Why Free Markets Make Fools of Us

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An advertisement for Rolls-Royce from the late 1950s

Very few economists foresaw the great recession of 2008–2009. Why not? Economists have long assumed that human beings are “rational,” but behavioral findings about human fallibility have put a lot of pressure on that assumption. People tend to be overconfident; they display unrealistic optimism; they often deal poorly with risks; they neglect the long term (“present bias”); and they dislike losses a lot more than they like equivalent gains (“loss aversion”). And until recent years, most economists have not had much to say about the problem of inequality, which seems to be getting worse.

There is a strong argument that within the economics profession, these problems are closely linked, and that they have had unfortunate effects on public policy. Most economists celebrate free markets, invoking the appealing idea of consumer sovereignty. If people are buying potato chips, candy, and beer, or making risky investments, that’s their business; they know their own values and tastes. Outsiders, and especially those who work for the government, have no right to intervene. To be sure, things are different if someone is inflicting harms on third parties. If a company is emitting air pollution, the government can legitimately respond. But otherwise, many economists tend to believe that people should fend for themselves.

It is true that companies might try to take advantage of consumers and investors, perhaps with outright lies, perhaps with subtler forms of deception, perhaps by manipulating their emotions. But from the standpoint of standard economic thinking, that’s nothing to panic about. The first line of defense is competition itself—and the market’s invisible hand. Companies that lie, deceive, and manipulate people are not going to last long. The second line of defense is the law. If a company is really engaging in fraud or deception, government regulators might well get involved, and customers are likely to have a right to compensation. But for economists, competitive markets are generally trustworthy, and so the old Latin phrase retains its relevance: caveat emptor.

By emphasizing human fallibility, the group of scholars known as behavioral economists has raised a lot of doubts about this view. Their catalog of errors on the part of consumers and investors can be taken to identify a series of “behavioral market failures,” each of them calling for some kind of government response (such as information campaigns to promote healthy eating or graphic warnings to discourage smoking). But George Akerlof and Robert Shiller want to go far beyond behavioral economics, at least in its current form. They offer a much more general, and quite damning, account of why free markets and competition cause serious problems.

Both Akerlof and Shiller have won the Nobel Prize; they rank among the most important economists of the last half-century. They are also intellectual renegades. Akerlof has been interested in the persistence of caste systems, involuntary unemployment, rat races,…


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