Stephen LeRoy a visiting scholar at FRBSF gives this issue a historic perspective. Starts from Adam Smith and how Pareto gave it Smith’s ideas a more precise framework. He follows it up with contributions by Debreu, Arrow and Hayek.
The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.
How did Smith come to his main ideas?
In 17th and 18th century England prior to Smith it was taken for granted that economic and political leadership came from the king, not from private citizens. If the king wanted to initiate some large economic project, such as expanding trade with the colonies, he would encourage formation of a company to conduct that project, such as the East India Company. The king would grant that company a monopoly, usually in exchange for payment. Smith thought that these monopoly grants were a bad idea, and that instead private companies should be free to compete. He called on the king to discharge himself from a duty “in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it toward the employments most suitable to the interests of the society.” (Smith 1776 Book IV, Chapter 9)
Thus, Smith’s conclusion was that private markets worked better if they were free from government supervision, and for him it was just about that simple.
He explains how Smith’s ideas got a jolt from USSR and its initial growth. And then it all collapsed.
Now the contributions of Pareto and how Arrow-Debreu made Pareto’s ideas more precise:
Pareto’s version of the argument is usually taken to be a refinement of Smith’s. But, for the present purpose, it’s best to emphasize the differences rather than the similarities. First, Pareto provided a more precise definition than Smith of efficient resource allocation. An allocation is “Pareto efficient” if it is impossible to reallocate goods to make everyone better off. Or, to put it another way, you cannot make someone better off without making someone else worse off. This idea captures part of what we usually mean by “good performance,” but not all of it. For example, attaining a reasonably equal income distribution is often taken to be part of what we mean by good performance, but an equal income distribution is not an implication of Pareto efficiency. Indeed, public policies designed to reduce the degree of income inequality can involve redistribution of income, making some better off and others worse off.
Arrow and Debreu showed that allocations will be Pareto efficient even in economies in which time and uncertainty are explicitly represented. They showed that, in any economy, there is an irreducible minimum level of risk that somebody has to bear. In a competitive economy with well-functioning financial markets, this risk will be borne by those who are most risk tolerant and who therefore require the least compensation in terms of higher expected return for bearing the risk. This is exactly as one would expect—risk-tolerant participants use financial markets to insure the risk averse. These aspects of equilibrium are discussed in standard texts on financial economics (such as LeRoy and Werner 2001
Nonmathematical economists such as Friedrich Hayek proposed an argument for the superiority of market systems that did not depend on Pareto efficiency. In fact, Hayek’s argument was the exact opposite of that of Arrow and Debreu. For him, it was the existence of asymmetric information that provided the strongest rationale in favor of market-based economic systems. Hayek emphasized that prices incorporate valuable information about desirability and scarcity, and the profit motive induces producers and consumers to respond to this information by economizing on expensive goods. He expressed the view that economies in which prices are not used to communicate information—planned economies, such as that of the Soviet Union—could not possibly induce suppliers to produce efficiently. This is essentially the same as the argument against socialism discussed above.
Excellent stuff. Stitches these insights from economic history really neatly.
What about this crisis? Markets or Government? Leroy says it is a bit of both. You cannot follow one extreme over another.
And, while the particulars of financial reform are still to be determined, it appears that current sentiment is less supportive of Adam Smith’s verdict on the efficiency of markets than was the case prior to the financial crisis. At the same time, it seems clear that neither extreme view of the causes of the financial crisis is accurate. Reforms based only on one of these views to the exclusion of the other will not lead to a set of changes that will guarantee improvement of the performance of financial markets and prevent recurrence of financial crisis. The problems are complex, and sweeping changes in the regulatory structure could do more harm than good. A better strategy may be to identify specific problems in the financial system and introduce regulatory changes that address these clearly defined weaknesses, such as executive compensation practices that encourage excessive risk-taking.
Again, I believe Adam Smith’s ideas have been taken to one extreme. Same is the case with Keynes, Friedman etc. Basically most economic ideas come under a particular situation. Smith’s ideas came where there seems to have been a lot of control of the government (or kings). Keynes in time of depression and Friedman when Keynes ideas were taken to one extreme of governments trying to control everything.
The flow of economic thought is kind of pendulum swing with extreme ends becoming mainstream more often that not. Even now, we need to avoid too much govt intervention for sure, but also need to do away with the belief that markets know it better. Seeing recent episodes of Goldman Sachs Abacus, Lehman Repo 105 and credit rating agencies transactions has been really bad. They have dug graves for themselves and the entire fin sector/wall street. Their reputation has taken a huge hit. The govt/regulators have little choices than to act. But still above all, you need people who can regulate.