Tuesday, November 11, 2008

Why Markets Fail

Markets fail for many reasons. With all the attention to the current financial crisis, the time has come to look at another part of market failure -- the reluctance to invest in long-lived plant and equipment. I'm not merely thinking about the deindustrialization of the US economy, but a more general reluctance.

The commitment of funds for fixed capital entails taking a risk. In the words of John Hicks, one of the earliest economists to win a so-called Nobel Prize, pointed to the obvious problem: "an entrepreneur by investing in fixed capital gives hostages to the future" (Hicks 1932, p. 183). Unfortunately, neither Hicks nor virtually any other economist has explored this fear of investment.

The most popular response to this reluctance to invest came from a very conservative Austrian economist, who once served as a socialist minister of finance, before landing at Harvard. Joseph Schumpeter was indeed one of the giants of 20th century economics. Here his reputation to his personal brilliance, as well as a willingness to learn from Karl Marx.

I have posted the rest of the piece as a pdf at


It was written to help me focus my thoughts for my talk in San Francisco tomorrow. Any comments will be appreciated.


Myrtle Blackwood said...

The process as described sounds much more benign than it actually is:

"As business stagnates and profits fall, money will seek higher profits and finance, which will become riskier and riskier. Eventually, the house of cards falls, irrational and outdated investment becomes scrapped, and one of two things will happen. After a painful depression, bankruptcies will wipe out a good deal of debt. New investment opportunities present themselves. Eventually, the economy will be reinvigorated for a while until the cycle begins again.
Alternatively, the dislocation of the depression to a different way of organizing production.

This could be rephrased to:

As business stagnates and profits fall, corporate bureaucrats will seek higher profits and finance, which will become riskier and riskier. They also increasingly turn to such things as deforestation, patents for biotechnology designed to control the world's food supply, cheap unsafe chemicals for household and other forms of wide-scale use, forms of monopoly (in general) to acquire price-making capacity etc.

Eventually, the house of cards falls, and the global environment begins to fail.

Irrational and outdated investment
continues because the new and powerful corporate monopolies and conglomerates now sponsor government itself.

Painful depressions and bankruptcies become dominant despite and because of the increased dominance of a handful of powerful and unethical 'market' players.

Corporate debt is wiped by tax-payer-funded bailouts whilst ordinary citizens are evicted from their homes and live in new tent cities.

New investment opportunities present themselves as revolution ferments and the dire state of the earth makes new unpolluting technologies undeniable.

Eventually, the economy will be reinvigorated for a while producing alternative energy technologies,weapons and spy technology associated with widespread civil unrest. Millions of new homes need to be rebuilt after they are destroyed.

Eventually the destructive cycle eventually begins again but with fewer and fewer natural resources. World population dramatically declines.

Alternatively, the widespread destruction of the biosphere and the dislocation of repeated economic depressions lead to a different way of organizing production and social life before too much damage is done.

Myrtle Blackwood said...

"In the 1980s, 1990s, and early 2000s, debt was driving commercial deforestation in some developing tropical countries. Strapped for cash, these countries turned toward their natural resources as the fastest and easiest way to service debt and interest payments. Readily available without capital investment or skilled labor, often non-renewable, forest products like mineral wealth, timber, oil, and hydroelectric power were liquidated in an effort to raise much-needed funds.

While efforts in the last couple of years have sought to reduce or eliminate debts of the world's poorest countries (World Bank / IMF), debt payments still are an important factor in the need for governments to pursue and exploit natural resources in a non-reponsible manner....


Anonymous said...

Forgive a pedantic copy-editor:

"Here his reputation to his personal brilliance, as well as a willingness to learn from Karl Marx."

This isn't a sentence.

I hope that's helpful!

Michael Perelman said...

Not pedantic at all.


& Thanks to Brenda, as always.

Myrtle Blackwood said...

"..Eventually the destructive cycle eventually begins...

Sigh...sometimes I can't bear to read what I've written... I'm crook with a flu virus which is clearly draining my brain.

rosserjb@jmu.edu said...

A curious aspect of Schumpeter's view was that he believed in quite regular business cycles, including long waves. He basically saw three different cycles of different periodicities operating simultaneously, Kitchin, Juglar, and Kondratiev. When they would coincide in an up or down movement would be when the economy would experience the most dramatic movements. This was essentially his theory of the Great Depression, now followed by very few.

Indeed, the technological part depended on the downturn to bring about a new wave of possible innovations, carried out by whomever. The innovations that would drive the long waves were dramatically new technologies, such as the major innovations of transportation that could transform an entire economy, as in the example you gave. In the US, the 1920s was the decade of the massive expansion of the automobile industry and accompanying road building, that decade being when a majority of families came to own a car in the US. In a sense the G.D. was, among other things, the period of massive consolidation and shaking out of that industry.

Eleanor said...

There are a number of typing errors, but I was able to figure out what you meant to say, except in the case of the sentence Tim caught above.

I had the same question as Brenda. Can the world afford creative destruction? I flat out don't think we have the resources to continue to grow through trashing the planet. We not be able to fix the damage we have already done.

You mentioned the current situation in the airline industry as contemporary example of the kind of problems faced by railroads.

I quoted your book Railroading Economics to my brother, who knows a lot about the airline business. According to him, airlines lease their planes rather than buying them, so -- from the point of the airlines -- the business is not capital intensive; and it's actually comparatively cheap to start an airline. You lease the planes; you lease the gates; and you're set to go.

Now, from the point of view of the companies who own the planes, the air travel business is capital intensive. I didn't ask my brother about those companies.

What is true, I think, is that deregulation has been very bad for the airline industry, maybe because it's fairly easy to set up an airline. For whatever reason, airlines can't handle a lot of competition.

I find your discussion of the difference between low capital and capital intensive industries really interesting. Is the end conclusion that capitalism and the market work for small businesses and start ups, but not for capital intensive and large industries?

Eleanor said...

I just hopped over the Mark Thoma's blog, which I do every day, after reading Dean Baker and Econospeak. Thoma has posted this essay. The comments are worth checking out, because a lot of people are missing the point of the essay, I think. paine made a typical and not very nice remark about Econospeak. I did not respond, because I don't want to attract his attention. One of the lovely things about Econospeak is the high level of civility.

Sandwichman said...


The question, "why markets fail" is much broader than the question you actually address in your paper. What you are talking about is more like "why markets fail to promote innovation." Innovation isn't the be all and end all. Conceivably markets could succeed in other, more important aspects and yet fail to promote innovation. I think "markets" simply fail to explain what goes on.

Just because people have noses doesn't mean they "follow them around." Just because markets exist to some extent, doesn't mean that they determine the course of human events. In fact, I would say that markets "succeed" in covering up and objectifying what is really going on. Every once in a while they succeed so brilliantly at the ruse that people come to believe in markets as the subject of (economic) history. That's when their failure becomes manifest.

Eleanor said...

I like the Sandwichman's comment on markets covering up and objectifying what is really going on, so that people come to believe markets are the subject of economic history.

I keep thinking -- in a very non-economic sort of way -- that a huge amount of society, most of society, does not take place in the marketplace. Even in a capitalist society, there are families, neighborhoods, fraternal organizations, unions and governments.

Michael Perelman said...

Regarding Barkley's comment, Kuznets harshly criticized Schumpeter for assuming that innovations bunch up in a cyclical way.

For Sandwichman, I explicitly focused on on the question of innovation.

Eleanor, I apologize for the typos & the like. I was working very fast. Sorry.

The question is not whether we can afford more creative destruction, but rather if there will be any positive creativity to accompany the destruction,