Roger Bootle: To defend the free market we must admit it is built on human behaviour

In the early part of the lives of today’s decision-makers, there was an alternative to the market economy, in the shape of the planned economies of the communist bloc. The choice between economic and political systems found expression in the conflict that we all know as the Cold War.

For most of this time, there was a corresponding intellectual battle – fought in the pages of economics journals. The subject of this conflict was essentially whether self-interested behaviour by individuals and firms, freed of all government interference, could produce the best results for society. In the dominant school of thought, the answer was yes. So, as in all the best fairytales, this one had a happy ending. Greed is good.

Thankfully, we have now got beyond this stuff. The collapse of communism has made it clear that there is no alternative to the market economy.

Surely, we can now examine the limits to markets without believing, or being thought to believe, that the market system is intrinsically evil, or that there is in fact any viable alternative?

In my view, we need more of the market, not less, in healthcare, education and transport – particularly travel by road.

Equally, we need less of the state, not only in these activities, but also in the redistribution of incomes, the provision of “social security” and countless other areas. And we surely need lower levels of taxation.

But that does not mean that markets can and should be left well alone in all parts of the economy. There are some areas where the state needs to be more involved in order to make markets work better.

If supporters of markets fail to acknowledge their limitations and fail to address the areas of market failure, then they will undermine the case for markets overall and risk losing the wider battle against the champions of egalitarianism and state bureaucracy.

A prime example comes from the furore over the 50 per cent tax rate.

The reason why this tax is so popular – and accordingly so difficult to abolish – is not so much a widespread antipathy towards the rich but rather an almost universal loathing of bankers.

It may be a blunt instrument, but a large part of the population sees the 50 per cent tax rate as a way of penalising the undeserving plutocrats in the financial sector.

This is a prime example of the costs of not facing up to the need to make markets work well and thereby ensuring a modicum of common sense – if not justice – in the system of remuneration.

The financial crisis has now become all things to all men. To many on the left, it surely revealed the defects of markets.

To many on the right, however, it did no such thing, because the villains in the piece were the regulators and the central bankers.

Banking was one of the most highly-regulated of all activities.

Partly because of this, everyone involved with banking was insufficiently circumspect.

The widespread belief that the public authorities would not allow any bank to fail encouraged bankers to take excessive risks. And it led bank shareholders and bank customers not to notice or, if they did notice, not to care. Meanwhile, all of this was underwritten by the most lax monetary policy since Adam and Eve.

Who is right? There clearly were massive errors of public policy.

I, among many others, and from some way back, criticised the excessive emphasis on short-term inflation targeting and urged that greater attention be given to asset prices in the setting of interest rates.

As for the system of regulation, it is now widely acknowledged, not least by many of the regulators, that it was a sick joke.

Nevertheless, the idea that the crisis revealed nothing ill about financial markets I find incredible.

Why were boards so reckless?

Why did so few banks and bank managements stand out against the crowd?

It is all very well criticising the system of regulation. But the important question to ask is why the system of regulation was so inept.

The fundamental answer is that even the regulators themselves did not believe in what they were doing – and neither did anyone else. They may not have realised it, but they all believed in some version of the efficient markets hypothesis – as well as all the other hogwash that went with it: liquidity crises a thing of the past; and macro behaviour is not a subject in itself but is rather just the result of adding up all of the micro elements, which are all appropriately profit-maximising in the usual way – and with all the usual fairytale results.

This crisis arose from many causes but prime among them was that financial market participants were thoroughly human, in the time-honoured way of financial markets.

Specifically:

They were short-sighted;

They were over-optimistic about sustainable returns; and

They displayed herd behaviour.

As a direct result of people’s very humanity, financial markets are prone to bubbles that, when they burst, can endanger the stability of the whole financial system.

Only some outside body, acting in the public interest, can fully appreciate these stability risks. It is incumbent upon such a body to make these risks evident in the incentives which face market actors.

Human failings governments can do nothing about; nor should they try.

But they can and should make policy recognising them to be true, rather than pushing them to one side and ploughing on as though everyone was like the homo economicus of the textbooks.

As such, the key to success for any society lies in achieving the right balance between the pursuit of individual success and pursuit of the common good.

Get that balance wrong and economic disaster may ensue.

Indeed, an economy without effective limits to self-seeking behaviour ends up as Upper Volta – without the rockets.

* Roger Bootle is managing director of Capital Economics. This is an edited extract of the Keith Joseph Memorial Lecture that he delivered last night in honour of the former Leeds MP. The event was organised by the Centre for Policy Studies think tank.