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John Kay: The Truth About Markets:
why some nations are rich, but most remain poor
(Penguin: 2004)


“Self-regarding materialism is the principal determinant of economic behaviour, and government should not restrict it. Financial markets are the main regulators of economic activity. The economic role of the state is the protection of property rights and the enforcement of contracts; I call this the American business model [ABM]...as the greatest admiration for [the] model is to be found in the American business community. Arbitrariness and disparities in the distribution of income are justified - even morally justified - simply because they are market outcomes.... Greed in politics is disastrous, because politicians can use the coercive power of the state to get other people’s money. Greed in business is virtuous, because producing the goods and services people want is the only way to extract money from them. [Therefore,] the political sphere should be as small as possible, and the business sphere as large as possible.... [And,] with greed the mainspring of the market economy, redistributive taxation inhibits its progress.... The model meets a deep-seated need for simple, universal explanations of complex phenomena. Its appeal directly parallels that of the Marxist doctrines it has supplanted, [as] its prescriptions are not just right, but inevitable, [and] its proponents show the same ingenuity in attributing all social and economic problems to government that Marxists displayed in attributing all social and economic problems to capital.... [However, despite such myths,] the real issues of economics are vital and fascinating, and raise some of the most important social and political questions of our time. Why are some people and countries rich, and others poor? Why did centrally planned regimes fail in economic competition with market economies? How do decentralized market economies co-ordinate complex products, and global distribution? How do economic systems handle risks? How do they deal with inequalities of information? How do they distribute the rewards between different members of the teams which manage complex production processes? How do markets co-ordinate networks? How do they stimulate knowledge and innovation? What really determines our economic behaviour - how we work, and what we consume? What should be the role of government in a modern economy? These are the questions with which this book is concerned. [And,] in answering them, I shall show that the American business model is not, and could not be, a correct description of how the American economy works, [for] the countries that most closely resemble its prescriptions of unrestrained individualism with minimal government are among the poorest on the planet. Effective market economies are embedded in an elaborate social, political, and cultural context, and could not function outside that context.”
(Kay, pp.4-10)

As I write these words in 2008, the American business model is indeed demonstrating its manifest inadequacy, in the face of massive systemic failure on the  commanding heights of Wall St...making this a particularly timely review. For, with the self-evident breakdown of the mythology, what is now needed - more than ever - is a comprehensive & accessible overview of the real import of the full range of economic studies, rather than just the narrow & misguided mainstream. And this,  John Kay offers, whilst - in passing - delivering well-aimed asides skewering the key weaknesses of neo-liberal orthodoxy:


“A good model is like a biblical parable and, like parables, is neither true nor false: only illuminating or unilluminating.”
(Kay, p.11)

“The ABM is deficient for its naive approach to issues of human motivation, its simplistic analysis of structures of property rights, its inability to maintain efficiency in the face of imperfect information, its misleading account of markets in risk, its glossing over of problems of co-operation and co-ordination, and its failure to describe the generation of the new knowledge on which its very success depends.”
(Kay, p.319)

For an in-depth analysis of said deficiencies, I would recommend Paul Ormerod’s Death of Economics (1994)...however, for readers aiming at an overview of exactly where scientific (as opposed to ideological) economics stands of late, John Kay’s work can hardly be bettered. An economist himself - and columnist with the conservative Financial Times - Kay begins with the most basic questions a reader would have, establishes historical context throughout, and is unafraid of theoretical pluralism - a genuinely rare virtue in an economist. The outcome, as a result, shows us what we can properly learn from economics today - as well as clearly marking its many failings...


“What features of the environment into which people are born, or migrate, make...a difference to their economic lives? For most of economic history, it was believed that the explanation was to be found in the availability of physical resources....[but] it is a modern cliché that Silicon Valley is not built on reserves of silicon.... [And] productivity is not simply the result of the availability of capital and technology, of differences in the skills of individual workers. In the modern world, skills can be developed everywhere, and capital and technology flow freely between countries. Economic differences persist because output and living standards are the complex product of the intersection of the economic environment with associated social, political and cultural institutions, [and] the economic lives of individuals are the product of the systems within which they operate.... This is what I describe as the embedded market.... That embeddedness is the continuing theme of this book. Different cultures have made different choices about the ways in which the capacities of their economies are reflected in the economic lives of their citizens. These choices are partly the result of individual decisions - how long to spend over lunch - and collective decisions - what resources to devote to public schools or transport systems. [And] there are no economic criteria that enable us to conclude that some choices are right and others wrong. Nor is there an inevitable convergence. Diversity is an important feature of economic life.... But differences in economic performance and experience among rich states are small and temporary, differences between rich and poor states large and enduring, [and] any theory of the relative success and failure of economic systems must explain this central fact.”
(Kay, pp.14-36)

