The Truth About Markets – Their genius, their limits, their follies by John Kay

John Kay is an academic economist of high quality but he writes for the general reader. He introduces economic theory through stories drawn from daily life. He draws on psychology, biology, and mathematics to explain economic behaviour. He does not advance one great economic theory that will be true for all time. As he sees it, the science of economics will always be a work in progress. The end of history will never arrive.  

Why do some countries get rich while others stay poor ? Now that communism has failed, should the state stay out of business altogether and allow competitive markets to allocate all resources between people ?  These are the sorts of questions he tackles.

The big economic problem for communism, according to John Kay, was not its lack of incentives. After all, the threat of being sent to the Gulag was a pretty powerful incentive. The problem of communism was the lack of reliable information about supply and demand for what one was producing. Centralised planning, relying on arbitrarily chosen and always out-of-date statistics, was and is ill-informed on the needs of complicated consumer markets. Free markets, which mobilize the constantly updated knowledge of millions of anonymous buyers and sellers, are usually a better guide for economic decisions.

Sometimes politically regulated markets get out of their depth too. The electricity blackouts in California happened because there was no voting system which could prevent the Californian electorate from simultaneously demanding low electricity prices, no new generating plants, and ever increasing amounts of electricity.

This is because markets will only work for things whose value you can measure in money, and it is difficult to agree the money value of not having  a power station at the end of your back garden! It is even  more difficult to put a current money cost on the pollution to be created by a new power generating station that may cause the summer temperature to rise in twenty years time, on the other side of the world.

This is where you cross the boundary between the science of economics to the art of political economy.

Free markets will only work at all if there is a state in existence that will enforce contracts, keep the peace, and ensure that some people do not become so rich or so powerful that the resulting social tensions or monopolies overwhelm the system.

This is how some countries went wrong. Argentina, one of the richest countries in the world a hundred years ago, has gone backwards because its property and political systems lacked a sense of legitimacy based on fairness. Newly Capitalist Russia is heading in the same direction because its distribution of wealth, based on faulty privatisations, lacks legitimacy and fairness.

John Kay also explores the recent dilemmas of American capitalism, where foolish stock option incentives for Chief Executives encouraged them to exaggerate paper earnings, and thus contributed to the recent stock market crash.

But then the trouble with trying to regulate all these problems by democratically ordained rules is that in a democratic system the transaction costs - the costs and delays in getting a decision or indeed of reversing a mistaken one - can be very high. Much higher than the costs and delays of buying and selling things in a free market !

As we try to get our present economic downturn into proportion, this is a very timely book.