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Opinion

Markets fail. That’s why we need markets.

It may sound odd, but only free and open markets, not government regulation, can quickly and effectively clean up the mess that markets sometimes make.

By Arnold Kling and Nick Schulz / December 28, 2009



Arlington, Va.; and Washington

Two camps have fought the political and philosophical battle for influence over the economy in the United States for the past 100 years. They differ in their views over the nature of markets and government. And both are wrong.

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One camp makes it sound as if markets can do no wrong. Their views were ascendant in the 1920s and again in the 1980s. 

The other camp argues, “Markets fail, and that’s why we need government.” The idea is that markets are prone to excesses and imbalances and need the thoughtful, steadying hand of government to protect consumers and investors from flaws and uncertainties of the market. This camp believes that wise technocrats can and will bring order to the markets. 

In the wake of the financial crisis that gave way to the broader economic downturn, the advocates of government involvement in the economy are once again on the march and traditional defenders of markets are in retreat. And so we have seen government advance its role with partial ownership of many big banks, with a take-over of automotive firms, with a large “stimulus” program, with proposals for cap-and-trade for carbon emissions, and with a major initiative on healthcare.

The traditional defenders of free markets have had a rough time getting a hearing lately. After all, it certainly appears as if markets don’t work in any meaningful sense. The Dow rises and plummets in harrowing fashion, the housing market balloons and then craters, financial services firms teeter on the edge of extinction one minute and swing to record profitability the next. 

Surely, government can do better. 

Or can it? Over the past two generations, a different view of markets and government has begun to emerge, one whose moment may have arrived. It is a view that believes both traditional camps have overlooked some important aspects of markets. 

What’s more, it is a view that, if embraced, helps reinterpret market gyrations and government interventions in a way that better reflects reality. The view is subtle, but it has a profound influence on how the public and policymakers should think of markets and, ultimately, the role of government in the economy. 

This view can be summarized as “Markets fail. That’s why we need markets.” 

This seemingly paradoxical view is based on several overlapping strands of research in economics as it pertains to development, history, technology, business expansion, and new-firm formation. According to this view, entrepreneurs at work in the economy – in finance, high tech, manufacturing, services, and beyond – are constantly experimenting, creating new business models, techniques, and technologies that upend the established order of things. 

Some new technologies and innovations are genuine improvements and are long-lasting welfare enhancers. But others are the basketball equivalent of pump fakes – they look like the real deal and prompt market actors to leap hastily into action, only to realize later that their bets were wrong.

Given this dynamic, markets are unpredictable, prone to booms and busts, characterized by bouts of exuberance that are rational or irrational only in hindsight.

But markets are also the only reliable mechanism for sorting out this messy process quickly. In spite of the booms and busts, markets drive genuine long-run innovation and wealth creation. 

When governments attempt to impose order on this chaotic and inherently risky process, they immediately run up against two serious dangers. 

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