Philip Pilkington: Why “Free Markets” Accommodate Speculation and Lead to Disequilibrium

Philip Pilkington is an Irish writer and journalist living in London. You can follow him on Twitter @pilkingtonphil

Perhaps the most effective myth that mainstream economists have propagated over the course of the last century is the idea that the majority of prices in an advanced capitalist economy are set by the interaction of supply and demand in a market for scarce resources. Perhaps the second most effective myth they have spread is that this interaction tends toward equilibrium and stability.*

Both myths, being myths, are completely untrue. In fact, empirical surveys, together with more realistic theories, tell us that the prices of most goods in advanced capitalist economies are, in some way or another, administered. Moreover, observation tells us that markets that are largely subject to supply and demand interactions are highly unstable and prone to sometimes dangerous speculation.

Yet it is accepted without question that in “normal” situations, supply and demand for scarce resources sets prices and that such processes, left undisturbed, tend toward equilibrium and stability. We’ll explain why this is a superstition and will see what truth we can tease out.

First let us focus on how most prices in our economies are actually set. After that we will turn to those markets where supply and demand do indeed play a rather large role and see what properties are typical of such markets.

Administered Prices

The neoclassical fable that supply and demand for scarce resources sets prices in modern capitalist economies rests critically on the notion that firms experience rising marginal costs as they increase sales past a certain point. Those familiar with mainstream economics will recognise this as the condition for a so-called “upward-sloping supply curve” which ensures that prices are set at a stable equilibrium. In theory, the firm tries to maximise gains by producing up to the point where the cost of producing one more unit of output becomes unprofitable.

This conclusion, in turn, rests on the notion that firms are constantly producing at full capacity. That is to say, for example, that all the machines in a given firm’s factory are being used in their most effective capacity any given point in time. Thus, to try to increase production would only result in marginal costs increasing and the firm making a loss.

There are many problems with this theory but here is not the place to run through them in detail. Instead we will simply point out that empirical research, time and again, has refuted the idea that firms face rising marginal costs. For example, in his study of pricing “Asking About Prices”, former vice-president of the Federal Reserve Alan Blinder wrote that:

Only 11 per cent of [U.S.] GDP is produced under conditions of rising marginal cost… Firms report having very high fixed costs-roughly 40 per cent of total costs on average. And many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks. (P. 105)

The reason for this is that, contrary to what the neoclassical economists implicitly assume, the engineers and managers that operate businesses are not stupid. Like the fairly rational beings that they are, they take account of the fact that the firm may need to increase output some day and so they ensure to build excess capacity into said firm.

It’s not hugely surprising that they should do this. Imagine, for example, that an employer asks you for a deadline when you think you will finish a certain project. Since you are planning for an uncertain future, and provided you are not naive or self-sabotaging, you will set the deadline slightly later than you think you might actually complete it were you to work exactly according to schedule. This way if circumstances change, which they might, you have some breathing room. When they can, most people tend to build uncertainty into their plans for the future. Similarly, those that plan capitalist firms build in breathing room should demand for their goods or services increase.

Post-Keynesian economist Nicholas Kaldor puts it as such in his paper “Limits on Growth”:

The manufacturing sector is the archetypal case of a fix-price market… In markets of this type uncertainties concerning the future growth of demand mainly affect the degree of utilisation of capacity; it pays the manufacturers to maintain capacity in excess of demand and keep the growth in capacity in line with the growth of demand. (P. 193).

So, how do these firms set prices? Unlike in the neoclassical theory there is no abstract agency called ‘The Market’ ensuring that firms set prices in a precisely dictated manner. Instead all firms have a certain amount of agency. In practice the empirical literature suggests that firms estimate the amount of output they expect to sell, calculate the total costs involved and then place a mark-up on the price that they deem to yield an appropriate amount of profit for their investment. Needless to say, this is subject to norms and even firms with a fairly substantial degree of monopoly will not get away with blatant price-gouging. Even Apple are aware that consumers will only pay so much for an iPad.

This is, in somewhat simplified form, how the prices for most goods – and possibly even most services – in a modern capitalist economy are set. This should be obvious to anyone who takes a look at the world around them. The prices of most goods and many services do not fluctuate significantly when demand varies – indeed, apart from keeping up with the slow drift of inflation**, they do not generally fluctuate at all. For the most part, the price changes we do actually notice are the result of technological innovation – camera phones and laptops, for example, have become significantly cheaper in recent years.

