Markets are good, but we need clear signals

Perhaps the most enjoyable aspect of the general election result is the abuse which is now being heaped on the metropolitan liberal elite from many quarters.  Theirs is truly a difficult mind set to comprehend, based as it is on an unshakeable belief in their own omniscience. Yet this is confounded on an almost daily basis by the response of ordinary people to incentives. The central planning mentality is simply not able to imagine all the ways in which markets operate.

Orlando Figes gives an illustration in his excellent book on the Russian Revolution, A People’s Tragedy.  Shortly after coming to power the Soviets imposed strict price controls, on vegetables. They forgot to include onions in the list. The result was a massive glut of onions, this being the only vegetable on which the growers might conceivably have made a profit. Admittedly, this was a simple bureaucratic mistake. But at the moment, Venezuela is imposing price controls, and the economy is being devastated, with many basic commodities, even lavatory paper, being virtually unobtainable. Many African countries, in the first flush of independence, did the same thing. A friend of mine went to work in Tanzania in the 1970s, full of idealism. Confronted by massive queues for almost everything, it did not take him long to respond to incentives and do what every other ex pat was doing. He sent his servant to queue for him instead.

The incentives created to get people to switch to diesel, such as lower vehicle taxes, proved very effective, and over the past 20 years the number of diesel cars in the UK has risen from just under 2 million to 12 million. Yet the consequences were unforeseen. It has only emerged this year that diesel engines create much more pollution than petrol ones. Environmentalists bullied the government some years ago to cut the speed limit to 20mph in Richmond Park, near where I live. It turns out that this is much worse for the health of the numerous cyclists than when cars are allowed to run at the more efficient speed of 30mph.

Gordon Brown epitomised this view of the world. Under his control of the economy, the tax manual more than doubled in size. Regulators came to see their jobs as devising more and more rules to try and anticipate every eventuality. It was a doomed mission, as the complete failure to anticipate the financial crisis shows.

But there is an important flip side to this. If we are to rely more on markets and incentives than on tomes of regulation to produce reasonable outcomes, it is essential that markets are seen as giving reliable information. The Americans understand this, hence the massive fines just imposed on banks. There are also serious questions to be asked about the increasing dominance of algorithmic trading in financial markets. Not only are the chances of ‘flash crashes’ increased many times, but it becomes less clear what information is being signalled by market prices. This is something useful for the regulators to examine.

Paul Ormerod

As published in City AM on Wednesday 27th May 2015

Image: 20mph by Edinburgh Greens under license CC BY 2.0

Leave a Reply