Chief Executive of the Urban Forum, Toby Blume, explains the logic of intervention in a market where irrationality is sometimes rational
I've been reading a fascinating (but heavy going) book about the credit crunch – 'How Markets Fail,' by John Cassidy – which looks at the current financial crisis through the prism of economic and political theory. The book covers free-market heroes like Adam Smith and Milton Friedman and left-ish thinkers like Keynes and Minsky and shows how politicians and regulators distorted these theorists' ideas in justifying their actions. Nothing too surprising there, but what struck me was how polarised the debate about financial regulation and reform has become.
The arguments are too often presented as a straight choice between, on one hand, liberty and the power of the market, and on the other, state intervention and socialism. Whereas in fact – at least from a theoretical perspective – the boundaries are much less clear. My contention is that we should be able to have our cake and eat it.
For example, Adam Smith, the founding father of free market capitalism, was very clear in his writing that financial services was tne market that could not be left to regulate itself. Smith's ‘invisible hand' – that supply and demand will ultimately find the equilibrium price – did not extend to banks and financial services, even before the emergence of things like mortgage backed securities and credit default swaps.
That advice seems to have been hopelessly ignored by the likes of former Chairman of the US Federal Reserve, Alan Greenspan, and even Gordon Brown during his time as Chancellor. US and UK politicians and regulators appear to have seen their role as getting out of the way as much as possible to let the market do its best. But the market throws up some very peculiar incentives, which are best described as ‘rational irrationality.'
Without boring you with ‘game theory' and ‘the prisoner's dilemma', what this basically means is that actions that may make sense for an individual (or an organisation) to follow can, when taken together, throw up a wholly illogical response. For example, it might make economic sense for one London borough to transfer all its housing stock in order to reduce their maintenance costs, as people in housing need can be accommodated by neighbouring boroughs. However, if all the London boroughs were to follow the same (logical) path, it would lead to a situation that would be illogical (no council housing in London). Although it is seen as acceptable to lose money in a declining market, failing to match profits in the midst of a bubble is regarded by financial institutions (and their investors) as a cardinal sin. So instead institutions blithely follow the herd in offering products they know to be of dubious quality. It may be rational for an individual institution to follow this path in order to retain their investors, but the overall effect is anything but rational. The only way to sort out these perverse incentives is through positive, measured government intervention.
The bailout of the banks has severely undermined the credibility of the efficiency of lax financial service regulation, but policy makers on both sides of the Atlantic continue to lack a clear vision of where we go from here. We need a new way of thinking about economics that acknowledges the usefulness of markets but also recognises their limitations.
A recent policy response to this has been a growing interest in mutuals and cooperatives as a vehicle for modernising public service delivery. The cooperative sector has, despite more than a decade of a Labour government , fallen out of favour with policy makers in recent times. Its re-emergence as a powerful model of positive social action is entirely welcome
. However a note of caution is needed. Cooperatives cannot be regarded as a golden bullet for policy makers that will cure all our ills. Political history is littered with the graves of good ideas inappropriately used and ultimately discarded and mutuals must not be allowed to suffer a similar fate. I'm reminded of Abraham Maslow's line that ‘it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail'.
Similar issues surround the, also valuable, focus on social return on investment, social and community enterprise and corporate social responsibility. All have the potential to play an important role in redefining the complex relationships between citizens and the state, corporations and the voluntary and community sector. But none, on their own, will achieve the sort of change we need to see.
So although there are signs of growing recognition for the need for a way of looking at economics, the response thus far from political leaders seems some way short of a compelling vision of the future. Some of the challenges we face in the future – climate change, financial service reform, social care and an ageing population – are simply too important to be subject to petty political point scoring. Given that so much political and economic debate is characterised by trivialities and childish squabbling, perhaps we ought to call this new way of thinking ‘adult economics.'