Wednesday, October 12, 2011

The Paradox of Free Markets.

There has been a lot of discussion the last few years about deregulation and allowing "the free market" to operate. In many/most cases, that is the most effective solution. Allow buyers to "vote with their dollars" by supporting the sellers who offer the most suitable (including price, quality, performance, etc) product for the buyer's needs. That is fundamental to capitalism as an economic model.

However, "free markets" do not work when any of the following are true:

  • One company controls 45%+ of the marketplace, or a few companies control over 75% of the market.
  • There are high barriers to entry for new competitors (including regulatory or capital cost barriers).
  • There is a limited supply or distribution chain. This includes "natural monopolies" such as utilities, cellular providers (since RF bandwidth is a limited resource), etc.
  • Corporations/companies get special interest exceptions or special benefits (e.g. tax abatements) from the government.
  • Regulations to prevent collusion by sellers are absent or ineffective.
  • The "buyer" has a medical emergency or urgent medical/health need and therefore has no real opportunity to compare providers of medical services. Healthcare delivery is rarely a free market because the of the limited opportunity to research and compare providers, services, and prices.
Note that markets must be considered on a local, regional, and national level. Other levels such as state/province may also be useful measures.

Any of those situations shift the balance of power in favor of the seller, such that free markets don't work. In any of those situations, competition is limited and the buyer has very little power or choice, therefore, it is no longer a free market. When any of the above conditions (and perhaps there are a few I've missed) occur, progressively stronger anti-trust/anti-monopoly regulations should begin to apply as needed to balance the market. If the above situations are not properly regulated and limited, greed and power will always eventually lead to corruption and abuse, it's human nature.

"With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly."
- Ben Bernanke, November 15, 2005, less than 2 months before he became Chairman of the Federal Reserve. Approximately 2.5 years before the banking crisis that was as extensive as it was in large part because of trading said derivatives.

The restraint must be preemptive. Because corruption and abuse cause damage that is difficult (frequently impossible) to repair, and because history shows that they are inevitable, regulatory limits should kick in automatically as soon as one of those conditions exists, even if there is no actual evidence of corruption, collusion, anti-competitive activity, or abuse. I know some people will disagree with that statement, calling it a prior restraint of trade, etc. However, history has demonstrated many times that no matter how benevolent the intent, eventually it will become corrupt because power and money draw people who will abuse and corrupt the organization. By the time the corruption or abuse is clearly demonstrated, the damage is likely to be irreversible, extremely costly, and difficult to restrain.

"I made a mistake in presuming that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms ...."
- Alan Greenspan, Chairman of the Federal Reserve when the Glass-Steagall Act was repealed in 1999 and he supported it's repeal, testifying to Congress on the banking crisis in Oct 2008.

Unregulated free markets don't work when any organization has sufficient power to manipulate the market. Corporations can not be relied upon to act in the best interest of their shareholders, much less the best interest of the market or the people. The history of anti-trust violations makes that abundantly clear. The repeated banking failures make that abundantly clear. The US auto industry in the 50's-60's (unsafe vehicles) makes that abundantly clear. There have been thousands of anti-trust suits filed by the US Government against companies alleged to have engaged in anti-competitive practices, manipulating a market, etc. Anti-competitive behavior is not a rare occurrence.

Even renowned economist and free market advocate Milton Friedman, acknowledged that monopolies arise in free markets, and that at least one of them has persisted (for over 130 years):
“A monopoly can seldom be established within a country without overt and covert government assistance…The De Beers diamond monopoly is the only one we know of that appears to have succeeded. We know of no other that has been able to exist for long without the direct assistance of governments.” -- from "Free to Choose".

Note that he acknowledges others have existed, but didn't last "for long". He doesn't say what the others were, or how long they lasted. Did they last 10 years? 20? 50?. How long does a monopoly have to exist before it causes harm to consumers or the market? While he dismisses them as not lasting for long, he never addresses whether the monopoly was harmful while it existed.

