The ALP national platform says the following about markets and market failure:
“Markets have fostered abundance and growth that would be inconceivable to previous generations. All markets are structured by legal frameworks, as well as underwritten by public investments in physical and human capital. Markets exist to serve communities and government can and should shape markets to support a democratic, prosperous and inclusive society. The market will often create the most equal and efficient distributions of power, wealth and services, but markets sometimes fail. Labor supports an active role for government in addressing market failure and improving equity, promoting equality and social justice through the full range of policy instruments including expenditure, taxation, regulation and the provision of goods and services. Strong regulatory frameworks in both the global and Australian economies are important to ensure markets operate with transparency and openness and to prevent and expose misconduct. Government should intervene to address market failure and the extremes of capitalism”.
But what exactly is market failure?
A narrow definition is any departure from a (mostly theoretical) perfect market in which all participants have full information and all costs have been properly priced.
But some economists cast the definition of market failure in far wider terms.
For example, the website economics online lists the following as market failures:
- Monopoly power– Markets may fail to control the abuses of monopoly power.
- Missing markets– Markets may fail to form, resulting in a failure to meet a need or want.
- Incomplete markets– Markets may fail to produce enough merit goods, such as education and healthcare.
- De-merit goods-Markets may fail to control the manufacture and sale of goods like cigarettes, alcohol and other drugs of addiction.
- Negative externalities– Transactions between two parties may have negative effects on third parties, or the public as a whole- pollution is a classic example of a negative externality.
- Property rights– Failure to assign property rights may limit the ability of markets to form.
- Information failure– Markets may not provide enough information because it may not be in the interests of one party to provide full information to the other party.
- Unstable markets– Sometimes markets become highly volatile, such as certain agricultural markets, foreign exchange, and credit markets.
- Inequality– Markets may also fail to limit the size of the gap between income earners, the so-called income gap.
Every economic problem and most social ills, including poverty, substance abuse, lack of education and healthcare and their concomitants, all fall within this broad definition.
But if”market failure” is defined this broadly then the term starts to become meaningless or trite. One might just as well say that sometimes markets produce good results and sometimes they produce bad ones.
Such a broad notion of market failure can never be seriously tested. It is incapable of being disproved because of the circular nature of the definition. If there is an ill this must represent a market failure because if the market was functioning properly the ill would not exist. This circular slight of hand neatly gets rid of the notion that the nature of a market itself, not a failure in the market’s operation, might actually be responsible for the ill.
But not all economists agree on such an all encompassing definition of market failure.
French economist Thomas Piketty has attained notoriety for his theory (based upon an extensive study of income and taxation records) that capitalism has an innate tendency to increase inequality. His explanation for this tendency is disarmingly simple: the rate of return on capital is generally higher than the rate of economic growth. Returns on assets, like real estate and shares, disproportionately held by the wealthy, rise faster than overall economic growth, thereby increasing the overall proportion of the total pie of wealth that is held by the rich.
The point has been made by Nobel prize winning economist Robert Solow that for Piketty, the tendency for capitalism to increase inequality and to concentrate wealth is not a market failure. On the contrary, Piketty asserts that the more perfect the capital market, the more the rate of return on capital will exceed the overall growth rate, thereby exacerbating inequality.
The absurdity of regarding inequality as a market failure is apparent when we consider the types of sub-market that operate within a broader market economy.
Currency markets, financial markets, stock markets and commodity markets sit at the commanding heights of the capitalist market economy. They generate enormous wealth. But do not have equality even as a subsidiary goal. To suggest that these markets are “failing” when they reproduce inequality is nonsense. There can be no “failure” when equality is not even a goal of these markets.
Consumer markets do not really aim to produce equality either. Their primary goal is exchange of goods and services for money. Regulation, usually in the form of information provision or quality standards, aims to protect consumers against the effects of the pre-existing inequality in power and information that usually exists as between seller and buyer.
It is really only in the labour market where equity is often expressed as an explicit goal. Regulation of wages and conditions aims to ensure a more equitable distribution of wealth between capital and labour. The labour market is important, indeed crucial, to the standard of living for wage and salary earners. But as the analysis above demonstrates, it is only one of a number of important sub-markets that operate within the economy.
Apart from regulation of the labour market, and to a lesser extent the consumer market, most of the measures a society adopts to ameliorate inequality actually have nothing to do with the market at all. It is government action, not the market, which ameliorates inequality: redistribution through the taxation system, transfer payments and provision of government services.
The narrower definition of “market failure” referred to above can certainly be a useful framework for analysing where regulation should be deployed to improve the functioning of markets. But what is the purpose of the term “market failure” where it is defined so broadly as to include any economic or social ill?
One purpose is probably ideological. Referring to “market failure” allows all those across the political spectrum to position themselves as starting from the assumption that, absent any of evidence of “failure”, markets should be left alone. Because of the prejudices of the privately owned media, especially the financial press, this is where most centrist parties generally want to be positioned from the political point of view.
