Chaotic evolution defines the market economy

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Markets are not a well-oiled machine: they are a constantly changing, adaptive biological system.

The fall of the Berlin Wall in November 1989 was the defining economic event of our lifetime. It marked the end of the largest controlled experiment in the history of social sciences – the division of Germany into two economic zones, one centralised and planned, the other a market economy. After 40 years, the gap in living standards between the two was so extreme that the experiment terminated.

But why? A popular caricature of the market economy sees greed as the dominant human motivation. Economic progress is best achieved by acknowledging that reality and imposing as few restrictions as possible. This is the economy of Nigeria and Haiti, and it does not work. It is also the commercial environment of the Ik mountain people described by anthropologist Colin Turnbull, and Lehman Brothers as written up by former vice-president Lawrence McDonald. It did not work in these cases either.

A more thoughtful account of the success of markets has three elements. Prices act as signals – the price mechanism is a guide to resource allocation rather than central planning. Markets are a process of discovery – an economy adapts to change through a chaotic process of experimentation. The third element is the capacity of the market to bring about diffusion of political and economic power. This is the most effective way to protect society from rent-seeking – a culture in which the principal route to wealth is not creating wealth, but attaching oneself to wealth created by others.

Modern economics and economic policy put too much emphasis on the first of these elements. But the second and third are probably more important. The result is that both supporters and critics of the market economy confuse policies that are pro-business with policies that are pro-market. That confusion has undermined the social and political legitimacy of the market economy, and has led to serious policy errors.

Friedrich von Hayek is the most eloquent expositor of the market as a process of discovery. His argument was a priori, but vindicated by events. From the failures of the eastern bloc in the postwar era, we now have clearer evidence of how these planned economies failed in the development, not just of consumer products, but in business methods and in almost all areas of applied technology not related to military hardware.

Centralised systems experiment too little. They find reasons why new proposals will fail – and mostly they are right. But market economies thrive on a continued supply of unreasonable optimism. And when, occasionally, experiments succeed, they are quickly imitated.

If market economies are better at originating and diffusing new ideas, they are also better at disposing of failed ones. Honest feedback is not welcome in large bureaucracies, as the UK government’s drug advisers can testify. In authoritarian regimes, such reporting can be fatal to the person who delivers it.

Disruptive innovations most often come to market through new entrants. The health of the market economy depends on constant replenishment of ideas, often from unpredicted sources. If you had been planning the future of the computer industry in the 1970s, would you have asked Bill Gates and Paul Allen? If you had been planning the future of European aviation in the 1980s, would you have asked Michael O’Leary or Stelios Haji-Ioannou? If you had been planning the future of retailing in the 1990s would you have asked Jeff Bezos? Of course not: members of the politburo, cabinet or large company board would have consulted grey men in suits like themselves.

Markets are not a well-oiled machine: they are a constantly changing, adaptive biological system. Pluralism is their motive force, their essence chaotic, their development inherently uncertain. If we could predict the evolution of markets, we would not need markets in the first place. Next week, I will review the other part of the market story – barriers to rent-seeking.

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