For an extra challenge, substantiate that "markets" have "caught on so well throughout the world in the last 200 years." 'Cause a lot of what is being called "markets" sure looks like political cronyism to me. The political unit enforcing the cronyism isn't a state in the traditional sense of the term, but a decision doesn't become magically apolitical - or uncorrupt - just because it's being made in an unaccountable boardroom rather than a democratically accountable parliament.
- Jake If you only spend 20 minutes of the rest of your life on economics, go spend them here.
Willeb Buiter: Useless finance, harmful finance and useful finance (April 12, 2009)
Financial markets are inefficient in any of the ways specified by James Tobin in a great 1984 paper - information arbitrage efficiency, fundamental valuation efficiency, functional efficiency or Arrow-Debreu full insurance efficiency.[1] Financial markets even often are technically inefficient. A market is technically or trading efficient if it is liquid and competitive, that is, it is possible to buy or sell large quantities with very low transaction costs, at little or no notice and without a significant impact on the market price. We have seen many examples, from the ABS markets and the commercial paper markets to the interbank markets of massive and persistent failures of technical or trading efficiency. Even in those financial markets that are reasonably technically efficient, like the US stock market, the foreign exchange markets and the government debt markets, Tobin saw frequent departures from efficiency in the less restricted senses of the word. He accepted that financial markets possessed what he called `information arbitrage efficiency' that is, that they were informationally efficient in the weak and semi-strong sense. You cannot systematically make money trading on the basis of generally available public information. Clearly, however, trading profitably on the basis of insider information is possible. He did not believe that financial markets consistently possessed `fundamental valuation efficiency': financial asset prices do not necessarily reflect the rational expectations of the future payments to which the asset gives title. Key financial markets, including the stock market, the long-term debt market and the foreign exchange market are characterised both by excess volatility and persistent misalignments, that is, prices deviating persistently from fundamental valuations. Tobin also contested the notion that the financial markets delivered `value for money' in the social sense. "the services of the system do not come cheap. An immense amount of activity takes place, and considerable resources are devoted to it." (Tobin [1984, p. 284]). Tobin referred to this aspect of efficiency as `functional efficiency'. Finally, the system of financial markets can be efficient in the technical, information arbitrage, fundamental valuation and functional senses without possessing what Tobin called Arrow-Debreu full insurance efficiency, that is, without supporting Pareto-efficient economy-wide outcomes. The reason is that real world financial markets interact with labour and goods markets that are inefficient in every sense of the word. When financial markets are inefficient, the distinction between fundamental, exogenous variables and endogenous variables disappears. CDS prices can become quasi-autonomous drivers of the bond prices. The tail can wag the dog. The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies. Activities in derivatives markets, including futures markets, can feed back on sport markets and real production, consumption and storage decisions. Unbridled derivatives markets may be liquid, but the question is, to what purpose? If, as I believe, there is no economic rationale for `naked' CDS positions (that is, CDS that do not insure an open default position in the underlying security), then liquidity of the CDS market only serves those who want to trade naked CDS. This, in my view, only wastes real resources through (a) churning and (b) unnecessary bankruptcies.
Even in those financial markets that are reasonably technically efficient, like the US stock market, the foreign exchange markets and the government debt markets, Tobin saw frequent departures from efficiency in the less restricted senses of the word. He accepted that financial markets possessed what he called `information arbitrage efficiency' that is, that they were informationally efficient in the weak and semi-strong sense. You cannot systematically make money trading on the basis of generally available public information. Clearly, however, trading profitably on the basis of insider information is possible.
He did not believe that financial markets consistently possessed `fundamental valuation efficiency': financial asset prices do not necessarily reflect the rational expectations of the future payments to which the asset gives title. Key financial markets, including the stock market, the long-term debt market and the foreign exchange market are characterised both by excess volatility and persistent misalignments, that is, prices deviating persistently from fundamental valuations.
Tobin also contested the notion that the financial markets delivered `value for money' in the social sense. "the services of the system do not come cheap. An immense amount of activity takes place, and considerable resources are devoted to it." (Tobin [1984, p. 284]). Tobin referred to this aspect of efficiency as `functional efficiency'. Finally, the system of financial markets can be efficient in the technical, information arbitrage, fundamental valuation and functional senses without possessing what Tobin called Arrow-Debreu full insurance efficiency, that is, without supporting Pareto-efficient economy-wide outcomes. The reason is that real world financial markets interact with labour and goods markets that are inefficient in every sense of the word.
When financial markets are inefficient, the distinction between fundamental, exogenous variables and endogenous variables disappears. CDS prices can become quasi-autonomous drivers of the bond prices. The tail can wag the dog. The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies. Activities in derivatives markets, including futures markets, can feed back on sport markets and real production, consumption and storage decisions.
Unbridled derivatives markets may be liquid, but the question is, to what purpose? If, as I believe, there is no economic rationale for `naked' CDS positions (that is, CDS that do not insure an open default position in the underlying security), then liquidity of the CDS market only serves those who want to trade naked CDS. This, in my view, only wastes real resources through (a) churning and (b) unnecessary bankruptcies.
Efficiency: not wasting resources. Most of economics deals with the social efficiency gains by allowing freely negotiated exchanges of things between individual actors. This means that although no new wealth is created when exchanges occur between individuals, the amount of already produced wealth that is usable by individuals increases dramatically -- the so-called gains from trade.
Although you didn't ask it, equity, or fairness, is also an important element but, like wealth, it is a completely relative term, dependent upon subjective determination of needs and wants. Every economic change can be be divided into just two effects regarding how social welfare is impacted: and efficiency effect and an equity effect.
Although it can be shown (Stiglitz has the Nobel Prize for this, as well as Arrow in another sense) that, in the real world, the assumptions of effective omnipotence and omniscience on the part of market actors doesn't exist and means that markets cannot be efficient, it has also been shown that no other system yet devised is superior to markets (Stiglitz again) and that other means of allocating resources are almost always worse, especially in large-scale social systems like nation-states, because of the inescapable information asymmetry problem -- that it is rational for people to lie to each other for personal advantage.
Efficiency: not wasting resources
Quite regardless of any other criticism that may be applied to the efficiency of markets, it must be noted that market transactions do not actually reflect the underlying resources, unless externalities are priced in. And since many externalities cannot be assigned a fair value through anything but a collective political decision, the efficiency of markets becomes inherently and inseparably entangled with political and regulatory systems.
Most of economics deals with the social efficiency gains by allowing freely negotiated exchanges of things between individual actors [my emphasis]
Thereby becoming, to a greater or lesser extent, inherently counterfactual right from the first axiom. In some cases, the error introduced by this simplification is negligible (in a well regulated market, where no non-state player has excessive market power, the state player(s) are democratically accountable and so on and so forth). In others (transnational corporations having budgets comparable to a mid-sized sovereign state, lack of effective regulation of cross-border capital flows, etc.), not so much.
To these two considerations must, of course, be added the information asymmetry issues raised by Stiglitz.
It's a question of whether markets are BETTER able to minimize the biases toward the powerful and the crooked than other means of allocating resources.
There's a reason that the OECD capitalist countries are so powerful and have so much higher standards of living than the formerly (and currently) communist countries.
You mean apart from colonial militarism and outright theft?
You're being terribly naive if you really think that markets make people rich without any other factors.
While the OECD basks in its financial superiority, most - if not all - of the countries benefit from straightforward colonial resource extraction of both materials and labour from the rest of the world.
