The water is not the cup

The basic idea of "free-market economics" is that, if properly regulated, markets will lead to an optimal (efficient) outcome. This was the idea behind Adam Smith's "invisible hand," and, later the key "welfare theorems" of general equilibrium theory. It is a powerful idea, and not always right. Externalities - pollution, public goods, etc. - throw a wrench in the works, as do asymmetric information, imperfect competition, and other departures from the basic theory. But the idea of markets remains the jumping-off point for all modern economics; the goal of policy is to correct the things that impede markets, not to replace the market mechanism.

And yet, the idea of "the market" is not always grasped by those who write about economics; in fact, those who claim to support market mechanisms often spend the least time thinking about what markets actually are in real life. Among these writers, there is a tendency to replace "markets" with "businessmen"; to think that the functioning of the market is based upon the good judgment of the agents who act in it. This is a wrong but popular idea. Businessmen are a visible hand, and people believe in things they can see.

Case in point: the bias against nationalization of banks. Faced with a choice between Japan's unsuccessful no-strings-attached "zombie" bailouts of banks in the 90s and Sweden's successful nationalization of its banks around the same time, it would seem obvious that we'd prefer the latter solution. But our economic policymakers, including Tim Geithner and Larry Summers, are strongly against nationalization. They'd rather give the banks "cash for trash," buying up their bad assets to keep them on life support without forcing them to reform their management. When forced to choose between two totally non-market policies - nationalization vs. zombification - they go with zombification because of their faith in the wisdom of businessmen. This is ironic because, in actuality, nationalization would probably return the banks to full private status much more quickly than a "cash for trash" life-support program.

Second case in point: Greg Mankiw, writing in the NYT, argues strongly against U.S. attempts to get China to un-peg its currency. Mankiw labels such efforts "protectionism" - i.e. government interference in international markets. But as Brad Setser points out, it is actually China's yuan peg that is the market distortion. Arguing against the yuan peg is actually arguing for free markets. So why does Mankiw support the peg? That's anybody's guess, but my guess is that it's because many Amerian businessmen like the peg. The peg, which is inefficient, allows American company owners to reduce their labor costs by moving production to China - the market distortion thus decreases the total size of the economic pie, but increases the share of the pie going to businessmen. And hence Mankiw, erroneously assuming that "what businessmen want" = "the market outcome", ends up defending Chinese government interference in the market.

Confusing markets with businessmen is lazy at best, venally dishonest at worst. Academic eonomists are not, nor should they be, paid shills for America's managerial class. The invisible hand may be harder to photograph than a bunch of men in suits, but in general it's a lot wiser.