Montreal, November 15, 2004  /  No 148  
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Chris Leithner grew up in Canada. He is director of Leithner & Co. Pty. Ltd., a private investment company based in Brisbane, Australia.
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by Chris Leithner
          In unguarded moments and at some rarefied and abstract level, far removed from flesh-and-blood people and the gristle of everyday experience, some mainstream economists will concede that unfettered markets “work.” They grudgingly accept that, given certain very stringent assumptions that never obtain in the real world, profit-seeking producers will provide goods and services in the various combinations of quantity and quality that consumers desire. Further, competition among producers will also ensure that goods and services are provided at the lowest possible price; and competition among bargain-hunting consumers will reward those who can (and penalise those who cannot) supply the most-desired goods and services at the lowest price.
          Yet a fundamental – and very surprising – void lurks at the very heart of the mainstream conception of markets. As an experiment, ask a conventional economist how a real-life market (as opposed to the abstract and stylised version that inhabits the textbooks and journals) actually operates. In response, you will likely receive an arcane explanation that is riddled with caveats. Contemporary mainstream economists can explain with great sophistication the operation of imaginary markets that conform to stringent assumptions. But they offer startlingly few insights into real-world markets that mock these assumptions. 
          Typical economists, in other words, describe in great detail make-believe markets whose assumptions guarantee that they “work;” but they say little or nothing about the origins and operations of the actual market processes that generate desirable results in the real world. To members of the general public – and, one suspects, to many politicians, business executives and policymakers – the surprisingly smooth (despite the massive and growing intervention by governments) operation of real-world markets is shrouded in mystery. Accordingly – and whether in Parliament or on the hustings or in the boardroom and classroom or in the editorial pages and letters-to-the-editor – the many benefits of voluntary exchange are usually obscured or denigrated and often flatly denied. 
The myth of perfect competition 
          Several premises underlie mainstream economists’ conception of markets. The starting point is that they comprise very large numbers of buyers and sellers, and that each market participant possesses clear objectives, prioritises them and decides strictly rationally (i.e., as a priority-maximiser) and without error. When mainstream economists think about markets, they instinctively think in abstract and mathematical terms; and when they think abstractly they almost automatically assume that markets possess the necessary and sufficient characteristics of perfect competition. They assume in particular that stylised market participants possess perfect mutual knowledge. Not only is each buyer and seller fully aware of the decisions made by all other market participants: each is also aware of the decisions that all others would make under every conceivable market situation. Accordingly, perfect competition among buyers and among sellers will ensure that the market for a given good or service is an “equilibrium” market that clears rapidly and effortlessly; similarly, adjustments between markets will also occur swiftly and smoothly. 
          Markets are to owners of businesses and lenders to businesses – i.e., investors – what water is to fish. Clearly, an investor’s survival and prosperity presuppose a comprehension of the principles governing the environment he inhabits. So why, from the point of view of an investor, does the mainstream model of perfect competition, its various extensions and elaborations and its totem of equilibrium, provide an unsatisfactory explanation of how markets work? First, the model’s requirements do not even remotely refer to real people; accordingly, they do not even crudely approximate reality. If you think that the two preceding paragraphs are a fantastic caricature, then peruse Frank Knight’s classic articulation of the perfectly competitive market economy (Risk, Uncertainty and Profit, Beard Books, 1921, 2002) and any mainstream textbook published since the first edition (in 1948) of Paul Samuelson’s Economics (McGraw-Hill, 17th ed., 2001). You will look vainly for any reference to the role in the market of a concrete individual exercising a free will. 
          The mainstream model has a second glaring defect: it opens the paddock gate to a variety of distracting pests and damaging predators. Talk to a conventional economist and you will soon realise that you are conversing with someone who eventually (and perhaps readily) concedes that his assumptions about market participants, dynamics and equilibrium apply to a world other than the real world. Alas, when the typical economist thinks about real-world markets his thinking suddenly becomes slipshod – and distinctly interventionist. The typical economist applauds the real-world market economy with only one hand – and on the condition that aggressive government intervention accompanies it. “Grant me chastity and continence,” said St Augustine, “but not yet.” Similarly, the typical economist mouths market rhetoric and solutions but champions voluntary exchange only under conditions that never exist in the real world. 
     “The typical economist applauds the real-world market economy with only one hand – and on the condition that aggressive government intervention accompanies it.”
          In the meantime, it is alleged that producers (and various “experts”) know far more about medicine and education than do consumers. It thus follows, according to many economists and policymakers (eagerly mimicked by politicians seeking ways to bribe voters), that in order to “protect consumers” and redress these “information asymmetries” and “market failures” the government must arrange and preferably run schools and hospitals. It must also enact torrents of “consumer protection” legislation. It is also implied that “public goods” exist, that only governments can furnish them, and that transport networks, “national security” and “the environment” are public goods. 
          Much more generally, economists and policymakers readily concede not just that most real people possess imperfect or incomplete information but also that they cannot properly assess it. (The anointed, of course, exempt themselves from this characterisation of the benighted). For this reason, they bless the market only if the incomes earned thereon are “corrected” by “progressive” (i.e., high) taxes, if “life chances are improved” by extensive and intrusive welfare programs, and if the property rights of the “greedy” people who decline to acknowledge their “social responsibilities” are weakened by myriad coercive regulations. 
