Monthly articles (English and French) on the theme "Querying economic orthodoxy"

No. 37 - January 2009

The market is knowledgeable, but also ignorant


New Year resolution: Because of my increasing research and writing activities, monthly articles on this site will henceforth be shorter. I trust you will find them no less interesting.
In the absence of strong political regulation, free competition in no way guarantees efficient use of resources; it even diverts them from uses that are the most urgent and the most legitimate for humanity.
Jacques Généreux, Les vrais lois de l'économie (Editions du Seuil, Paris, 2001), vol. I, introduction

To its devotees, the market is omniscient

How did the free-market enthusiasts succeeded so well in taking over economic thinking and policymaking? There are several answers to that question; here is one of the most convincing.

The free-marketers persuaded us that the market always knows best because, they tell us, it has greater knowledge of economic facts than any individual or institution can ever have.

In a certain way, they are right. If by the market we mean the aggregate of all the various particular markets that make up the whole economy, then it is true that the market as a whole possesses an enormous amount of extensive and detailed knowledge. As Hayek has put it (1), the shipper who earns his living from using otherwise empty or half-filled journeys of tramp steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities...perform eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.

In effect, we can say that the market 'knows' the current demand, at any moment, for every product and service available in the entire economy, as well as the current supply, at any moment, of all these products and services. Could all that knowledge be gathered together, and kept up to date, in any planning office? Evidently not. It follows, according to hard-line free-marketeers, that all attempts at economic planning by governments, regulators, town councils or other institutions are pointless.

We must therefore leave to the market alone the task of determining all the quantities to be supplied of every product and service, and to fix their prices. This is the theory of distributed intelligence (or market omniscience) trumpeted by Mises, Hayek, Friedman and their innumerable followers, who since the 1970s have been masters of the economic universe.

A plausible argument against planning

This theory is clearly a powerful weapon in the hands of those who oppose any kind of economic planning or regulation by the state or by other authorities, whether to preserve employment, to reduce inequalities, to avoid the problems caused by excessive credit, or to limit the environmental damage wrought by our production of goods and our discarding of rubbish. According to the theory, even if the market does not always succeed in coping with these issues, state intervention is sure to make matters worse, given that the state knows less than the market.

It would be absurd to deny that the market 'possesses' a formidable collection of economic data, which could not in practice all be gathered together by any administration. That fact is obvious. But it is far from being the whole truth.

Market ignorance

The oil market knows all the world's supplies of crude oil and its demands for the stuff. But it acts as though it does not know that we need to limit our consumption of oil products, in order to avoid further degradation of our climate, and to be able to pass on adequate reserves to our descendants. According to the market, there is only one reason for using less oil: namely, that we find it too expensive. And indeed, if we do not restrain our consumption, then sooner or later oil will become permanently impossibly expensive. But by then, it could well be too late to avert the lamentable consequences we have just mentioned.

The labour market knows how many jobs of each kind are on offer and how many people are looking for these jobs; it does not know that a worker needs a living wage. Thus it can happen, in a free labour market, that wage rates fall to clearly inadequate levels. The Viennese economist Carl Menger, in his Priniples of Economics (1871) remarked that seamstresses in Berlin could not earn enough for their subsistence (see Value: an economic puzzle, October 2008); yet he lambasted (2) the agitation of those who want society to allocate a greater share of consumer goods to the workers. These kind-hearted people, he complained, in effect want nothing less than that workers should be paid more than the value of their work. For him, the true value of work could not be other than its market value. Even if that was not enough to keep the workers alive.

The market knows the demand for houses and the availability of houses for sale, in all their variety of character and location and condition; it also knows the supply and demand for loans on mortgage. But it seems not to know that it is dangerous to borrow too much in relation to one's income.

Market perversity follows market logic

It will be replied, sure enough, that the individuals who participate in the market are indeed well aware of these facts. Nevertheless, they act in the market as if they were unaware of them. And we must note that their actions, though perverse, are generally logical according to the logic of the market.

If you are running a transport company, you cannot replace your diesel lorries with much more expensive vehicles running on electricity or liquid hydrogen, so long as your competitors are not doing likewise. You would very soon be run out of business.

If you are trading in a sector where the normal level of wages is less than a decent livelihood, you cannot pay your workers much more than the norm so long as you are up against tight-fisted competitors who do not share your scruples.

If the property market, inflated by overabundant credit, is absurdly overpriced, it may well be that you cannot buy a house without crippling yourself with excessive debt.

Time to turn a deaf ear to the dogmatists

Paradoxical though it may seem, the market in effect does not know, or behaves as if it does not know, many things that are perfectly well known to its participants. That is why interference by the authorities, or by other organistions such as trade unions or industry associations, is often necessary; however much this may infuriate the ideologues who insist that nobody can know better than the market.

So let us no longer be intimidated by the free-market dogmatists. The market is indeed extremely knowledgeable; it is also gravely ignorant.

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1 Friedrich von Hayek, The Use of Knowledge in Society in American Economic Review (Pittsburgh, Pennsylvania), vol. XXXV, no. 4 (September 1945)

2 Carl Menger, Principles of Economics (Grundsätze der Volkswirtschaftslehre, Wien, 1871), trans. J Dingwall and B F Hoselitz (New York University Press, 1976), chap. 3, #3E