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Why Markets Fail

The reason we need universal property is that, without it, markets fail in calamitous ways. Let us see how and why.

At first glance, markets are amazing things. They spur people to work, generate prodigious wealth, and once their basic rules are established, largely take care of themselves. That's because markets do two things really well: process vast amounts of information in real time, condensing it into simple numbers called prices; and reflect a kind of "general will," as in this is what the market thinks.

But that superficial view is deceiving. What markets think is not, in fact, what everybody thinks. Markets represent the general will of those with money today, and no one else. No money today means no voice, no vote and no power in markets. It should therefore come as no surprise that, even in the world's most productive economies, people sleep in the streets, die of preventable diseases and suffer constant economic anxiety. Nor should it astonish that nature and future generations, with no money at all, get no respect in markets whatsoever.

Economists use the term market failure to describe situations in which, as textbook author N. Gregory Mankiw puts it, "the market on its own fails to allocate resources efficiently." Classic examples include excess profits extracted by monopolies and harms caused by pollution.1

This is a reasonable definition of market failure if efficient allocation of scarce resources is our primary concern. If, however, we have larger goals, such as a stable society and a liveable planet, market failure is something else. It is the failure to advance these larger goals at all, whether efficiently or not - or worse, to efficiently advance their opposites. So I will continue to use the term market failure, but with the caveat that the failure must be measured against the meta goals of our economy.

Let me expand on that last phrase. Micro-economics focuses on the behaviors of households and firms and how supply and demand affect prices and vice-versa. Macro-economics focuses on the relationships between aggregate phenomena such as employment, interest rates, inflation and the summum bonum, gross domestic product (GDP). In the 1970s, British economist E. F. Schumacher introduced the concept of "meta-economics" as a step beyond macro. Its focus would be on the relationships between our monetized economy and the larger realms of nature, society, and the human psyche. And its goal would be to make those relationships as stable and mutually beneficial as possible.2

Schumacher's goal can be described in other ways. We could say that markets should aim for the most well-being for the most people while staying within the thresholds of nature. Or we could use the visual metaphor proffered by British economist Kate Raworth, who compares our ideal economy to a doughnut bounded by an ecological ceiling and a social floor. Our paramount goal, she says, must be to get markets inside the doughnut's boundaries and keep them there.3

Figure 2 Raworth's Doughnut

The three market failures

With the preceding considerations in mind, let's now look at the market's three biggest failures: ever-widening inequality, disruption of nature, and a third slightly lesser failing, financial instability. What lies behind them, and how might they be fixed?

Market failure #1: ever-widening inequality
As Marriner Eccles, chair of the Federal Reserve from 1934 to 1948, wrote about the Great Depression, "A giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth . In consequence, as in a poker game where the chips are concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out the game stopped."4

What interests us here is the suction pump. (We'll come back to the poker game and borrowing later.) How does the suction pump work, and why can't we constrain it?

Wealth concentration is a repetitive two-step dance. It begins with unequal starting conditions, magnifies those initial differences, and then repeats. This is aptly captured by the Biblical algorithm, "To them that hath, more shall be given."5

Most people know this instinctively. They know that money begets money and that, relatively speaking, the rich get richer while the poor get poorer. They see how the rich use their initial advantages - money, education, connections - to gain even more advantages. And they sense, accurately, that money has the loudest voice in politics.

But what lies beneath the dance? Why does wealth endlessly concentrate? Part of the answer is that property commands more market power than labor. While wage earners are paid only for their own efforts, property owners gain from many people's efforts. Further, while wage earners are paid only for current efforts, property owners reap from past, present, and even future efforts (because stock markets capitalize expected future income into current prices). What's more, since collateral is needed to borrow money, only those who already own property can use other people's money to acquire more.

The inherent advantages of property, plus its historically unequal distribution, combine to produce the result that French economist Thomas Piketty summed up mathematically as r > g: the return to capital exceeds the growth rate of the economy as a whole. Which means that capital owners continuously extract money from elsewhere in the economy. That is Eccles' suction pump.

From whom or where does capital extract that money? Marx believed it comes from workers, which is true but only part of the story. To an even greater degree, capital extracts financial value from our co-inherited wealth (mostly in the form of higher share prices) while paying almost nothing for it.

Consider, for example, Mark Zuckerberg, the founder and largest shareholder of Facebook. According to Forbes magazine, Zuckerberg is the fourth richest person in the world, with a net worth exceeding $90 billion.6 No one doubts that he is brilliant and hardworking, but there is no conceivable way any mortal can earn $90 billion in ten years. The reason Zuckerberg is so wealthy is that the value of Facebook's stock comes overwhelmingly from co-inherited wealth: the internet, computers, silicon chips, and all the science and research that preceded them, not to mention the millions of people whose eyeballs supply its revenue base. Though Zuckerberg himself might not acknowledge this, his fellow billionaire Warren Buffett has been frank: "I personally think that society is responsible for a very significant portion of what I've earned."7

Market failure #2: disruption of nature
As many of us recall from school, the Earth has passed through numerous geological ages: Cenozoic, Jurassic, Cambrian, and so on. All sorts of dramatic things happened in those early ages. Continents drifted, volcanoes erupted, asteroids crashed, glaciers moved, oceans rose and fell, species appeared and vanished. All these commotions were caused by natural forces. Humans played no role at all.

Scientists call the age we live in now the Holocene. It began some twelve thousand years ago when the last Ice Age ended. Since then the Earth has remained remarkably calm and congenial to life. We humans took advantage of this congeniality to develop agriculture, cities, and iPhones. But while we did these things, we also razed forests, dammed rivers, fouled the air, filled the land with chemicals, and depleted the oceans of fish. The result is that the majority of ecosystems on Earth are now shaped by humans, and non-human species are vanishing about 1,000 times faster than in the early Holocene.

This planetary reshaping is what Paul Crutzen, a Nobel chemist, was pondering during a scientific conference in 2001. When one of the speakers used the word "Holocene," Crutzen turned to a colleague and whispered, "No, damn it, we are in the Anthropocene," inventing the word on the fly (anthropo means human in Greek). Since Crutzen's epiphany and subsequent scholarly article, the term has been widely used by scientists and is being considered by the International Commission on Stratigraphy, the body that adopts the official names of geological eras.8

The basic idea of the Anthropocene is that Homo sapiens is no run-of-the-mill species; it is a geological force, like plate tectonics. We have the power to reshape the entire planet and eradicate millions of non-human species, and are currently doing so. We've built an economic juggernaut that is like a runaway bulldozer. We can't go on like this, a rational person would think, and yet we do - for a couple of reasons.

One is the dominance of profit-maximizing corporations. These powerful entities are non-stop growth machines. Each year they must sell more than the year before. If they don't, their value deflates and their managers are eventually sacked.

A second reason is that nature and markets don't talk with each other. The biosphere communicates with chemicals while markets talk with money. There is no lingua franca. It does no good, for example, for a CEO to learn that the...