Now we have the paradox:
A free market is the most effective, most responsive, and least costly method of creating competition and allowing the market to respond to consumer wants and needs. Yet a free market can't be truly free, it must be guided toward balance via regulations that take effect when any of the above conditions exist.

The solution is not more laws and regulations. That's the solution proposed by many people whenever there is another problem, however, that usually makes matters worse. A better solution is to start by replacing almost all existing regulations with fewer, simpler regulations that have less overlap, less duplication, and very few exceptions. The regulations should be as few and as simple as necessary to prevent most abuse, corruption, collusion, fraud, and deliberate or negligent harm to buyers and to keep the market from becoming significantly unbalanced. As new situations arise that aren't addressed adequately by the laws and regulations, reevaluate and update or replace existing regulations. When I say update, I literally mean update the existing regulation, don't just add another new law or an addendum to the law, add, update, or remove sections to that the changes are incorporated naturally into the text of the law.

Keep it as simple and straightforward as possible. Complexity will make the laws and regulations ineffective and costly. The market should be allowed to operate as a free market so long as conditions allow for a balanced free market, with just basic regulations regarding fraud, liability, negligence, etc. Regulations to prevent abuse when the above conditions exist should be as few and as simple as necessary to allow a balanced market. The regulations should also be progressive, with minor restrictions when the threshold is crossed, and stronger restrictions if the market continues to be unbalanced (e.g. one or a few suppliers continue to gain control of a larger percentage of the market). The goal is to "nudge" the market into balance, not to manage the market. Markets are far too complex and dynamic to be managed, regulations must merely restrain abuse and promote a balanced free market, they must not attempt to manage the market or steer it in a specific direction.

Special interest exceptions or exclusions should almost never be included in a law or regulation, even temporarily. There will be some legitimate exceptions. Some exceptions might be permanent, and those should be part of the law. Temporary exceptions should be via an addendum that automatically expires and cannot be extended. "Temporary" laws must be kept temporary. Writing a new law that has the effect of extending a temporary law must require a "super-majority" vote for it to be enacted.

Laws and regulations should be simple enough for the majority of people with at least an 8th grade education to understand what the law says. Lawyers and judges can debate the details, limits, and exceptions when necessary as that's a legitimate purpose of the courts, but the legislation and regulations should be understandable to most adults. For instance, we don't need separate laws for computer fraud, insurance fraud, credit card fraud, securities fraud, etc, we just need one law that makes fraud illegal, and establishes penalties based upon the extent, value, and impact of the fraud. Fraud is fraud, how you commit it should be irrelevant. A similar approach applies to other crimes.

I stumbled across a document that covers this in some detail. It's longer than my post, but worth reading. Here's one relevant excerpt:
All economic systems are governed by certain rules of game, and the governing rule for a modern market economy is the rule of law. The rule of law has two economic functions. First, the rule of law regulates and limits discretionary interventions of the state in economic activities. Secondly, the rule of law regulates the economic behavior of individuals and enterprises to create an orderly, stable environment with fair competition, clearly defined and well protected property rights, and effectively enforced contracts. In essence, these two economic functions of the rule of law are about regulating the relationship between the state and the market through legal institutions so that economic development is both possible and sustainable.

According to a NYTimes article, Sanford Weill, former CEO of Citigroup, the man considered to be one of the most influential in the repeal of Glass-Steagall, and one of the people who profited most from it when Citigroup was created, now says:
“What we should probably do is go and split up investment banking from banking. Have banks do something that’s not going to risk the taxpayer dollars, that’s not going to be too big to fail.”
Many of his counterparts at other banks have agreed:
"In 2009, John S. Reed, who with Mr. Weill forged the megamerger that created Citigroup, apologized for creating a lumbering giant that needed multibillion-dollar bailouts from the government. Philip Purcell, the former chief executive of Morgan Stanley and David H. Komansky, the onetime leader of Merrill Lynch, two other main figures in the fight to repeal Glass-Steagall, have echoed similar concerns about deregulation." - NYTimes

Related links: Updates:
2011-10-27. Updated with quotes from Bernanke and Greenspan, added examples where free markets have failed, and expanded the section on keeping the regulations simple.
2011-10-28. Changed the title from "What is a Free Market?".