“A modern economic system is a complex, interacting set of institutions, which has evolved over thousands of years.... [However, as late as] the second half of the eighteenth century, there was little difference between living standards in Western Europe and those in the rest of the world.... [But] in the first half of the nineteenth century, a small group began to pull away, and in each subsequent period a few other states caught up, mostly those which were more productive to begin with. And the newly productive countries have almost always been on the geographical borders of those that are already productive.... [In] Western Europe, the group expanded steadily from a central core, gradually encompassing peripheral areas, [but] in Asia, geographic contiguity seems to be equally significant, but precisely in the opposite direction. Richer states are peripheral and, even within China itself, coastal regions have higher incomes. It is as though an economic blight has centred on Beijing - and perhaps this is the right way to see it.... The history of the world, said Carlyle, is but the biography of great men. Perhaps, but the history of the market economy is not.... The evolution of market institutions took place within the context of a range of other evolutions - in technology, in culture, in politics and the organization of society - and could not have occurred in their absence. But pluralism was common to all these processes. Modern scientific method generated and tested new hypotheses: the principles of science fed into the new technologies. Intellectual life emphasized the claims of reason over traditional authority. Political systems made the transition from absolutism to democracy. This was the common background.”
(Kay, pp.37-51)

“Economic life is a set of transactions, within a framework of rules. Some of the transactions are contractual, some informal. Some of the rules are legal, others are expectations about behaviour.... We acquire legal rights, in a market economy, by statute (a relationship between the individual and the state) or by contract (a relationship between two individuals). This distinction loosely parallels the distinction between property rights and exchanges, between rules and transactions. But most transactions in a market economy are governed by expectations and conventions, not the law, [as] we are rarely conscious of making contracts...[and] the costs of writing individual contracts, and using legal mechanisms to enforce them, are prohibitive for most transactions. And the law follows rather than leads the behaviour of buyers and sellers, [as] it requires us to...fulfil reasonable expectations. The rules, laws, and conventions that govern our economic lives have evolved over thousands of years, and they evolved in different ways in different places.... Different continents, different circumstances, different coevolutions.”
(Kay, pp.52-5)

“Many economists talk about the rules of a market economy as a distribution of property rights, but the development of market institutions involved far more than the invention of property rights, and many modern market institutions are far too complex and subtle to be easily described in terms of property.... [Moreover,] the emphasis on property has a conservative flavour...[yet] market economies must constantly evolve new rules. The analogy with property is unhelpful: the best structures will give encouragement to investment and innovation in new technologies, just as dynamic societies of the past evolved new structures for ownership rights in living animals and plants, developed employment contracts, and invented limited liability companies. These accompanied and allowed the historical development of agriculture, wage labour, and large-scale industrial organization.”
(Kay, pp.60-1)

Which is where history as such comes in. Regular readers of this site will be well aware of the value of multiple tellings of history - drawing upon the different viewpoints of specialist disciplines - and economics is certainly no exception, despite history’s shameful (and clearly unscientific) neglect by neo-classical economists. Contrast, for example, the following w/Jared Diamond on the advent of agriculture...as a near-perfect illustration of why we genuinely need such multiple accounts, to begin to adequately grasp the historical...


“Agriculture developed from population pressure and new technology. The institution of employment developed for the same reasons...[yet] we are so accustomed to jobs that we rarely think about the nature of the institution. Yet, for most of economic history, jobs were unusual. And, outside rich states, careers are still unusual, [as] few people have, or had, any choice about the work they perform...[since] their economic lives were - and are - almost completely determined by where they were born - geographically and socially - and by the traditions and conventions of the society in which they lived.... The shift by Cro-Magnons from production for use to production for exchange was an institutional innovation to rank with technical innovations such as the manufacture of tools and the invention of the wheel. But only in today’s rich states is most production for exchange. For most of history, and in much of the world even today, the main economic activity is the production of food for own use. And, throughout history, the allocation of scarce resources between competing ends was determined by custom, or by force. In a traditional society, decisions about what to produce, and the division of what was produced, were barely decisions at all, [as] each year followed the pattern of preceding years.... A customary economic system is an alternative to either a market economy, or a planned society - but a static one. Customary economics had little capacity to deal with change, and offered little encouragement to initiate change.”
(Kay, pp.55-66)

“It is common to think of exchange as a process where one party wins at the expense of another, and some exchanges are like that...[but,] whenever there are differences in talent and a mutual desire for variety, there is the possibility of a division of labour, and mutually beneficial exchange.... [Therefore,] comparative advantage dictates that we should focus on what we do best.... Economies from specialization, differences in capabilities: these are the factors which lead to mutual gains from trade.... Trade between corporations was once mainly based on the benefits from specialization, and today relates much more to difference in capabilities. [Interestingly,] trade between countries seems to have evolved in the opposite direction.... Like trade between individuals, trade between countries results from mutually reinforcing differences in capabilities and specialization...acquired over time, and are embedded in the cultures which gave rise to them. The world’s most productive economy - Switzerland - relies on exports of precision engineering and speciality chemicals, which...have nothing to to with the Swiss climate or terrain.... Capabilities and specialization have reinforced each other, in a process of coevolution...[and since these] depend on past choices, forgotten or now irrelevant historical events still influence the location of production today.... Films are rarely made in California any more, but Hollywood remains the centre of the world film industry.”
(Kay, pp.67-73)

As Kay insistently continues to remind us, history is actually the key to economic success - bound up as the latter is with the complex co-evolution of institutions and cultures. In consequence, simplistic denunciations of “command and control” mechanisms are out of place - as are the dreams of free-market utopians. For all such mechanisms are flawed - and each has virtues if applied at the correct scale, and to the right ends.


