So This is How Capitalism Works

According to standard theory, capitalism, or at least “free market” capitalism, works by individuals and businesses trying to maximize their own self interest. In essence they act selfishly and the net result is that they create a benefit for the overall society. While selfishness might seem dangerous, this selfish behavior is actually constrained by the market. If, for example, a company acts selfishly by selling shoddy goods, they will eventually loose sales when the public finds out that they are buying junk. This acts as negative reinforcement which essentially constrains the company’s ability to sell junk. A rational company will, therefore, not sell junk.  There are two important aspects of the free market that help to provide this governor of selfish behavior: the first is that people as economic actors are assumed to act rationally, and the second is the idea that the market works best when everyone has complete and accurate information. So to continue with my example, we should assume that people will act rationally and not purchase shoddy goods, and second we should assume that people will have an easy ability to know what is a shoddy good. The problem with the free market, however, is that (1) people are not rational, and (2) people do not have complete and accurate information. Examples of both abound. Advertising is based on the proven fact that people can be swayed to buy things that they do not need. And, even with the internet, we do not have complete and accurate information about products and services in the marketplace. So these regulators of selfish behavior do not work properly. Despite that, many economic purists believe that it is not just OK, but actually preferable, for people to act selfishly.  

But that type of behavior has negative consequences. Here are two recent examples. First, a drunk commodities trader in England singlehandedly pushed up the price of oil, and cost his firm millions of dollars. Drink. Trade. Refill. Lose $10 Million. The New York Times, July 1, 2010.  http://www.nytimes.com/2010/07/01/business/global/01oil.html   The second story involves Goldman Sachs and the kinds of derivative that nearly brought down the world’s financial markets in 2008. Time Magazine: How Goldman Trashed a Town, Time, July 5, 2010. Pg 32-33. http://www.time.com/time/magazine/article/0,9171,1999417,00.html Apparently Goldman created a derivative based on adjustable rate mortgages for a trader named John Paulson, who was pretty sure they were crap and would fail, and who therefore shorted them, or bet against them. Goldman, apparently knowing they were junk, engaged in some slick trading to unload the derivatives. It involved multiple sales to various different people, and at each point the new purchaser became less aware of the true nature of the derivative. Finally a number of municipalities bought the derivatives from companies that they had dealt with before, and therefore considered reliable. But what they bought was junk, and they lost millions when the derivative market crashed.  So how does that comport with economic theory? Plenty of people acted selfishly, but what about rationally? And how could people have full and accurate information when they were being lied to? And finally, how does laissez-faire economic theory explain drunk commodities brokers?

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