Free markets are the best means for efficiently allocating society’s economic resources… except when they’re not. Given the U.S.’s current economic morass I thought I’d blog a little about why a free market needs regulation.  First off, it’s worth noting an economy is a complex adaptive system. Meaning, it consists of interactions by a large number of semi-independent agents all focused on their individual goals. Via this complicated web of interactions, larger patterns, emerge, merge and perish. Alternatively one could view these patterns (read: organizations, businesses, relationships etc.) as going through evolutionary algorithmic searches for optimal solutions to their current environment.  The whole becomes greater than the sum of it’s parts. Companies get built, resources get leveraged and, overall, economic progress lurches forward.  So why is government regulation desirable? Why isn’t the libertarian view of unfettered free markets the right approach. I can think of three reasons, each residing at a different scale within society.

1) Humans can not be consistently counted on to be economically rational.

2)  The potential problem of “Increasing Returns” as identified by the economist Brian Arthur.

3) The Economy resides within a larger social political system.

Behavioral Economics is the branch of economics studying how humans make (sometimes irrational) choices. Some of the findings suggest humans are quite susceptible to heuristic biases and framing. Heuristic biases can be thought of as “rules of thumb”, an example might be, if someone I perceive as a leader does X then I should do X as well, even if I’m not sure why I should do X or if X will get me anything. Framing describes the ability for human choices to be swayed by how options are presented to them. My current favorite example (typically given regarding morality) is the oncoming train question. If there is a train track that branches into two tracks. Down track A five people are working while down track B one person is working. An out of control train is hurtling down the track, you can do nothing and the train will go down track A, killing five people or you can pull a switch and send the train down track B killing one person but saving the other five. Will you pull the switch. Most people say they would pull the switch thus, saving five people while killing one person. But, if you frame the question differently, and tell them five people are working on a train track below you. You see an out of control train hurtling down the track and you know if you push the obese person next to you, onto the train tracks, it will stop the train, save the five workers but kill the obese person. Would you push fatso onto the tracks. Most people would say no, even though, the economics of the question are exactly the same in each case.

So what’s the problem? As companies get more and more sophisticate in their marketing efforts, their ability to override an individual’s rationality becomes stronger. If people are not making choices based on maximizing their own self interest, the philosophical underpinnings for arguing the ethical advantages to free markets disappear.

A second problem can be found in the study of group psychology. As Keynes (quoted by David Ignatius) notes: “It is of the nature of organized investment markets . . . that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force,” he wrote. “Once doubt begins it spreads rapidly.” In other words, when your mother asked you if you would jump off a bridge just because your friend did, the honest answer is: “Sometimes”.

2) Increasing Returns describes the idea of markets becoming dominated to such an extent that the winner will continue to win just because they won previously. Increasing Returns are sometimes illustrated through “the Network Effect”, the example usually given is the dominance of the PC. Once everyone starts using a specific technology, it will make sense for the individual to choose that technology not because it is necessarily superior to its competitors, but because barriers to entering the network are too costly without the “winning” technology. Now, its true that over the long term the network effect can be overcome through the introduction of a “game changing” new technology, but its also true that the system can reach a state of equilibrium where innovation is permanently stifled and the system lodges in an evolutionary cul de sac.

3) The Economy resides in a larger Social Political system: In order for any economy to work right it must reside within a society of laws. Contracts must be enforceable, property rights respected… For the rule of law to be respected there must be some mechanism for enforcement, punishment and redress. Mechanisms of this sort require a concentration of power. Concentrated power invites corruption and secrecy. Without mechanisms for insuring fairness and the rule of law a free market cannot hope to stay free.

Further, there must also be mechanisms in place to minimize negative externalities and the ability of larger entities to socialize costs while privatizing profits. You know, like if an industry got into trouble so everyone was forced to give money to bail out said industry without the givers getting equitable compensation for their forced largess. I’m sure there’s an example of this issue though none come immediately to mind.

In short, I do not believe, given society’s current level of technological sophistication and interconnectedness that a free market is even possible, let alone desirable. Having said that, I am quick to acknowledge economies as complex adaptive systems. Too much regulation can send the economy into a state of equilibrium, effectively killing the goose that lays the golden egg. But, that argument will be made in a future post.