The Regulatory Policy Institute Research Group

Markets versus regulation?  Drop the ‘versus’!

Much debate of late has focused on the call for more (or fewer) pro-market policies to address current economic challenges. Yet those involved seem unable to articulate what they actually mean by the word ‘market’. Many speak of the market in glowing or dismissive tones, but very few attempt to define what they mean by the word and the economics textbooks are largely silent on the matter.

A market economy can be viewed as an economic system characterised by a ubiquitous reliance on voluntary exchange of goods, services, and assets. At this broad level, proponents of ‘free markets’ often embrace (or allow themselves to be stereotyped as embracing) a rather wider set of beliefs encompassing notions like a laissez-faire approach to economic policy, a smaller state, and lower taxes.  None of these, however, have any direct bearing on the efficacy of markets.

Thus, Milton Friedman observed of pro-market sentiments that “liberal principles offer no hard and fast line how far it is appropriate to use government to accomplish jointly what it is difficult or impossible for us to accomplish separately through strictly voluntary exchange.”  As to the nature of markets themselves, Ronald Coase provided the key insight: “Markets are institutions that exist to facilitate exchange, that is they exist in order to reduce the cost of carrying out exchange transactions.”  Put simply, they serve to make it easier to buy and sell things.

Elaborating on Coase, in social studies the word ‘institution’ refers to a system of rules ranging from formal laws and regulations to socio-economic norms, conventions and even habits which serves to organise/govern/regulate patterns of human conduct. In this sense, it can be said that markets themselves serve both to regulate and co-ordinate economic behaviour. They are part of an economic order.

At this point, it should become clear that a term like a ‘free market’ is meaningless, if not made much more precise.  The question is:  free of what precisely? Does it mean that there should be no market rules?  That would imply a return to ad hoc transactions by way of barter, a rather extreme view that would certainly make it much more costly to do business. 

Ironically, pursuit of a general policy of hostility to markets would lead to much the same outcome, to an economic system without rules governing trading activities.  The seemingly strongly opposed views – unqualified advocacy of free markets on the one hand and calls for abolition of markets on the other – are substantively the same in economic effect.  The differentiation serves only to provide ‘rallying calls’ for warring factions and ideologies, “full of sound and fury, signifying nothing”.

Economists are fond of stressing that it is the price mechanism that co-ordinates commercial behaviour across myriad would-be buyers and sellers, but Coase’s point indicates that this is a far from complete account of things.  A general change in prices ‘in a market’ may induce and co-ordinate adjustments in the behaviours of buyers and sellers, but for that to happen there needs to be a market in the first place.

In reality, the textbook co-ordination of the price system occurs within an institutional structure and the nature of that structure matters greatly for the effectiveness of the system.  The institutional structure performs much of the heavy lifting of economic co-ordination – so much so that Coase was led to define economics as the study of “the social institutions which bind together the economic system: firms, markets for goods and services, labor markets, capital markets, the banking system, international trade and so on.”  

Adopting this ‘gestalt’, both the introduction of new regulations and removal of existing regulations imply a change in the institutional structure and a relevant question is:  do the changes make it more or less costly/difficult to carry out exchange transactions?  And to be pro-market is simply to favour regulatory policies that move things in the direction of ‘less’.

It is, then, not a sine qua non that being pro-market precludes public regulation directed at problems like asymmetries of economic power (between buyers and sellers), trading standards, fraudulent trading and the like: such measures can potentially reduce the difficulties/costs of engaging in exchange transactions, precisely the purpose/function that well-functioning markets serve. By seeking to attach the term ‘pro-market’ (and a fortiori, the term ‘free market’) to wider sets of beliefs, many participants in public discourse betray a lack of understanding of the meaning of the word ‘market’ and risk undermining the very institution(s) in which they claim to vest such confidence.

Finally, it is useful to bear in mind a salient empirical observation: liberal economic orders tend to have much more extensive rule-books for engaging in commercial conduct than economic tyrannies.

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Richard Street
Richard Street
6 months ago

I totally agree. Well run orderly markets are a necessity for prices to be reportable. Transactions that are ‘off market’ can distort the understanding of market prices. We see this in most commodities trading where quality, delivery location, delivery terms, flexibility in quantity actually delivered/received can all affect the contract value.

There is a reason that price reporting agencies like ICIS highly value the role of regulators and governments in ensuring that market behaviours are fair and above board (in accordance with the law). We can only operate to bring transparency to opaque markets if the trades themselves are done at arms length and parties are truly free to transact with whomever they wish.

But that knife cuts on both sides. Regulators and governments who have built systems and markets on the back of market signals, need to understand that the market wont give them a politically convenient answer. It will answer the question, what is the price needed to be paid to fulfil market demand.

We see this now in European energy markets where political leaders claim the TTF market has failed.

It hasn’t failed. It has been hugely successful. It has kept the lights on across Europe and attracted more LNG to European shore than ever before. It has done this in the face of a c.30% drop in Russian flows of gas to Europe.

Ultimately, however the perception of failure is because the politicians don’t like the price at which the TTF has balanced the market. And it isnt clear at all that they really understand or care about the alternatives.

If regulators and governments want markets to price responses differently then they will need to carefully rethink how they intervene. Current proposals have significant consequences and I fear could even result in fatalities if security of supply is disrupted.

Spending time to understand consequences is something that isnt valued at the political level at the moment but I fear it is a lesson we may have to learn the hard way.