“Two types of mechanism define the ways goods can be assigned in an economic system. One type is political, hierarchical, and personalized: the mechanism of complaint is voice. The other is market-based, decentralized, anonymous: the mechanism of complaint is exit. Each of these approaches has merits and disadvantages...[and] both processes are open to corruption.... To allocate scarce resources between competing ends, it is necessary to assess what abilities are - what it is possible to produce - and what needs are.... But, almost all this information has to be obtained from the various proponents of the competing ends.... [In consequence,] investment appraisals put to the senior managers of large businesses are always optimistic, and the business plans which utilities show their regulators are always gloomy.... [And] obtaining the information needed to plan production encounters similar problems...[for] it was above all on...information and incentives that the Soviet economy foundered, and the information problem is the more fundamental.... Lenin claimed to have found the answer to this problem: ‘Seize the decisive link.’... But these are subject to ‘Goodheart’s Law’ - any measure adopted as a target changes its meaning.... If corporate executives receive bonuses related to earnings per share, then earnings per share will rise, but whether the business is better, or more valuable, is another question. Political decisions suffer acute problems of incentive compatibility, [and] these may not only produce bad answers to the assignment problem, but also undermine the integrity of political decision-making itself.”
(Kay, pp.78-86)

“Centralization, conformity to internally generated values, too much authority seized by leaders whose adjutants derive no advantage from telling the truth, are inescapable in very large organizations.... [Conversely,] markets work because there is never a single voice.... It is tempting to believe that if we entrusted the future...to the right people, they would lead us unerringly to the promised land. [But] such hopes are always disappointed. Most of Thomas Edison’s inventions did not work, [both] Ford...and Mao ended their careers as sad, even risible figures.... But, because most decisions are wrong and most experiments fail, it is also tempting to believe that we could manage businesses and states better if only we assembled sufficient information and cleverer people, and debated the issues at length. This is how decision-making is supposed to be in the public sector, and in many large organizations.... But nobody has such foresight.... Because the world is complicated, and the future uncertain, decision-making in organizations and economic systems is best made through a series of small-scale experiments, frequently reviewed, and in a structure in which success is followed up, and failure recognized but not blamed: the mechanism of disciplined pluralism.... Both within organizations and outside them, it is in the combination of pluralism and discipline that we find the truth about markets.”
(Kay, pp.98-108)

This is a good point at which to pause, and take stock of Kay’s pluralism. His discussion here, for example, takes in Hayek’s key insight into the role of markets as information processors, Hirschman on exit & voice, and Schumpeter on pluralism - all enriching (and, most importantly, qualifying) Adam Smith’s basic insight re markets. The result tells us a lot about the role of institutions in the real world - as opposed to the world as modelled - and helps bring into focus much that we have already observed for ourselves. Moreover, the further you read, the more coherent and fair-minded Kay’s approach seems...for he refuses to gloss over the real problems of any system in operation:


“In rich states, we are so accustomed to the absence of surpluses and shortages that we feel angry when we encounter them.... Market economies have solved the co-ordination problem more successfully than centrally planned ones. This discovery astonished Khrushchev, and it should astonish us. Many of the failures of planned economies were failures of innovation, [as] the pluralist programme of experiment, failure, and fresh experiment did not occur.... But the greatest failures of centrally planned economies were in co-ordination...[and] for the casual visitor, failures of co-ordination are one of the most obvious differences between rich and poor countries. The electricity supply is often unreliable, some essential goods are not available. This is sometimes the result of poverty, but also a cause.... [However,] rich states are not free of co-ordination failures...[and] the most serious...in productive economies is unemployment, a...failure that planned economies have largely avoided, although at the price of other co-ordination failures elsewhere.”
(Kay, pp.111-13)

“In a perfectly competitive market, the price of goods and the features of goods will correspond to the value buyers attach to them. This is the basis for using market prices to achieve commensurability....[However,] the obvious problem is that the value people attach to particular goods or services is the result not just of how much they want those goods or services, but also how much money they have...[so] the legitimacy of market values [for this purpose] depends on the legitimacy of the income distribution.”
(Kay, p.177)

Which is where the modelling comes in - along with the utopian assumptions. However, by beginning his discussion of same w/the flower market at San Remo - which regulates behaviour/rents space, but does not impose any form of price controls - Kay reminds us of exactly why such commodity markets are theoretically important...because they demonstrate the very real possibilities of self-organization and self-regulation, and certainly not because all social intercourse could be regulated by such means:


