Why Markets Fail

" I will make here a simple but strong claim. Free trade in competitive markets does not, in general, lead to a Pareto Optimal outcome. I will show that that there are two reasons why markets fail. The first is a systemic failure of financial markets. The second is a systemic failure of labor markets. In the following sections I will explain why both financial markets and labor markets fail, and I will present a policy that can improve the standard of living for all of us. Laissez-faire capitalism is a good deal better than the central planning that was implemented in Maoist China or Soviet Russia. However, unregulated free markets can sometimes go very badly wrong. There is no excuse for a society that condemns 50% of its young people to a life of unemployment.  We can and must seek prosperity for all."

Prosperity for All, Page 9.

Which Free Market?

"When Hayek criticized socialism, he was informed by experience. Beginning in the 1920s, Soviet leaders pursued central planning as an alternative to the free market system as a way of allocating resources, and China followed suit when the communists came to power in 1947. Hayek’s critique proved prescient as the failed experiments of communism were swept away with the opening of China to trade in 1972 and the fall of the Berlin Wall in 1989.

Hayek believed that central planning was inferior to free markets and that market capitalism is the best possible form of social and economic organization. He was right to infer that some form of market organization is better than central planning at allocating resources and creating wealth. But, that observation does not help us to decide which form of market organization is to be preferred.

There is no such thing as the free market. All market systems operate within systems of rules that define which property rights will be enforced and which will not. Those rules are themselves determined by the interaction of human beings in a political process that is still evolving. We cannot just decide that goods will be allocated in a free market. We must decide which free market. That is what I mean by institutional design."

Prosperity for All Chapter 1, Pages 7-8. 

Classical and New Keynesian Schools of Thought

“There are two leading explanations for the very slow recovery in the unemployment rate, and the continuing low growth of labor productivity, in the aftermath of the Great Recession. One group of classical economists clings to pre-Keynesian ideas that blame the recession on bad economic policy. The second group of New Keynesians seeks to resuscitate failed interpretations of Keynes on which the profession gave up, rightly in my view, during the 1980s. Both groups are wrong.” (Pages 12-13, Prosperity For All)


The Role of the State

"The question we must ask ourselves is not: Do we wish to live in a free market or a socialist economy? It is: What set of regulations can we put in place to ensure markets provide the maximum prosperity for all?

If a politician or commentator argues that the state should intervene in a contract between two or more people, the burden is on him or her to provide a clear explanation for the failure of free markets to deliver an optimal outcome. Any argument for the control or regulation of markets must be clearly defended. I have such a defense. There is a simple answer to the question: Why do markets fail? In the following pages I explain that answer and I offer a set of policies designed to ameliorate and, I hope, to prevent the worst effects of financial crises."

Prosperity For All, Page 2

The Demise of the Natural Rate Hypothesis

Quote for today (and tomorrows)...

The history of economic thought in the twentieth century is the history of a struggle between classical and Keynesian ideas. Two events have transformed this history since 1900. The first was the Great Depression of the 1930s, a prolonged period of high unemployment and low growth. The second was the Great Stagflation of the 1970s, a period of simultaneous high inflation and high unemployment. I believe the Great Recession is a third transformative event. Just as the Great Depression and the Great Stagflation changed economics forever, so will the Great Recession.  Prosperity for All, Page 31.

Read about this and so much more in Prosperity for All: How to Prevent Financial Crises