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When the intersection of economic theory and policy fails

American economic policymaking is dominated by the widely taught and cited neo-Keynesian synthesis, which argues for government intervention on the ground that markets are not efficient.

By Chidem KurdasGuest blogger / June 3, 2010

n this 2009 file photo, a bank clerk counts U.S. 100 dollar bills near bundles of Chinese notes.

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Headline topics like derivatives are part of the larger issue of how markets function. About this big question there’s been profound confusion in the past two years. Peter Boettke’s article in the Winter 2010 issue of the Independent Review clarifies the muddle.

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A particular mathematical interpretation of what an efficient market is has hogged the limelight. In order to achieve a high degree of mathematically useful abstraction, this neoclassical model ignores market adjustment processes; changes are instantaneous or nearly so. Under a set of assumptions chosen for mathematical convenience rather than any real-life correspondence, the model shows that prices fully reflect available information and there are no unexploited opportunities for mutual gain.

This neoclassical model of efficiency was not how Adam Smith, other classical economists and 20th century thinkers in the classical tradition – like Friedrich Hayek – analyzed markets. On the contrary, they focused on adjustments and changes. Moreover, even before the 2008-2009 crash, many people in the financial industry would tell you that they did not think prices fully reflect information. Ironically, then, neither free market advocates like Hayek nor market players like hedge funds had use for the mathematically-driven academic construct.

If anything, it was central planning advocates who proposed to use an early version of neoclassical theory for comprehensive government ordering of the economy. In the early 20th century central planning debate, Hayek confronted neoclassical planning proponents, in particular Oscar Lange. Hayek argued out that planners can not get the right prices by solving a simultaneous equation system, because the information necessary for such a solution is dispersed across the population and not available to any centralized entity.

Markets, where each participant indicates his or her preferences, are spontaneous orders that collect dispersed information. Market prices emerge from the aggregation of participants’ knowledge. Markets are efficient in the Hayekian or classical sense because they are better than the real life alternative, namely government action, in making use of information. Many decades later, the collapse of centrally planned systems corroborated Hayek in the most spectacular way.

What’s happening now? American economic policymaking is dominated by the widely taught and cited neo-Keynesian synthesis, which argues for government intervention on the ground that markets are not efficient—by the criteria of neoclassical theory. Professor Boettke of George Mason University points out that policy debates do not compare markets to real government.

Instead, an abstract market model and an artificial government are the main references. Just as the neoclassical model ignores market adjustment processes, advocates of government activism discount the reality of interest group influences or ballooning deficits and debt. In other words, markets that are failing according to a fairyland theory are compared to a fairyland government that never grows gigantic subsidized appendages like Fannie Mae.

In real markets people make mistakes and take time to adjust to changes, but their efforts create prosperity as long as government policies are not excessively obstructive and distorting. Mr. Boettke writes that markets are alive and kicking to survive, trying to correct previous resource mis-allocations caused by Federal Reserve policy and government subsidies for housing. Market adjustments remain obstructed by policies and political maneuvers—which for instance delay the resolution of non-viable mortgages by encouraging people to wait longer.

In this predicament, classical insights are very much germane, as Mario Rizzo and Jerry O’Driscoll have argued here on ThinkMarkets.

Neoclassical models and efficiency criteria have certainly been misleading, as many recognize. The theory has no useful explanation for the boom-and-bust cycles we’ve lived through. Paul Krugman, for instance, says, “the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

The problem is that the mathematical confection is confused with real markets. The theory is kaput; markets would work if perverse interventions could be kept down. Maybe one day people will look back and see much of today’s policies in the same light as we regard medieval medicine—at best useless, at worst deadly. Whatever problems markets have on their own, their ability to survive endless wrong-headed interference shows the power of spontaneous orders where free action by millions of people brings about – not fairyland – but the best that can be achieved.

Peter has great quotes. Here is one from Adam Smith: “The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle, that it is … not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations…”

To the folly of bad laws must be added the folly of bad theory. Our only recourse is to be clear about both.

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