I'm in the middle of Oxford economist Ha-Joon Chang's great new book, 23 Things They Don't Tell You About Capitalism.
I highly recommend it as an antidote to all the "free-market" claptrap that we're constantly bombarded with. In his earlier books, Chang has consistently called out the world's rich countries (especially the U.S.) for their hypocrisy about things like protectionism and demanding that less-developed countries "open their markets."
Today I want to highlight just one idea in the new book: why government regulations can improve the functioning of markets, even when the regulators don't possess all the information that the market's players do. It's an interesting argument…
First, the standard "free-market" dogma: It's impossible for government to improve the functioning of a market by regulating it, because the government can never know how the market works as intimately as do the people and firms that are actually in the trenches, participating in it. These players each pursue their rational self-interest, and—presto!—the optimum outcome automatically emerges. Government can only gum up the works by distorting incentives, creating friction, etc.
Well, not so fast. As Chang points out, there are a few problems with this notion.
First and maybe most obvious is the "rational man" fallacy. Economists like to believe that people always behave on a perfectly rational basis, sagely calculating every last effect of everything they do in advance, and choosing the actions that maximize their "utility." Anyone care to argue that no hard-charging Wall Street bond trader has ever made a decision based at least partly on fear, or greed, or bravado, or ego, or desire for revenge, or any of a dozen other irrational motives? I thought not. So much for the "rational man."
But it goes beyond that. Chang notes that it's a complicated world—too complicated for anyone to fully understand and deal with, even if they were behaving with perfect rationality. The only hope we have of dealing with it is to make simplifying assumptions: to "deliberately restrict our freedom of choice in order to reduce the complexity of problems we have to face."
This leads directly to the money quote:
Often, government regulation works, especially in complex areas like the modern financial market, not because the government has superior knowledge but because it restricts choices and thus the complexity of the problems at hand, thereby reducing the possibility that things may go wrong.
An example: it was a choice of the banksters to operate with 30X leverage. Given their confidence that they were too big to fail, you could even argue that it was a rational choice (further encouraged, let's admit, by the irrational glory of being the baddest gunslinger in town). Had the government regulators simply restricted this choice (and perhaps a few other similarly irresponsible ones), we wouldn't have had to do the hated bailouts or cope with the Great Recession.
And one final key point: even if you grant the free marketeers that an unregulated market works best for that market, there is obviously no guarantee that what's best for that market is best for the society as a whole.