“If no-one has much influence over the price in a competitive market, how is the price determined? In one sense, prices are not fixed at all...[but] a spontaneous order is formed every day.... Most traders attend  every day, and use their experience to judge the level of stocks and the level of demand. They judge each other, too: some traders will be particularly influential...[as] activism by skilled traders determines the price. [However,] trading at San Remo is about as close to a perfectly competitive market as we find, [since] no individual buyer or seller has much influence over price. And trading at San Remo is also close to being incentive compatible. There is rarely much to be gained by strategic behaviour...[as] subtle ways of beating the market are hard to devise, and likely to backfire. And concern for reputation with fellow traders also encourages incentive compatibility.... [Unfortunately, however] once buyers or sellers are sufficiently large for their behaviour to influence the price, they start behaving strategically.... [So] once products become differentiated and sellers have sufficient market share to influence price, the problem of setting price and managing demand is very different, and more complex. And co-ordination may actually be more difficult, as anyone who has experienced an overbooked flight knows.”
(Kay, pp.131-8)

“The concept of spontaneous order - the idea that complex systems may have properties of self-organization - is powerful: but the knowledge that self organization is possible falls a long way short of either demonstrating that co-ordination happens spontaneously, or explaining how it might happen spontaneously. Competitive markets...produce their own local equilibrium, which equates supply and demand...[which] solves part of the co-ordination problem, but only part, [for] the remarkable feature of the market economy is that it seems to solve a large variety of co-ordination problems simultaneously.... Central planners always found it easy to deal with any particular co-ordination problem...[but] the trouble is...when we solve one problem, we almost always create another elsewhere.”
(Kay, p.159)

“Neoclassical [economic] theory is elegant and, in a sense, comprehensive. But it cannot be the end of our search for the truth about markets. It is not that it is wrong, or even irrelevant: many practical insights into how markets work emerge both from the analysis of individual markets, and from the theory of competitive equilibrium. It is just that it is not enough.... [Economics Nobel laureate] Gary Becker’s assertion that ‘the combined assumptions of maximizing behavior, market equilibrium, and stable preferences, used relentlessly and unflinchingly, form the heart of the economic approach’ is, on reflection, extraordinary. Why should ‘the economic approach’ rest on specific empirical assumptions about behaviour, especially when these assumptions are, at best, partially true? The thoughtful economist, like the trained physicist or skilled doctor, will use whatever techniques and assumptions are appropriate to the task at hand, and expect different assumptions and techniques to be appropriate to different tasks. Economics is not theology, but a means of understanding...[and] the limited truth about markets which emerges from the perfectly competitive model provides a base for further exploration - no more, no less.”
(Kay, p.190-9)

“The Chicagoean emphasis on rationality is taken to extreme lengths. But, it is [still] almost a badge of honour among mainstream economists to seek explanations in rational or self-regarding behaviour, [and] often, this is achieved by stretching the meaning of rationality...[which] is generally used by economists in one or other of two senses: rationality as consistency, and rationality as self-regarding materialism. Neither of these corresponds to the ordinary meaning of the word ‘rational’.... Economists insist on rationality because they do not like the alternatives. Self-regarding materialism is a better predictor of behaviour than altruism...[but] reality is somewhere in between. Such reality is necessarily complex, however. There are few ways to be rational, but many ways in which it is possible to be irrational...[and] self-regarding materialism is predictable...[so] that conclusions can be drawn from wholly a priori reasoning. No empirical investigation required.... [But] behaviour is a product of the environment in which people find themselves...[and] the explanation is found in path-dependency and adaptation.... Evolution favours what is good at replicating itself, rather than what is good, [and] this fundamental distinction is essential to understanding any evolving system.... The phenomenon of self-regarding, self-perpetuating selection mechanisms is common in the public sector, but can equally be found in private sector monopolies.... [However,] reality must be faced if there is a level of selection which reviews output, rather than procedure.... [Conversely,] organizations which face no competition, or have no mechanisms for responding to it, may continue such behaviour for extended periods...[for] adaptive behaviour, by definition, is self-sustaining and self-reinforcing.”
(Kay, pp.201-9)


As Kay shows us, there is no technical/economic escape from the ethical - merely some highly useful guides as to the traps we fall into when we ignore incentives. This should hardly be surprising, were it not for the (purely ideological) successes of economic technocrats, who managed to privilege narrowly-defined efficiency to the point that substantive questions of ends became (for awhile) almost illegitimate in policy deliberations. But, as we’re now seeing, assumptions of perfect markets are almost never justified, whilst a modest and pluralistic viewpoint such as Kay’s seems ever more prescient by the day...