Before moving on to markets based on scarcity where the interaction of supply and demand proper does play a role, let us briefly consider a thought experiment that will prove useful shortly in showing why such markets are prone to instability.

Speculating on Refrigerators

Administered prices clearly have the advantage of ensuring stability. Provided that we do not live in a country that is experiencing significant inflation, the prices of most goods are pretty constant. And yet, as shall be discussed further below, the prices in some very particular markets – say, the housing market – are subject to wild fluctuations. This is, as everyone is aware, due to speculation. That is, the fact that price-rises can often beget price-rises as eager investors pile into a given market in order to try to profit, thus inflating unsustainable bubbles – and driving up costs for consumers in the meantime.

But why doesn’t this occur in markets for manufactured goods? Why don’t investors ever speculate on refrigerators in order to turn a profit? This may seem an absurd question but it is one that, if considered for any period of time, actually yields a rather interesting result.

Imagine for a moment that speculation began to take place in the refrigerator market. Speculators started buying up significant quantities of the output coming out of the refrigerator factories. And, as demand for new refrigerators began to outpace supply, the price of new refrigerators rose. This, in turn, provoked more speculators to pile into the market buying up new refrigerators to the point where consumers largely stopped buying new refrigerators and instead started buying second-hand refrigerators. But then, as the price for second-hand refrigerators began to climb, the speculators piled into the second-hand market and the prices for second-hand refrigerators started to rise too.

The end of this story need barely be told. Eventually the Great Refrigerator Bubble would burst. Whether due to interest rate hikes, underlying demand for refrigerators falling as prices rose too high or some other arbitrary reason, refrigerator-mania would eventually come to an end and many of those that participated would take heavy losses.

Pretty fantastic story, right? After all, we could never imagine such a thing happening. But why not?

Well, recall what was said above about manufacturers ensuring that they have excess capacity should demand increase. The simple fact is that a speculative bubble could never arise in the refrigerator market – or, indeed, the market for any manufactured good – because as demand began to rise, rather than the price rising, the amount produced would increase instead. Since the price for refrigerators would stay the same and instead the amount of refrigerators produced would increase there would be no incentive for more speculators to pile into the market. And those that were silly enough to try to speculate on refrigerators would find themselves holding large inventories that were subject to depreciation.

It is the excess capacity itself that provides a barrier against speculation. If we think carefully about this it has a rather fascinating consequence: namely, that the mechanism for speculation is actually inherently built into the very market-mechanism that is championed by the neoclassical economists as a bulwark against disharmony. It is the interaction of supply and demand under conditions of scarcity that opens the door for speculation and it is only markets in which prices are administered in a manner that allows for flexible output and so in which scarcity is largely not an issue that are immune.

Let us turn now to the housing market, the most extreme of the “free markets”, to see how this occurs.

Housing Bubble!

The housing market is, of course, well-known as a cesspit of speculation. The reasons for this are many and much discussed but we will here focus only on the fact that housing is a somewhat scarce commodity that is subject to almost perfect market forces (yes, new houses can be built slowly, but it’s all about location and space is scarce).

A fairly well-known neoclassical economist once told me that the housing market is based on arbitrage; that is, on buying low and selling high. The idea here seems to be that a crew of house-arbitragers stalk the streets pricing homes, buying up those of them that they estimate to be below the going market price, selling them at this price and pocketing the difference. Presumably the speculation we sometimes see in the market thus comes from this process – that is, when arbitragers start buying up too many houses in the hopes of future gains.

When I told this economist that I worked part-time selling houses all through college (yes, this was during the Irish property bubble), that arbitrage only really took place in the market for land and that his abstractions were at best a misunderstanding, he quickly shut up. The way the property market actually functions is more like an auction – hence why in Ireland we call real-estate agents “auctioneers”.

The prices are already known prior to bids. Sellers know roughly how much their property is worth based on past values in the area and buyers have access to enormous amounts of price information simply by reading the property section of their local newspaper. When bids around the asking price are made they are passed by the real estate agency (or “auctioneer”) back to the seller who then surveys the offers and either accepts the highest or leaves the property on the market in hopes of an even higher bid. This, of course, is as close one can come to a so-called ‘Walrasian auction’ in the real world, thus making the property market, in a very tangible way, an almost perfect neoclassical market.

