The Regulatory Policy Institute Research Group

On trust in markets

It was a great pleasure to spend two, sunny, late November days in Melbourne this year (2019) discussing the future of regulatory policy with Australian friends and colleagues, particularly since their own, national discourse has been at a rather higher intellectual level than the UK’s for a few years now. The theme for the meet-up of the Regulatory Policy Institute of Australia and New Zealand (RPI ANZ) was ‘Rebuilding faith in institutions, markets and competition’. It was motivated by a phenomenon that is shared across the hemispheres: a steady erosion of trust/confidence in these things.

It was clearly a very broad theme and my own, limited contribution concerned faith/confidence/ trust in markets. As usual, I stressed the importance of being clear about the meaning of words: no end of confusion can be sown at the outset, if this is not done and if different interlocutors in a discussion are attributing different meanings to the same terms. Such an unresolved clash of meanings can lead to unproductive – and sometimes toxic – discourse, something that has, unfortunately, happened in UK arguments concerning Brexit.

To avoid this kind of development, it is easy enough to fix broad meanings at the outset. Thus:
• Market: an economic institution whose purpose or function is to facilitate exchange transactions between buyers and sellers.
• Trust in markets: a firm belief in the reliability of markets in serving their purpose/function.
• Economic institution: an established set of laws, practices and customs (norms) that serves to govern or guide economic conduct.

Given these meanings, and given that markets have served the relevant purposes/functions for millennia, the phenomenon of interest is a contemporary proclivity for declaring that this or that market has “failed” and demanding that something be done about it, up to and including the possibility of dispensing with a market or markets altogether. More specifically, the questions to be asked are: why has this development taken place and what are its likely consequences?

My simplified answer to the first question is that the proclivity is a function of tendencies to expect the institutional form we call a ‘market’ to do rather more that serve the purpose/function for which is has, historically, evolved or been developed.

To illustrate, Prof Nick Stern, author of the UK Government’s Stern Report has said that “Climate change is a result of the greatest market failure the world has seen.” Now that’s a rather strong indictment of an institutional form that does not have prevention of climate change as a purpose or aim. One might equally well say that democracy, or the monarchy, or the army has failed in preventing climate change.

This is not to pass comment on the issues raised by the prospect of climate change itself: it is rather a challenge to the notion that a failure to achieve a desired outcome or set of outcomes can be so easily attributed to a failure of a particular institution which, as a matter of fact, exists to serve rather different purposes. Shouldn’t the success or failure of institutions be more narrowly judged against their own, specific purposes/functions?

I have in previous work referred to the tendency to proceed by assessing market performance on the basis of wider policy criteria and, where found deficient on that basis, to seek to alter market ‘rules’ (the set of laws, regulations, practices, customs and norms which define a particular market) so as to contribute to wider policy objectives as the ‘repurposing of markets’.

Significantly, re-pursposing has a number of negative consequences.

At the most general and abstract level, the addition of other aims and purposes can be expected to lead to a reshaping of market rules so that they are no longer best adapted to serving the single, original purpose of the institutions. Thinking of matters in terms of an optimisation process in which the rules are the control variables, it is obvious that (a) the solution of a problem with a multi-argument objective function will differ from the solution when the objective function has a single argument (i.e. the preferred market rules will differ as between the two) and (b) performance in meeting the single-argument objective will be poorer in the multi-argument case.

Put another way, the repurposing of markets will tend to render exchange transactions between buyers and sellers more difficult/costly than otherwise: there will be greater restrictions of, or higher barriers to, trading activities. This can have both static and – typically much more important in practice – dynamic consequences. Statically, the volume of trade at a particular moment may be lower than in a realistically feasible counterfactual (in which re-purposing is absent). Dynamically, since sequences of exchange transactions can be characterised as processes in which new, economically valuable information is discovered, the rate of innovation may be slowed in consequence of the lower level of commercial activity.