“Social behaviour needs to be understood in many dimensions, and at many levels...[and] there is no incompatibility, and no need to choose between these elements of thick description. The economic imperialism which seeks to ‘explain’ all behaviour by reference to rational choice is absurd, but so is a purely anthropological account which denies or disregards the economic functions of social practices. The Arrow-Debreu [general competitive equilibrium] model is not a grand narrative, providing a ‘true’ description of the world, but a particularly elaborate and sophisticated little story, shedding light on the possibility of spontaneous order in complex economic systems. [In fact,] the very clarity and simplicity of the...model demonstrates its weakness. Indeed, its creators understood very well that a primary purpose of their analysis was to spell out the elaborate and extensive assumptions needed to make that version of spontaneous order coherent. Economic research since Arrow and Debreu has drawn game theory, transaction costs, and most recently behavioral economics into the mainstream of economic theory. In the Arrow-Debreu framework, interactions are anonymous, and there are many buyers and sellers in every market. In game theory, the players are not anonymous, and there are few of them. In the Arrow-Debreu model, institutions do not exist, or are dealt with in a reductionist way. Institutional or transactions-cost economics recognizes that economic lives are lived in and through economic institutions.... [However, while] neoclassical economics was enhanced both by game theory and by transactions-costs economics...neoclassical rationality assumptions were imposed on both. The transactions-cost solution...is that the economist should optimize within constraints.... [But,] how could the economist know when to stop calculating, when he cannot know the benefits of further calculation? If we knew enough to be boundedly rational, we would know enough to be completely rational. The best answer is an evolutionary one: but such an answer leads us to adaptive, instinctive responses.... We apply conventions and rules of thumb, that generally serve us well. Some are probably genetic, some the product of learning, imitation, and reward, some universal, some culturally specific, [and] we occasionally apply these rules in situations where they do not work for us - many so-called irrationalities are of this kind.... We behave adaptively in our economic lives, and the institutions in which we act these lives are themselves adaptive...[and] have coevolved.”
(Kay, pp.194-211)

“Modern economies require, and obtain, more co-operation than can be explained either by coercion or by reciprocity.... This behaviour is not rational, if rationality means self-regarding materialism. But it is adaptive - societies in which people help strangers are not only nicer, but more prosperous...[and] public goods will not be produced by self-regarding individuals in competitive markets.... Social institutions, mainly government, provide a range of public goods - the police, street cleaning, national defense, a framework of rules and laws - [for which]...no one who refuses to contribute can be excluded. For a broader category of goods, it is possible but undesirable to exclude those who refuse to contribute. Perhaps it is more costly to set up mechanisms of exclusion than to allow universal access....perhaps exclusion is undesirable because everyone benefits from general provision, [or] perhaps exclusion would violate norms about the kind of society we want.... [Still,] these goods must be provided in productive economies, and also paid for...so the level of provision of public goods is rarely decided dispassionately.”
(Kay, pp.237-40)

“This is not to deny that self-interested materialism is an important feature of economic life. [and that] economic systems based on appeals to work for the common good will fail. But self interest is necessarily hedged in by the complex institutions of modern economic, social, and political life - formal regulation and implicit rules, mechanisms of reputation and co-ordination, instincts and structures of co-operation, feelings of solidarity. Without [these]...there will be chaos. [For] modern societies did not develop ethical norms which limit and deplore self-regarding materialism out of a perverse desire to restrain entrepreneurial spirits. Economic motivations are complex, multi-faceted, and not necessarily consistent. The study of human behaviour is an empirical subject, [and] it cannot rely solely on introspection and a priori assumptions. Still less should it rely on introspection and a priori assumptions that do not correspond to experience. The best starting-point is to expect that behaviour will be adaptive - that people will behave in the way they are normally expected to in the circumstances in which they find themselves. [But] this expectation will sometimes be false, [for] economies would not develop otherwise.”
(Kay, pp.316-7)

“We are usually more productive when we work in co-operative teams...[as] humans are among the most social of species, [and] this sociability is fundamental to our economic organization.... Through team working, we can make use of the division of labour, and exploit gains from specialization and differences in capabilities...[and] by sharing information and pooling risks. [In addition,] public goods require co-operative behaviour....  [Thus,] when there are large gains to be made from co-operative behaviour, an instinct to form and enforce co-operative groups is advantageous, not just for the group, but for each individual member. It is also advantageous - in cold-blooded evolutionary terms - to be naturally co-operative, to sweat, blush, and avoid the eyes of our colleagues when we make promises we do not intend to keep, [as] these characteristics make it possible for colleagues to trust us.... [And] competition in business and economics mostly does take place at the level of the group.... [Still,] the provision of public goods benefits from both solidarity and competition, and these are not always easy to reconcile.... For all of them, the social context of the transaction is vital.”
(Kay, pp.241-8)

While behavioral economics is clearly the most challenging to neo-classical assumptions, it is important to understand the basics of the other main contributions as well, since they all have real value in re-assessing different areas of economic theory - as Kay’s discussion of risk markets (see derivatives, anyone?) makes perfectly clear...


“Institutional (or transactions-cost) economics regards as its founder Ronald Coase...[whose] thesis was that the boundaries of firms - islands of organization in a sea of markets - were determined by the balance between the costs of alternative systems. Transactions costs in markets [absent in the general equilibrium model] must be set against the problems of incentive compatibility within organizations. Is it cheaper to hire someone and tell them what to do, or negotiate contracts with potential suppliers? This make or buy decision is a central issue for every business.”
(Kay, p.196)