So, why then is our perfect market subject to consistent and catastrophic speculation? Again, it is impossible to delineate the precise reason why the housing market is often chosen as the playground of speculation rather than any other market with similar properties; however, we can confidently say that the auction structure of the market accommodates speculation enormously. The bidding process gets people all hot under the collar in boom-time and they engage it with reckless abandon – yes, I’ve seen this first hand.

Even more important, however, is that the supply of housing is scarce; very scarce. As we have already noted, not only does it take a rather long time to build new houses but given that space is strictly limited and location matters more than perhaps anything else in the market the supply of housing is basically fixed. In contrast to our market for refrigerators, when people increase their bids on houses in a given spatial location it is the price of the houses that rises, not the quantity produced. This means that, in the housing market, a bubble could begin to form simply due to a rise in wealth or population. The process doesn’t even require a gang of nefarious speculators to set it off. This, in turn, probably explains why in a housing boom all homeowners and aspiring homeowners become speculators in certain sense.

And so we’re back to our startling conclusion: it is the very fact that the market for property is an almost perfect neoclassical market that accounts for its vulnerability to the wiles of speculation. It is the very fact that there is no excess capacity on tap which can be readily poured onto an overheating market to cool prices that accounts for the market’s proneness to disequilibrium and instability. It is the neoclassical market, based as it is on scarcity and supply and demand fundamentals, that generates the chaos.

The same can be said for every market where speculation plays a part and occasionally causes trouble: the stock markets; currency markets; markets for various other financial instruments; commodities markets; the list goes on. All these markets are characterised by the fact that they are based on scarcity and are driven almost purely by supply and demand.

The clever reader will, however, point out that many of these markets could easily be thought of as functioning with excess capacity. After all, if the demand for a company’s stock or a country’s currency goes up couldn’t the firm simply print up more stock or more currency? Even in the oil market insiders are well aware that the Saudis ultimately set the price. This is true, of course, and under certain very specific circumstances we do see this happen. However, generally speaking while a higher demand for refrigerators will always be met by higher refrigerator production as the single goal of refrigerator producers is to sell refrigerators, companies and governments issuing financial liabilities or oil producers with excess capacity will be primarily interested in maintaining a given price level or undertaking actions that will increase this price level.

The key point is that in order for a market to be immune from speculation there must be a quasi-automatic response on the part of the supplier to increase output rather than letting price rise. The potential for this, however, is simply not present in the housing market. And while it is present in other markets for financial assets, it is most often not utilised as issuers of these assets are often more concerned with their price rising rather than the amount sold***.


Now perhaps the reader can appreciate why we referred to the idea of the dominance and perfect functioning of markets driven by the neoclassical rules of scarcity and supply and demand as being the most effective myth spread by mainstream economists. Because, not only is this type of market not remotely dominant – at least, so far as the real economy goes – but it is a generator of price instability.

And as this bizarre myth has gathered pace over the past 30 or so years and politicians have worked as hard as they can to turn our world into one dominated by such markets, is it any wonder that we see around us only chaos, instability and disorder? In trying to turn various sectors of the economy into an approximation of the neoclassical market policymakers have merely summoned up the daemonic forces of speculative finance. When you crown anarchy is it any wonder you get a lunatic for a king?

* The following article is an outline of what the author hopes to present later this year as a dissertation.

** The keen reader will here note that we are quite consciously not assuming that the general moderate inflation – the “drift” – experienced in all advanced capitalist economies has anything to do with excess demand. More cannot be said about this here than that this inflation is probably institutionalised rather than strictly demand-led.

*** Such a mechanism is utilised, however, in the case of a currency peg. This, together with many other government initiatives in which the price-level is targeted, is just another example of administered prices, albeit undertaken for different reasons. The principle, however, is identical. In the case of a currency peg, if the government in question has enough breathing room to credibly defend their currency – i.e. if they possess sufficient foreign currency to defend their currency or they are simply printing money to suppress its value – one would be better off speculating in the refrigerator market.

