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 attached the rest of the piece as a pdf. It was written to help me focus my thoughts for my talk in San Francisco tomorrow. Any comments will be appreciated.

schumpeter

6 comments so far

  1. Peter Klein on

    Michael, you make some interesting points in your talk. But I’d urge you to take a more comparative (Coasean) institutional approach. To argue that markets underinvest, relative to some social optimum, in durable plant and equipment is one thing. To argue that governments, particularly democractically elected ones, are more likely to make such investments is another issue altogether. It’s not clear to me that the Hicks conjecture has any particular policy relevance, given that agents, whether acting privately or collectively, have finite time horizons. You have to show that acting collectively, through the “democratic process,” they will tend to be less myopic. I’m not sure how, exactly, you can show that.🙂

  2. mperelman on

    You are correct that governments, in an environment of disinformation and corporate influence ($700 billion bailout), are unlikely to behave well. Democracy can only work with an enlightened public.

  3. Steve Roth on

    This thinking is much in line with a recent two-part series by Mark Livingston, which I summarize and link to here:

    http://trueconservative.typepad.com/trueconservative/2008/10/all-cashed-up-with-nowhere-to-go-what-caused-the-depressions-and-what-to-do-about-it.html

    But Livingston’s angle is that there is often a paucity of productive investments available to investors–particularly in times when a larger percentage of GDP is profits as opposed to wages, and when income and wealth inequality are high.

    Neither this article nor Livingstons’, though give any data to support their views. (I’ve dug through Livingstons’ book as well, though I have yet to track through his footnotes.)

    Such data, or links to such data and studies of same would be much appreciated. For instance, a long-term historical series detailing investment dollars in different asset classes? (Notably, stocks, corporate bonds, derivatives.)

  4. […] Perelman, an economist at California State University, has an interesting take: …Industries that depend on capital-intensive plant and equipment have difficulty […]

  5. mperelman on

    Dear Steve Roth, what we did see was a great deal of investment, but it was in finance. The other investment might have been profitable, but much of it was long-term investment, which was frowned upon.

  6. Steve Roth on

    Dear Michael: I believe you (and Livingston) completely, but I really shouldn’t because I don’t have any good, pertinent data or analysis to support that belief. Would love to see some.


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