“Imperfect information changes everything. In perfectly competitive markets, exchange is anonymous. But, in markets with imperfect information, the identity of the trader is a key element of the exchange. In perfectly competitive markets, price equates supply and demand, but in markets with imperfect information, price is a means for sellers to communicate with buyers, and because it serves this function it may fail to equate supply and demand. In perfectly competitive markets, all exchanges are efficient, and only efficient exchanges occur. But in markets with imperfect information, exchanges occur which buyers regret [particularly under the so-called ‘winner’s curse’], and trades which would benefit both buyers and sellers may not happen. Yet market economies have been resilient, even ingenious, in developing mechanisms for dealing with problems of imperfect information, [and] to recognize [its] ubiquity is not to mount a critique of market economies, but rather a critique of the adequacy of the perfectly competitive model as a description of how market economies work. The truth about markets is much more complex.”
(Kay, p.223)

“Markets in risk are particularly subject to imperfect information, and vulnerable to ‘irrational’ behaviour. In fact, most trading in risk markets comes from one or both of these sources, while the same combination of factors ensures that many necessary-risk markets never come into being. [Firstly,] our attitudes to uncertainty are born of a mixture of hopes and fears, grounded in instincts and social conditioning, [and] our reactions to risk are often intuitive.... [Moreover,] asymmetric information pervades risk markets...[with] markets for life and medical insurance...possible [only] because medical knowledge is still rudimentary.... This is the tip of a large iceberg...[and] in fifty years time, private medical and life insurance may be as difficult to obtain as divorce and unemployment insurance today, and for the same reasons.... When people can opt out, adverse selection is a problem, [and] if what they’re doing can’t easily be watched, moral hazard is a problem. The combination...means that risks are best managed by groups which have other communal bonds, typically families, communities, workplaces and nations...[and] purely economic agencies, such as insurance companies and securities markets play only a minor role. Risk sharing in social groups is effective because there are many different advantages to participation in these groups, and also because solidarity and sense of obligation come into play. The traditional marriage vow - for richer for poorer, for better, for worse - could hardly be more explicit in identifying risk sharing as characteristic of the relationship.... Communities can be effective providers of medical insurance, [and] employers can be effective providers of unemployment insurance, [as] they are far less vulnerable to problems of moral hazard than either private insurers, or the state: who could be better placed to judge an employee’s commitment to work? And the issue of adverse selection simply does not arise. For most of the twentieth century, large businesses did provide such insurance, not as a formal contract, but as a mutual expectation...[that] there would always be a job The consequence was that the employer took much of the risk...[and] the employee paid a price.... In the last two decades of the [previous] century, many of these implicit contracts were broken [and] the long-run effect is that government is now the only credible supplier of unemployment insurance.... [Unfortunately,] government is well placed to reduce adverse selection because it can compel participation, but is less effective at reducing moral hazard than the social pressures of a local community.”
(Kay, pp.224-32)

“Economic policies based on abstract blueprints and imposed by government are rarely effective, [but] this is not to say that there is no role for government, or that only institutions which develop spontaneously can be effective. Policy results from the interaction of norms and values, and is part of a subtle relationship between private and social institutions, and the powers and resources of the state. This complex approach to economic policy making...denies the social democratic premise that the only legitimate source of economic authority is democratic election.... However, it is fundamental to the success of market economies that power is dispersed in this pluralist way. [Conversely,] a supporter of the ABM would be suspicious of the imposition of...obligations on employers.... [And,] in regulating corporate America, the prescriptive approach - which allowed players freedom within rules - failed, [as] the rules did not so much exclude the unacceptable as define the limits of the permissible. In complex, democratic societies, rules are implementable only if they define behaviour which most people would adopt in any event. That is why the approach of allowing maximum freedom within a framework of rules is bound to fail - and did.... Incentive compatibility and adaptive behaviour explain why this is so. The integrity of an institution is not the product of its governance structure, but of the values of those who work within it, [and] many different value systems will be supported by adaptive, self-reinforcing behaviour. If institutions are designed on the assumption that individuals are self-interested, self-interested behaviour will be adaptive within them. [And] if the premise is that people are not to be trusted, that expectation will be fulfilled. Self-interested behaviour by managers of large companies is corrosive of the integrity of companies, just as self-interested behaviour by government officials is corrosive of the integrity of government. The central premise of the ABM - that economic life is, or could be, successfully organized around the instrumental behaviour of self-regarding materialists, constrained only by externally imposed rules - is mistaken, and the mistake threatens both the viability and legitimacy of market systems. In both politics and business, the rise of the ABM created the very problem of controlling self-interest it purported to solve.”
(Kay, pp.341-7)

Which is well worth underlining, lest we get ourselves into this fix again. Moreover, once we have ruled out simplistic “greed is good” thinking, there are a variety of subtle - and not so subtle - changes we need to consider in basic economic policy...which will require rethinking across the ideological spectrum, not just on the right. As Kay  explains:


“Market economies are not about harnessing greed, and the elevation of greed as their dominant value undermined them. Market economies succeeded because they established disciplined pluralism, and put in place mechanisms which solved, or at least reduced, problems of incentive compatibility. The twin pillars of disciplined pluralism and incentive compatibility should support economic policy. [Unfortunately,] disciplined pluralism is contrary to the natural instincts of most political and business leaders...[and] centralized structures cannot cope easily with the normal fact of economic life, that it is very difficult to determine what the right thing to do is, and the best recourse is to try many things on a small scale, and see which few work. [Also,] pluralism necessarily conflicts with uniformity. But if government structures genuinely allow pluralism and decentralized authority, variability in the quality of what is provided is inevitable.... [Overall,] the objective should not be to introduce measures which bear superficial resemblance to the management systems of private sector businesses into the public sector, but to understand sufficiently well how market disciplines work to make it possible to introduce within the public sector systems which have analogous effects.”
(Kay, pp.355-7)