It can even lead those on the centre left of politics to such dubious conclusions as “the market will often create the most equal distributions of power, wealth and services”. Really? “Often”? How often?
And what of the assertion that “the market will often create the most efficient distributions of power, wealth and services”. Even if free market capitalism is inequitable, is it an “efficient” distributor of social goods?
It might depend which sub-market one is referring to. But the “efficient markets hypothesis”, the neo-liberal idea that prices generated by financial markets generally represent the best possible measure of the value of economic assets, and are therefore the most reliable guide to efficient decision making about investment and production, has proved a miserable failure. It contributed to the GFC and, even today, while financial markets are buoyant, the real economy remains moribund, stuck in a ‘secular stagnation’ of low, volatile growth, high and rising debt levels, slow investment, overcapacity, high unemployment, low income growth and low, or negative, real interest rates.
Yanis Varoufakis, Greece’s former Finance Minister says that during the last three months of 2015, in the United States, Britain and the Eurozone,3.4 trillion dollars was invested in wealth-producing goods -things like industrial plants, machinery, office blocks, schools, roads, railways, machinery, and so on and so forth. This sounds a lot. But over the same period $5.1 trillion that was slushing around in financial institutions, doing absolutely nothing except inflating stock exchanges and bidding up house prices.
Indeed some studies have established an empirical negative correlation between financial sector growth and productivity improvement. It has been suggested that finance sector growth “crowds out” growth in the real economy. As the finance sector grows capital increasingly gravitates to the higher return potential of the property and financial markets (equities, private equities, hedge funds etc.), rather than into the real economy. The money is diverted from the real economy into a parallel financial economy where it is used to gamble on property, shares, interest rates, currency and anything else the rich elite can find.
Just as the term “market failure” is open to ideological abuse so to is the term “market based solution”.
The term market failure is certainly properly applied to climate change. There is no doubt that carbon and other greenhouse gas emissions would come within any reasonable definition of market failure because these are an “externality”, an unintended consequence of transactions between market participants that affect third parties, indeed the public at large.
But the notion that emissions trading is principally a “market based” solution is surely one of the great myths of our time. Emissions trading is a regulatory solution much more than a market based one.
A carbon emissions market is incapable of arising spontaneously. It is not like the market for bread for example. The bread market arose spontaneously once we learned how to make dough. But it is necessary to artificially create an emissions trading market. This can only be done through regulation. The requirement to measure and audit emissions is regulation. The ability to acquire or purchase permits to pollute is regulation. The policing of those permits is regulation. The establishment of a price for the permits is regulation as is the number of them released into the market.
It is true that once the permits are first purchased, or otherwise received, they can be traded (on terms that will also be influenced by regulation). But this ability to trade permits is but a single feature amid an elaborate and complex regulatory structure. Further, the ability to trade permits is not even the main point of the regulatory structure. Or at least it is not supposed to be (though critics of emissions trading might beg to differ). The ability to trade the permits is only supposed to be a means to an end. The “end” is transition to a low emissions economy. After this transition the need to trade carbon emissions diminishes or, better still, is eliminated. Again, by way of contrast, it is not an aim of the bread market to eventually eliminate bread.
So why does it matter if “market failure” is defined so broadly? Isn’t this just a semantic issue? Not entirely. An ideological function lurks under the surface of this apparently neutral economic term. If nearly all ills can be characterised as market failure then the clear implication is that there is nothing fundamentally wrong in the basic structures of our economy. If it is only market failures that need to be addressed, not the very foundations of how the market economy is organised, then, as the ALP platform suggests changing the regulatory framework, or the mix of taxation and expenditure will be sufficient to address the “extremes of capitalism”.
But what if this is wrong? What if changing a regulation, or tax law, or a service here and there will not reverse the increased tendency towards growing inequality and growth in the extremity of capitalism? What if the power structures produced by the current economic structure operate to prevent even these moderate changes being sustained over any significant period of time? What if we really we do need to find new and more democratic ways of organising production? What if capital should be put to the service of workers rather than workers being put to the service of capital?
There are successful alternative co-operative models of production already in existence. Mondragon in Spain in the most famous. In the Emiglia Romana region of Italy, worker owned co-operatives are responsible for about 305 of GDP. ‘Earthworker’ has been established in Victoria. These co-operative methods of production are not anti-market. Neither do they replicate the failed models of state ownership of capital “on behalf of” workers. Instead they involve worker ownership and control. Co-operative ownership of production is the most fundamental innovation we can make to increase productivity, reduce inequality and improve quality of life. But it involves fundamental changes in the structure of the economy, in the ownership of the means of production, in the very structure and power relations that characterise our economy. These changes will not eliminate market failures- however defined. But without them, increasing inequality is unlikely to be reversed. This is because the tendency towards deeper inequality is largely a function of the market, not a failure of it.