermodynamic limits to energy growth, like political power and the mob psychology of bubbles, lie outside the economic sphere. The interaction of economic processes with energy resources creates another end run: extraction of fossil fuels to run the world’s economies, an economic process, drives the depletion of oil and other fossil fuel reserves, a noneconomic process, and this promises to flow back into the economic sphere in the extended downward spiral of contraction and impoverishment I’ve called the Long Descent.

Here again, neoclassical economics is poorly equipped to deal with the reality of noneconomic constraints on economic processes. It thus comes as no surprise that when an economist enters the peak oil debate, it is almost always to claim that there is nothing to worry about, because the market will solve any shortfall that happens to emerge. As shortfalls emerge, expect to hear the claim – already floated by a few economists – that declining production is simply a sign that the demand for fossil fuel energy has decreased. No doubt when people are starving in the streets, we will hear claims that this is simply because the demand for food has dropped............