“Most rich states have policies to maintain competition. But competition policies are often predicated on the assumption that the world should be aligned with the perfectly competitive model.... [Conversely,] disciplined pluralism implies that rivals pursue differentiated strategies, and the more successful of them earn rents, [so] competition policy should not seek to eliminate these rents: if it tries, it will diminish pluralism. The purposes of competition policy are to promote pluralism and make discipline effective.... [Similarly,] the case against price controls, tariffs, subsidies and tax breaks is not that the market always gets it right, [but that] the direct consequences of these policies are always to benefit the rent-seeking group directly, and the indirect consequences impossible to determine. There should be a strong presumption against arguments which are based on generalized economic benefits...from measures that are specific to an industry...[in contrast] to specific, largely non-economic, aspects of the nature of society. These issues can be be debated, but arguments for such intervention cannot be rebutted by generalized claims about the merits of free markets.... Good rules cannot be made by general principle: solutions are usually specific to technology and a market.”
(Kay, pp.364-75)

“Markets work, but not always, and not perfectly. Pluralist market structures promote innovation, and competitive markets meet many consumer needs, but there is no general reason to believe that market outcomes are efficient.... In the perfectly competitive model, and the simplicities of the ABM, it is obvious what the rules of a market economy should be, and easy to enforce them.... [However,] market economies have been successful relative to other societies precisely because the rules that govern them are not obvious to frame and easy to implement, and rich states have evolved complex governance structures embedded in other modern social and political institutions.... In addition, the distribution of income and wealth, and the process by which that distribution is established must, like the structure of market institutions itself, enjoy legitimacy if the market economy is to survive and evolve.... The embedded market describes the successful market systems of Western Europe - and the reality of the United States. It does not function within a minimal state: productive economies have  the largest, most powerful, and most influential governments the world has ever seen.... The job of government under the ABM is to define and enforce the rules of the market economy. The economic role of a social democratic government is to determine, through the democratic process, how society wishes scarce resources to be allocated between competing ends, and to direct the activities of businesses and households in order to bring that allocation about. Neither of these models describe the function of government accurately. The complex institutions of the market economy developed largely without central direction, and are constantly evolving. Government is an agent in that evolution, not a bystander, but government cannot control the process, and should not seek to.”
(Kay, pp.337-40)

“Socialism failed, because it substituted centralized direction for disciplined pluralism, and because it could not handle issues of incentive compatibility. Government agencies and large businesses face exactly these problems. Indeed, the ways in which capitalist economies fail are often similar to the ways in which socialist economies fail.... Firms in a market engage in market research, but they learn principally from the choices consumers make. These answers are reliable and definitive (unlike the results of market research), [for] the market economy is a discovery process which both reveals information, and reduces the need for it.... Whenever competitive mechanisms are not available, or not used, there are potential problems of incentive compatibility, [and] the common response is to set targets, and reward or punish by reference to the targets.... So managers aim to meet the targets, not the objectives.... The contractualization approach has been applied not just between the public and private sector, but within the public sector itself...[but] these mechanisms produce appearances of market disciplines without substance. Real contracts...are voluntary, mutually beneficial agreements between autonomous agents. And it is only possible to make such agreements where there are credible alternatives for both buyers and sellers.... These arrangements often attempt to shed responsibility, but not authority.... The alternative is to try to align the interests of the various players, [and] outside the American business model, this is not so hard.... The objective is not to design institutions that are robust to self-interest, but to stimulate elements of behaviour that are not purely self-interested....[However,] autonomy is only possible in conjunction with the process of audit and selection, and these function most effectively in conditions of disciplined pluralism.”
(Kay, pp.353-5)

With pluralism - rather than simple competition - of the highest value, Kay’s markets are not quite those we expected. However, in stressing ends rather than means, he returns economics to where it should have stayed in the first place...as one of the moral sciences - pluralist in theory,  and disciplined by empiricism, rather than by adherence to a particular model. For, the simple fact is that the model was always self-evidently inadequate in the face of the evidence...