Closet totalitarians 
          What has become mainstream economics has long contained many interventionists – and a few closet totalitarians. The preface to the German-language edition of The General Theory of Employment, Interest and Money (1936), for example, pandered openly to National Socialists – which is why they happily consented to the book’s publication and dissemination throughout the Third Reich. John Meynard Keynes wrote in the preface: “the theory of aggregate production that is the goal of the following book can be much more easily applied to the conditions of a totalitarian state than the theory of the production and distribution of a given output turned out under the conditions of free competition and of a considerable degree of laissez-faire.” Few of the book’s many other statements were so accurate.  
          Typical was Keynes’s convoluted and utterly fantastic claim “to suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth. It is only in a highly authoritarian society, where sudden, substantial, all-round changes could be decreed that a flexible wage-policy could function with success. One can imagine it in operation in Italy, Germany or Russia, but not in France, the United States or Great Britain.” To Keynes, apparently, laissez-faire meant non-adjustment, authoritarianism denoted flexibility and elasticity signified rigidity. In many respects The General Theory should be read in conjunction with George Orwell’s Nineteen Eighty-Four – both books describe a world in which up is down, war is peace and freedom is slavery. 
          Keynes and his vast number of contemporary descendants, safely tenured within universities and the civil service, neither champion the free market nor condemn coercion. For years, Paul Samuelson adopted this ambiguous position. According to Mark Skousen ("The Perseverance of Paul Samuelson’s Economics," Journal of Economic Perspectives), his text, “ranks with the most successful textbooks ever published in the field, including the works of Adam Smith, David Ricardo, John Stuart Mill and Alfred Marshall. Its [17] editions have sold over four million copies and have been translated into 41 languages.” It “has so dominated the college classrooms for two generations that when publishers look for new authors for a principles of economics text, they say that they are searching for the ‘next Samuelson.’” Accordingly, “for members of the economics profession, looking back at Samuelson’s text is like looking into a mirror that reflects many of our beliefs. If we are uncomfortable with some of what we see in that mirror, then we must also feel uncomfortable with the version of economics that was taught, and perhaps also uncomfortable with the impact that the teaching of economics may have had on the economy.” 
          Skousen notes that according to Samuelson’s first edition (1948), periodic “acute and chronic cycles” afflict private enterprise and government has a responsibility to “alleviate” them. Further, “the private economy is not unlike a machine without an effective steering wheel or governor … Compensatory fiscal policy tries to introduce such a governor or thermostatic control device.” By the seventh edition (1967), Samuelson had dropped the “machine minus the steering wheel” metaphor but continued to emphasise that “a laissez-faire economy cannot guarantee that there will be exactly the required amount of investment to ensure full employment.” If it did occur under free market conditions, then full employment would result from “luck.” Samuelson also contended that the “neo-classical synthesis” was “accepted in its broad outlines by all but a few extreme left-wing and right-wing writers.” This claim, or one very similar to it, appeared until the twelfth edition in 1985. 
          In the text’s first edition, Skousen also notes, Samuelson was sceptical about central planning. “Our mixed free enterprise system, [despite] all its faults, has given the world a century of progress [that] an actual socialised order might find impossible to equal.” By the fifth edition (1961), however, this view had changed considerably. Although he was somewhat sceptical about the reliability of statistics describing the Soviet economy, and whilst he acknowledged that it expanded more slowly than that of Germany, Japan, Italy and France, he concluded that Western economists “seem to agree that [the USSR’s] recent growth rates have been considerably greater than [America’s] as a percentage per year.” The fifth through eleventh editions (1961-1980) included a graph indicating that the “gap” between the American and Soviet economies was narrowing and possibly even disappearing. The twelfth edition declared that between 1928 and 1983 the Soviet economy grew at a remarkable rate of 4.9% per annum – more rapidly than its American, British, German and Japanese counterparts. In the thirteenth edition (1989) Samuelson and his co-author, William Nordhaus, culminated this theme. They declared “the Soviet economy is proof that, contrary to what many sceptics had earlier believed, a socialist command economy can function and even thrive.” 
          In the fourteenth edition, published during the collapse of the Soviet Union, Skousen wryly observes that Samuelson and Nordhaus dropped the word “thrive” and added the caveat “the Soviet data are questioned by many experts.” The fifteenth edition (1995) abruptly dubbed Soviet Communism “the failed model.” To their credit, Samuelson and Nordhaus admitted that they and other economists failed to anticipate the collapse of central planning. They might have added that, like most other Western academics, they had long regarded it through rose-tinted spectacles. But now, apparently, they saw things clearly: “in the 1980s and 1990s, country after country threw off the shackles of communism and stifling central planning – not because the textbooks convinced them to do so but because they used their own eyes and saw how the market-oriented countries of the West prospered while the command economies of the East collapsed.” 
          Did I hear anybody say that mainstream economists are rotten market timers? Did anybody say that they are also poor economists?