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  1. David Lentini

    Great commentary. But I wonder if you can also characterize the market myth as another example of the sort of “Jesuit logic” that is so common in economics: The assumptions of the structure and behavior of the market, and the buyers and sellers, are precisely chosen to support the desired conclusion of free market function.

    In other words, 18th and 19th Century economists sought to prove the existence of a self-regulating society; this foreced them to narrowly define the attributes of a market in which buyers and sellers mutually set prices in a mathematically “smooth” process that always reaches an optimal value. Thus, speculators, fluctuations in prices, and lags in supply and demand, etc. all had to be defined away, leading to the utopian conditions that your well-known neo-classical economist thinks actually exist. Of course, reality is nothing like the utopia. But having been so steeped in the dogma of neo-classical theory, which hides the key assuptions in a cloak of question begging, they can’t recognize a real economy since that would destroy the dogma.

    In shorrt, neo-classical economics is the catholicism of modernity.

  2. Paul Walker

    Empirical surveys demonstrate that people who don’t agree with me are abnormal – Phillip Pilkington

    No wonder economists of all stripes seem fixated upon defining rationality, and the expectations derived from same in their own mold of rationality.

  3. duggie73

    At the risk of total banality, houses are not fridges.

    Fridges have a limited lifespan, it is rare to the point of non-existence that a fridge is passed on through generations.

    It seems sensible to suspect that there will tend to be a undersupply of housing because the builder receives payment only from the first generation owner.

    To paint with a broad brush, the first owner is pooling the resources of the subsequent owners by going into debt and the interest charged on the mortgage prevents this from being an accurate representation of the true worth of the house over the house’s lifetime.

    It does seem at least possible that this is not the most efficient way of organising the market.

    Rent-seeking, eh?

    1. Philip Pilkington

      Yes, point taken. There are many differences between manufactured goods and those prone to speculation. But the above is a theory of why speculation happens. I think it explains it quite well.

      If we just take the transience manufactured goods we cannot explain speculation. For example, commodities and food are clearly subject to depreciation but they are also prone to speculation.

      1. duggie73

        So as a matter of public policy, would it not seem sensible to hold spare capacity in the housing market rather than expect new builds to meet excess demand?

        1. Philip Pilkington

          Yes, the unstated policy conclusion of the above for most markets prone to speculation would be buffer stocks. This might be hard in the case of the housing market though. We’d have to get the government to buy up significant amounts of prpoerty in all locations. But I guess if they bought when the market was low — as it is now — and sold as the market started heatingup, it might work. There would be ample space for corruption, of course, but what’s new there.

          1. duggie73

            Not sure how a policy of buy low, sell high acts counter-cyclically?

            It is virtually impossible to imagine any public policy succeeding anywhere without the realisation that gaming a system for personal advantage is impoverishing rather than enriching in the round.

            Nice gives better results than sharp, if you like.

            Given that those with an economic background tend towards more selfish game playing than the average, such should perhaps automatically disbar them from public office.

            Hey ho.

          2. Philip Pilkington

            Buy when the market is low to float depressed prices. Sell when the market is high to dampen prices. This is a typiacl buffer stock policy. As I said, though, it would be more difficult for housing than for cotton or whatever. I think some sort of legislation might be easier.

          3. Stephen Nightingale

            A government house-buying policy could also act to smooth out gouging in the rental market. When the government buys excess housing stock, it increases the rent-controlled public housing stock – since these houses will be rented out to needy tenants, tending to limit private rental rates. When renters want to get on the homeowner track, the government can opt to sell them the house they are in at a fair price, tending to limit speculation in the open market.

            Conclusion: public housing policy should be in and of the general housing market, not limited to public housing project ghettoes.

      2. jake chase

        It seems pretty clear to me that housing prices are prone to speculation mostly because demand is exaggerated by credit and leverage. Potential buyers can choose not to participate, but those who do not participate will be left out of the only game with potential to increase their wealth.

        As for the refrigerators, the speculation occurs in the shares of the companies making the refrigerators. Veblen explained all this in his Theory of Business Enterprise (1904), a book which no contemporary economist seems to have read.

        1. Philip Pilkington

          Have read Veblen.

          Difference is that commodity companies have their shares speculated on too, but the product is also speculated on. This is not the case for manufactured products.