“At the start of the twenty-first century, the American business model (ABM) plays the role in political economy that socialism enjoyed for for so long. All political positions, even hostile ones, are defined by their relationship to it...[and,] like religious or political fundamentalists, market fundamentalists regard the precepts of the ABM as self-evident, and inevitable...[and] if the the magic has not worked, it is because the subjects did not believe in it enough.... [However,] economic policies should be ranked by reference to relative economic performance...[and] GDP per head, or per hour of work, is the obvious starting-point. Economic stability - perhaps measured by inflation and unemployment - is clearly relevant; so are the quality of the environment and public infrastructure. Taking these criteria together, Norway and Switzerland are probably the world’s most successful economies. It doesn’t really matter what the answer is: the key point is that it is not immediately obvious that the world’s best-performing economy is the United States of America, [and] a search for countries characterized by overriding self-interest, market fundamentalism, the minimal state, and low taxation would not begin in Norway, or end in Switzerland. Economic history decisively demonstrates the superiority of market economies over centrally planned regimes, [but] it fails to demonstrate the superiority of any particular model...[and] the embedded markets of Norway and Switzerland are particularly idiosyncratic.”
(Kay, pp.307-11)

“[Moreover,] difference in capital per head is only a small part of the story. Without changes in the organization of land holding, without a reorganization of social relationships, without an educational revolution and without the infrastructure - from roads to repairmen - needed for different methods of production, imported capital could never be usefully employed.... Output is a function not just of capital and labour, but of institutions, in industrial sectors as in the traditional economy.... [Moreover,] natural resource endowments may actually damage economic development, because these resources distort the structure of economic institutions.... Some rich states - Norway and Iceland - have managed bountiful resource endowments well, others - like Switzerland and Japan - may have benefited from their absence. Tom Friedman, the herald of globalization, notes a still greater paradox. Sub-Saharan Africa is the place to find societies characterized by unrestrained greed and weak government: ‘Come to Africa - it’s a freshman Republican’s paradise. Yes sir, nobody in Liberia pays taxes. There’s no gun control in Angola. There’s no welfare as we know it in Burundi, and no big government to interfere in the market in Rwanda. But a lot of their people sure wish there were.... [Furthermore,] while there are elements of truth in dependency theory...the different economic experiences of Australia and Argentina do not originate in differences in relationships between these peripheral economies and Europe, but in the economic, social, and political institutions of the peripheral countries themselves.... [And, while] it is easy to romanticize life in what we consider primitive societies, agriculture...normally involves long days of backbreaking toil. The myth of Shangri-la is an enduring image in Western thought, and few descriptions survive critical scrutiny. It remains true, however, that our economic lives are not our only lives and happiness comes from the range of our experiences, not the quantity of material goods found in our houses.”
(Kay, pp.269-77)

John Kay’s The Truth About Markets (2004) is the finest survey of the broad sweep of current economic work’s implications for our basic economic understanding, and his discussion of greed and risk markets seems eerily prescient given the financial crisis of four years later. Nevertheless, it is not for prophesy that I particularly commend this book. Rather, it is for the balance between down to earth questions/examples - the latter I have saved for the final quote below - and a rich theoretical pluralism which is unafraid to venture beyond the typical bounds of economic theory. If there is one aspect of same relatively neglected by Kay, interestingly enough, it is the application of chaos theory to macroeconomics - making Paul Ormerod’s Death of Economics (1994) a perfect complement. Hopefully, as the false certainties of neo-classical ideology die away, our policymakers will have the sense to work within this more open, yet modest, approach, and learn - as the left are now beginning - to genuinely distrust the siren-songs of utopia...


“Heidi ($2,500) is a school teacher in Switzerland, Sven ($1,700) a farm worker in Sweden, Ivan ($900) a telecommunication engineer in Moscow, and Ravi ($320) an accountant with the State Bank of India. The figures in brackets are their monthly earnings. Although a dollar buys more in India than in Switzerland - purchasing power parities differ from official exchange rates - their earnings correctly rank their material standards of living. Heidi is best off, followed by Sven, Ivan, and Ravi. Why?  There are productivity theories and bargaining theories of income distribution...[and] productivity theories appeal to the rich.... If they take out a lot, it is because they have put more in. Bargaining theories appeal to the poor, [as] they can blame their status on the unfair organization of society.... The right won the cold war and the left lost, so productivity theories have the upper hand today...but, can these theories explain the different economic lives of Heidi and Ivan, Ravi and Sven? ....[Unfortunately,] productivity theories and bargaining theories are both inadequate...however, a synthesis helps towards the answer...in the theory of economic rent. Many rents are the product of scarce talents in individuals, or competitive advantages in firms; some reflect arbitrage gains of securities houses, or the rent-seeking activities of successful lobbyist, [so] the creation of rents is the result of a combination of productivity and bargaining...[and] most rents in modern economics are the product of teams, or can only be exploited through teams. The distribution of rents within teams is [again] the result of a combination of individual productivity and internal bargaining. [And,] the most important influence on our incomes is the teams we belong to.... These teams include the residents of the Canton of Zurich, the Organization of Petroleum Exporting Countries, the shareholders and employees of Wal-Mart stores, the family of the late Sam Walton, the citizens of Brunei, and its ruling family, the executive directors of the Disney Corporation.... The more exclusive the club, the more valuable the membership.... [Conversely,] Sicelo [- a South African subsistence farmer -] is a member of almost no economic teams, barely deriving benefit even from the division of labour, [and] Ravi and Ivan are members of fewer teams [than Heidi & Sven], and some of these are ineffective: because of poor internal organization, or because they are not directed to the relevant social and economic objectives.”
(Kay, pp.280-94)



John Henry Calvinist