Understanding markets: Does regulation make sense?

Though it should be obvious to all that markets are of immense benefit to humanity, any appreciation of these institutions is almost always hedged with a perceived need to constrain and regulate—in short, to subject them to conscious outside control. The reasoning is understandable: the unconstrained pursuit of self-interest can only lead to chaos.

But the preference for constraint through centralized direction betrays a profound misunderstanding of the way markets work.

Can we explain that claim any better than the volumes already written on the topic? We find that, when we discuss the issue, we agree on the basics, but differ in emphasis and details—and details matter. Here is part of our discussion, in point/counter-point format.

Thomas: I’d tackle the issue by emphasizing the futility of conscious control of complex systems. This is a Hayekian knowledge argument, but I’ll augment it by pointing to an interesting similarity between markets and scientific communities.

The basic interaction in markets is the exchange of goods and services. This relies on supporting arrangements—institutions such as property, contract enforcement, goods production and money. Those supporting institutions are a separate topic or, rather, many topics.

The market system itself is a large and highly interconnected system of exchanges, capable of generating beneficial effects unintended by the participants. The latter’s behavior is nonetheless shaped by feedback from these effects. And it is an open system, subject to and adaptive to changes, including attempts at outside control.

The recognition of some social systems as complex arrangements whose beneficial effects are the unintended consequence of people pursuing personal goals is an extremely important but seriously underappreciated scientific discovery. The idea has a long history among scholars with a classical liberal bent, from Bernard Mandeville, David Hume and Adam Smith in the 1700s to Hayek in the 20th century. But it is counterintuitive—surely, to generate societal benefits, people have to act with the intent to produce these benefits or to be constrained to act as if they do.

Not necessarily. There exist stable social arrangements in which repeated self-interested interactions generate as side effects certain societal benefits. At the same time, the effects feed back to constrain and channel the behavior of the participants. It is a characteristic of such systems that they adapt, in unforeseeable ways, to attempts from the outside to alter their functioning.

Take science, for example. Modern science – meaning the system of interactions between scientists that has predominated since its beginnings in the Royal Society of the late 1600s – does not rely on practitioners being dispassionate seekers of truth. It relies rather on the unhindered operation of the core institutions of publication and citation, on the self-interest of participating scientists in making use of contributions to further their own research, and on reputations built by producing work useful to peers.

There is no central control, yet these interactions lead to the generation of a relatively stable body of scientific knowledge while allowing for a wide range of personal motives. Attempts at central control lead to perverse results, Lysenkoism being the most notorious example. Sensibly, there is no serious call for direct outside intervention in the workings of science.

Market interactions are different from those in science, but the systemic operation is similar. Here, repeated interactions generate market knowledge in the form of prices for a wide range of goods and services. This benefits the participants by exposing opportunities for consumption, production, and exchange that would otherwise be difficult to discern. The system allows for a variety of motivations for interacting. And it generates feedback about the desirability of particular goods and services in the form of reputation, profit, and accumulated wealth.

In science, where concerns for “fairness” or “equality” do not have the same emotional tug, the inappropriateness of outside intervention is easier to appreciate. But the similarity should suggest that the argument against intervention in science applies with equal force to markets.

Chidem: That’s a fine explanation of how self-directed systems like scientific communities and markets work. But it ignores the creative destruction caused by innovation—or in the case of science, by paradigm shifts. Capitalism as a whole has thrived by creating new markets and destroying existing ones. To fully understand how it functions, one has to consult Joseph Schumpeter as well as Hayek.

Simple markets have been around for millennia, but economies were largely stagnant over the long haul. Political powers-that-be controlled economic activity and did not leave scope for much innovation—indeed often punished innovators. Economies grew and shrank without enjoying the permanent gains in affluence that we take for granted. Societies were not only materially impoverished but politically downtrodden as well.

What makes advanced capitalist systems distinctive is the profusion of new products, technologies and organizations. The decentralized structure of market economies was essential for the kind of innovation that accounts for the progress of the past several centuries. We owe our well-being to not having a single power controlling the economy.

People complain that nobody is in charge—but economies overseen by a central authority remain bereft of productive innovation. They may build pyramids or, in the modern example of the Soviet Union, send men to space, but don’t create mass affluence. Neither do they allow the exercise of liberty.

Classical liberals have long highlighted the link between central economic control and general lack of freedom—Milton Friedman perhaps expressed it best. We should not forget that a dearth of economically meaningful innovation goes with central control. Markets are complex systems with feedbacks and adaption mechanisms, as you show. That picture should be complemented with the understanding of how markets relate to freedom and the right to try out new ideas. … to be continued …

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