Systemic Failure in Markets and Politics

Below is Mark Pennington’s first guest post.  As you can see, it will be an interesting week! – GC

Mark Pennington

I am delighted to have been invited to contribute as the guest blogger on Pileus this week and to air some of the central ideas in my new book, Robust Political Economy: Classical Liberalism and the Future of Public Policy. At the core of this book is a very basic but oft neglected idea – ‘failure’ is endemic to all social institutions because human beings are imperfect. By far the most important imperfection is that people are cognitively limited and thus they make mistakes. Robust institutions, therefore, are not those that eliminate failure, but those that reduce the consequences of inevitable human errors. Before we determine that a particular set of institutions ‘fail’ meanwhile, we must explain how and why an alternative set of institutions can do better.

Basic as this insight may appear, most public policy discussion assumes that government action is necessary to ‘correct’ for ‘failure’ in markets and civil society without adequate consideration of equivalent if not worse failures in politics. Nowhere has this tendency been more apparent than in the claim that the financial Armageddon of 2008 was a ‘systemic failure’ of ‘capitalism’ and that moves to regulate the operation of markets are now required to reduce the prospect of similar failures in the future. What such arguments neglect to explain is why the prospect of ‘systemic failure’ in the process of regulating capitalism is considered any less likely than the market failure it is supposed to cure.

Contrary to fashionable commentary, the classical liberal tradition has never claimed that markets are ‘perfect’ institutions populated by fully rational agents. Neither has it denied the possibility of ‘systemic’ market failure. In a world where learning via imitation is crucial for transmitting knowledge and where ‘herding’ behaviour may be prevalent it is entirely possible that many actors may learn the wrong things and simultaneously invest in mistaken ventures – as the sub-prime bubble so clearly demonstrated. The great advantage of markets, however, is that they reduce the possibility of such failure because potentially erroneous decisions are not backed by the force of law – private property affords those who dissent from the way the crowd is behaving the liberty to act differently. 

By contrast the regulatory process which so many are now demanding should discipline markets, is not subject to an equivalent process of competitive testing. It is in the very nature of regulation that decisions are imposed on society as a whole in order to reduce behavioural heterogeneity. But if regulators are no more omniscient or rational than anybody else – and there is no reason to suppose that they are – then the consequences of any errors they make will be more far-reaching precisely because their decisions are backed by coercive authority. As Jeffrey Friedman[1] has shown in a truly brilliant essay, though market failure played a role in the recent crisis, the scale of the meltdown was in large measure due to a series of systemic failures in monetary and financial regulation. From the decision of monopoly central banks to keep interest rates at excessively low levels, to the regulatory and fiscal inducement of government-backed mortgage companies to relax lending requirements for low income families, to internationally enforced capital regulations which induced banks to securitize risky mortgages, and the creation of legally protected monopolies in the credit rating business – the homogenising effect of all these measures virtually guaranteed that if mistakes were made, the consequences would be devastating.  

The real lesson that must be learned from the financial crisis, therefore, is that regulators and politicians are just as prone to irrational and ill-informed conduct as is anybody else – but with their unique powers of coercion they have the capacity to do far more harm. Alas, as I aim to show in several of my contributions to Pileus this week, the area of monetary and financial regulation is but one of a raft of issues where policy-makers seem incapable of grasping this most basic principle of political economy.


[1] Friedman, J. (2009) A Crisis of Politics not Economics, Critical Review, 21 (2-3).

13 thoughts on “Systemic Failure in Markets and Politics

  1. The UK government has managed to stop the recession, and the economy is growing.

    It is not very dificult to do anti-cyclical measures in the economy, and only the government can do them.

  2. Love this: ” At the core of this book is a very basic but oft neglected idea – ‘failure’ is endemic to all social institutions because human beings are imperfect. By far the most important imperfection is that people are cognitively limited and thus they make mistakes. Robust institutions, therefore, are not those that eliminate failure, but those that reduce the consequences of inevitable human errors.”

    His book will be a worthwhile read, I do believe.

  3. Excellent post, Mark. Welcome aboard!

    One minor point: Some advocates of markets do, in fact, claim that markets are perfect, or at least that they do not fail. See, for example, Brian P. Simpson, Markets Don’t Fail! (Lexington Books, 2005).

    1. Thanks James – I’ll check that out. Glad you liked it – these are the first blog posts I have ever written. M.

  4. “Robust institutions, therefore, are not those that eliminate failure, but those that reduce the consequences of inevitable human errors.”

    Right on the dot… robust bank regulators are not those who believe themselves to be risk-managers for the world, and set up a system of capital requirements for banks based on the risk of default as perceived by the credit rating agencies, and which they apply by means of risk-weights they have arbitrarily decided on… but those who know that all systemic crisis has its origin in what has not been perceived.

  5. Great post, Mark! My one comment is that you might address regulatory capture a little more, i.e. surely the reason why there were “internationally enforced capital regulations which induced banks to securitize risky mortgages” is precisely because the banks sought to be regulated in this way and were successful in influencing policymakers to decide thus?

    One other thought: it is true that erroneous decisions are not backed by the force of law, but they are backed by the force of immense, amassed capital flows, which make it very hard for “those who dissent” to act differently and still presume to make some kind of livelihood. In short, if you didn’t want to be a part of the financial crisis, you could always have dug a hole in the ground and buried your money there, but it wouldn’t have given you much yield!

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