Why then does repurposing occur? The answer here flows from the influence that different interest groups can frequently have on the collectively shared market rules. Rules that serve the purpose of facilitating trade to the maximum extent possible may not be optimal for a particular interest group, which might derive greater benefits from more restricted levels of trading by being able to extract a significantly higher share of the aggregate benefits. To the extent that an interest group has the power to influence market rules then, it can be expected to tend to seek to ‘tilt’ them toward its own purposes and towards maximising its own benefits.

That re-purposing can constitute a major fragility of market systems is signalled by the fact that it was a central theme of Adam Smith’s Wealth of Nations. The main culprits for Smith were merchants who induced venal/biddable politicians to determine laws and regulations that would be particularly favourable to the merchants’ own commercial interests. However, Smith’s analysis also extended to ideological interests. He mentioned religion and agricultural policy in this category, which today would include movements such as Extinction Rebellion (XR).

Additionally, in today’s more democratic context, politicians have become a ‘partial [meaning partisan] interest’ in their own right via their search for electoral votes. Arguably a major example of this was banking supervision in the pre-2008 period, whose purposes were contaminated by political desires for cheap credit, particularly in housing markets. It is, however, only one of many examples of market rules being tilted toward producing outcomes that, at least in the shorter term, are popular with important voting constituencies.

A key point to note is that these interventions tend to be ‘outcomes-focused’, and the tendency has been to declare markets have ‘failed’ when the politically desired outcomes are not achieved. This stands in contrast to the view that markets exist simply to facilitate exchange transactions, that they are a framework that establishes a process (market trading), and that the process will ‘discover’ outcomes over time.

There is an analogy here with the rules of parliamentary democracy. They establish processes or procedures for determining who should govern, but the outcomes are determined by voting and are not necessarily what participants expect or, indeed, what many participants would like them to be. Crucially for the integrity and stability of the process, the rules are not readily dismissed as failures when particular expectations and aspirations are disappointed (although, slightly alarmingly, that is an argument that has been made by more than a few in the UK following the 2016 Brexit referendum: the traditional ‘losers’ consent’, essential to the functioning of the democratic system, has been given less consensually than normal.

So where does trust come into all of this? There are two points to be made here. First, if powerful interests acquire undue influence on market rules, other participants (and the public more generally) may come to see markets as ‘rigged’. Trust in the structures and processes may be lost, which in turn tends to increase exchange transactions costs: there will be risk to participants of getting a raw deal and the costs of those risks will discourage trading. Markets will no longer be seen to be serving their primary purpose/function.

In such cases, if the problems are sufficiently severe and there is evidence of reduced volumes of trading activity, it might be reasonable to use the term ‘market failure’, but note that this is a very different usage to one in which the perceived problem is simply that the outcomes of market trading are not as expected or hoped for.

Second, and more fundamentally, if market rules are viewed as instruments or control variables to be used in order to attain specific policy outcomes, something fundamental is changed. Since markets are institutional frameworks for learning and discovery (of preferences, of available goods/services, of prices, etc.), the outcomes of competition in markets are inherently unpredictable (indeed, on the sports field we tend to talk of a particular game/match as ‘competitive’ precisely when the outcome remains unpredictable over the duration of the contest. That in itself makes market rules poor control variables.

Moreover, if market rules are tweaked in the search for a particular outcome, missing the target would indicate that further adjustments are required. In this hit-and-miss iterative process, the rules tend to become temporally unstable and cease to be fully functional as an institution that serves to co-ordinate and guide the economic conduct of buyers and sellers. Trust in market institutions is thereby eroded.
Diagnosis of these problems points immediately to the broad shape of the remedies required: explicitly recognise the specific and limited purpose/function of markets and seek to protect their integrity in serving this purpose/function. This does not imply statis in institutional forms – rules should adapt over time to reflect changing economic circumstances – but it does indicate the desirability of impartial and considered rule-making that is resistant to the pressures of interest groups who would seek rule-changes that favour their own, partisan interests.

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