  1. My experience with laws and regulations is the spirit of all of them is, "don't be a dick-head."

    My experience with people of all ages and varied other demographics is a small percentage of any group are dick-head's.

    Simple law's or regulations imply a great deal of things that are innate to non-dick-head's. All the implied things in a simple law or regulation is an open invitation for a dick-head to break the law or regulation and win financially, and in court when claims are made against the said dick-head for obvious flagrant perversions of the law.

    [Jonny blows spitballs through a straw at many people in class]
    Teacher: Johnny stop doing that!
    Johnny: Nothing says I cant do that anywhere.
    Teacher: Honestly! Jonny, do I really have to write down, don't blow spitballs at people or things in school?
    Johnny: Yea.
    [teacher writes it on the top edge of board boldly in chalk]
    Teacher: Okay there it's written down.
    [Jonny lobs a spitball at teacher with ruler used as a catapult]
    Teacher: Are you fucking kidding me?
    Johnny: I didn't blow it at you.
    [Teacher fired for swearing at a student]

  2. A rule law prohibiting assault or actions which have the effect of assaulting another), covers all the situations you described and more. Punishment appropriate to the type and effect of the assault. Simple, to the point, and there are no loopholes. Stop trying to define every type of assault, or every action that could be considered an assault and you eliminate the loopholes.

    Simple rules work, when you keep them simple.

  3. Minor note depending on where you live: The spitballs would be Battery or unwanted touching, assault is the threatening that usually comes before the battery.

    The trouble is in the definition though. If you are too broad with it to keep it simple, you wind up validating claims that a law was broken when it wasn't in the spirit of the law; like when a player draws a penalty by tricking the referee. If you narrow the definition sufficiently to prevent convicting the innocent, you inadvertently make legal things that should be within the spirit of the law. Your law's definition is for the past and foreseeable future problems. We cannot effectively predict all future possibilities, and the cleverness of people to find new perversions is amazing.

    Just by the normal definitions of assault and battery, a person could be jailed from riding the subway at a busy time of the day. A grandmother could be jailed from how she mishandles her shopping cart in line bumping the ankles of the customer in front of her. Sporting events would be jailing many of the fans who shout out jeers against the opponents.

    It seems to work best when we broadly define laws, then throw out the weak cases in court, but then theirs always the dick-head's who will press to the supreme court to get the misdemeanor battery charges filed because their neighbor's lawn mower crossed the property line and cut his lawn wrong.

    A similar subject is computer viruses, and their is mathematical proof that we can't prevent the next virus. The guardian software's like McAfee, Norton, etc. have laws defining legal inputs into the computers environment. It is common to have your spyware or anti-virus stop the normal operation of good software that you want to use. It is also common that a new virus written by a dick-head gets by all the protections and ruins things. You can't prevent that, but you can edit the definitions to stop that newest security breech. That's how laws get messy over time. As for the good software that looks like a virus, you can tell the security to leave it alone, but that is asking a virus writer to make a virus that looks like that exception software and back doors the security. Eventually the security system becomes so cumbersome that the computer doesn't work fast enough to please.

    The real solution is to build a dick-head detector and deal with them appropriately. We wouldn't need any laws if we could just segregate all the dick-head's to a safe place.

  4. "It seems to work best when we broadly define laws, then throw out the weak cases in court...", exactly.

    As for the jerks, who will try to sue for stuff that's clearly not in the spirt of the law, you can address in several ways: First, in some cases, you can write the law in a way to exclude minor infractions, "no harm" clauses, etc. Second, you can make the penalties start very low so that it's impractical to sue for minor infractions. Third, you can implement "loser pays reasonable court costs" an option for the judge/jury in all civil (and maybe even in criminal) cases. Economic sanctions work very well at controlling lawsuit abuse.