Saturday, June 5, 2010

Free Market vs Keynesianism

It is often claimed by economists that there is essential agreement in the profession on almost everything. Well, if that was ever the case, it is not now. There are free market economists, Keynesian economists, Austrian economists, and even Marxists.
You can see the division among economists in the following remark by Paul Samuelson.
“And today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution. This prevailing ideology of the last few decades has now been reversed. Everyone understands now, on the contrary, that there can be no solution without government.”

The market system is generally the most efficient allocation system—it best satisfies people’s wants and needs and raises their standards of living. Without anyone dictating what buyers and sellers do, the market determines a price for each traded good at which the quantities that people are willing and able to sell are equal to the quantities that people are willing and able to buy. Day in and day out, the market system induces people to employ their talents and resources where they have the highest value. People do not have to be fooled, cajoled, or forced to do their parts in the market system. Instead, they pursue their own self-interests and, in so doing, generate the most good for society.

Firms acquire resources and then organize and coordinate the resources to create and offer for sale various goods and services. The value that consumers place on these goods and services must be more than the value they place on the individual resources alone or else the firm will cease to exist. When a firm’s goods and services have more value than the opportunity cost of the resources used to create and sell the goods and services, then rivals will begin to compete with that firm. In other words, when economic profit is negative, the firm will cease to exist; when economic profit is positive, the sharks will attack. Rivals will enter and compete. People will get the goods and services they want at the lowest possible prices and resources will be used where their value is highest.

A free, competitive market is usually illustrated as a simple downward sloping demand curve and an upward sloping supply curve. The price and quantity at which the curves intersect represent the result of competition, the price that is the lowest possible and the quantity that people want and are able to pay for. This price and quantity result from resources being used where they are most valued. If another department store could match Nordstrom’s products and service but do so at a lower price, consumers would abandon Nordstrom and shop at the other store. This would drive Nordstrom’s profits down until they were at the normal or zero economic profit level. If iPods can be replaced with another company’s MP3 at lower prices and/or higher quality, then Apple’s profit will be driven to the normal level. Thus, the intersection of demand and supply is the point where consumers are currently happy with what they are getting and prices are as low as possible.

When competition is limited and entry restricted, then the picture changes. With total entry restrictions, the entire market is converted into a single firm, the monopolist (or a cartel of firms acting as a monopolist). The firm maximizes profit by restricting quantity and raising price. If government intervenes in the fre market price and or quantity is distorted from the competitive outcome and either "too much" or "too little " is produced and consumed. Resources are misallocated. Intervening or interfering with free competitive markets harms society.

But even so, it is argued, a free market causes too many problems. For instance,if a free market is hit by a sudden reduction in demand caused by any number of things, such as speculative activities, unexpected resource changes, or some other crisis, the free market adjusts to the demand reduction by firms exiting business and price and quantity being reduced. The free market adjusts by price dropping until the demand and supply curves intersect again.

Here is the theoretical crux of the argument between free market economists and Keynesians – the speed with which the market adjusts to changes. Critics of the free market argue that the adjustment from the first equilibrium to the second takes too much time. Markets just take too long.

A slow adjustment of the market means resources will be unemployed and inventories will stock up on shelves for awhile. If demand decreases but price and quantity do not immediately follow, then a surplus will occur. If this market is wheat, then a surplus of wheat will exist; wheat will lie dying in the field. If this market is cars, then excess inventories of cars exist; cars will be piling up on dealer lots. But most importantly to market interventionists, if this market is the labor market, then there is a surplus of labor; unemployment rises.

John Maynard Keynes, the leading economist of the 1930s, captured this criticism of free markets with the following statement:"The long run is a misleading guide to current affairs. In the long run we are all dead." Tract on Monetary Reform (1923) Ch. 3.

Free market economists argue that intervening in free markets will make matters worse than just letting the free market adjust. Under this view, when something like the Great Depression occurred in 1930 or when the financial collapse in 2006-08 occurred, the free market response would be to do nothing - because in the long run the markets would solve the problem, the price of labor would fall, more firms would hire, people would return to work, and the economy would return to full employment.

Keynes said this was madness - in the depth of a recession, why not try to do something about it, rather than leave it to 'market forces'. In the long run the recession may end but the long run could be 10, 15 or more years. Keynes wanted to try and solve the depression now rather than wait for 10 or 15 years or however, long the 'longrun' was.

This viewpoint is the basis of many of the arguments between free market economists and the Keynesian or non-free market economists. "It simply takes too long for the market to work things out. People, central planners, and governments can do it better."

The counter to this argument is that while we might be dead in the long run, our children and grandchildren won’t be. So we should do what is best for the economy in the long run and that is leave markets alone. By intervening in free markets, inefficiencies arise that slow the growth of the economy and harm future generations. In the end, intervening in the functioning of free markets just makes the situation worse and creates additional problems.

But there is more to the story than this. The Keynesian solution does not even help in the short run. The GreatDepression lasted 13 or so years; the great recession of 1921 lasted two years. The difference was that the Keynesian solution was tried in the Great Depression. In 1920, nothing was done; the free market adjusted. In 2008 the free market was interfered with in a huge way with bailout, takovers, cram downs, huge expansoins of the money supply and other Keynesian policies. How effective have those Keynesian policies been to date?

Ignoring the long run is impossible. People care what happens to their children and grandchildren and the long run to someone, say Pratt, is much longer than it is to me. As a good friend of mine states, I don't even buy green bananas any more. The intergenerational robbery that has gone on with the Keynesian policies is perhaps the theft of the century.

1 comment:

  1. Nice article. Hope you don't mind I copied and pasted it to my facebook account. Thanks, -Zarda