          1. jake chase

            My point is that speculation is the essence of business. Manufacturing is partially about industry, but business is the sabotage of industry for speculative gain. Bank credit provides the leverage; the legal system greases the wheels. The result is booms and busts in which all the gains of workers are temporary. Economics is the fantasy wallpaper covering up the sordid reality.

            As for the refrigerators, most of them are junk despite a century of engineering progress. That’s business.

  4. Stephen Gardner

    I agree that it is important to debunk neoclassical economics but it has to be done without errors. The right will pounce on the slightest error and fixate on it. I think there is a relatively small error that must be corrected in this essay.

    Rising *marginal* costs are not necessary for an upward sloping supply curve. A constant marginal cost “curve” would be a straight line that sloped upward. I think you may be confusing upward sloping with concave upward. If marginal costs were to increase then the curve would indeed be concave upward.

    1. Philip Pilkington

      How else would you get upward-sloping supply-curve?

      If prices are fixed, the supply “curve” is generally flat until full capacity is reached when it rise sharply.

      1. Stephen Gardner

        My mistake–the price is a unit price already not a price for the number of units manufactured. I tried to reply to but the comment software garbled my answer. Sorry.

  5. Another Gordon

    Most businesses have economies of scale over the time horizon that they plan ahead for; many even build their corporate strategy on it – get big fast => get costs down => squelch the (still small) competion. That means they believe they have a downward sloping supply curve.

    Upward sloping supply curves are largely confined to mining and agriculture which were a far bigger part of the economy two hundred years ago.

  6. citalopram

    There’s no such thing as a ‘free market’. It’s an ideal notion created by libertarian types to bolster there wacked economic ideas.

    1. Susan the other

      How anybody can still believe there is a free market or free enterprise is amazing. To say that supply and demand create rather than diminish volatility also seems like a no brainer. Then we get to listen to Paul Ryan spewing his nonsense about the budget as if all we need to do is get government out of our free enterprise system and everything will right itself according to classical economic theory. I like PP’s phrase “to administer prices.” And the US should do so asap because we can’t afford anymore market stability like this.

      1. bluntobj

        Administer prices? My yes, we need a return to Blue Eagle! That worked out so well…

        I have to shake my head in wonderment. What part of government fixed prices sounds good? Wages and profits then become fixed by government fiat in a natural progression, corporations and industries get to buy special “exemptions” or price increases, etc.

        As an aside to PP;

        Housing is the worst possible example you could have chosen, and supply of real estate is only a small part of the speculative driver. Credit expansion, credit quality, human behavior, and government distortions in regulations from financing, land use, building codes, taxes, and incentives have far more to do with price fluctuations than location.

        Commercial buildings aren’t worth spit without the tenants to occupy them, houses have minimal value in prime locations without employers or jobs nearby, Ag or resource land isn’t worth anything if it can’t grow or produce, even if it’s in the best location.

        Last, seeking for stability is in fact a quest for death and destruction. Chaos and adaptation are vital forces in renewing life, economies, and civilizations. That which refuses to grow or change and instead seeks “stability” will be destroyed.

  7. Tom

    Tax land values because land values are what the population created – the community and public investment in roads, services, electricity, police, education etc gave it value. Home values – ie: improvements are now taxed and it makes no sense to penalize someone for improving his built structure so that he has less to pay for labor going into the improvements.
    Real estate is two things – land and improvements.
    We rarely add land to this planet – it is not an unlimited resource that can be produced to meet demand through some sort of capacity cushion measure. Land is required for every bit of wealth creation on this planet – it is not like we have factories on another planet.
    Look at farmland prices moving up even after drought hurt so many farmers. If the prices for land go too high then the profit margin for food production goes down and farmers will have less going forward. Otherwise, food prices will have to move up to meet the costs incurred.
    You have places that have expanded because of infrastructure spending in supplying water to once – dessert areas – look at Las Vegas. Tell me that that dessert location would be worth anything if it were not for the infrastructure and gambling business – it would otherwise be worth spit.
    Every time someone pays more for a place to live or work (land) he is forced to pay more of his inflow to outgo and, not to labor because he has less capital. Currently, the only benefactor of the increased value of land that other people have created in the community is going into the hands of those who have not done anything to increase the value of their land – ie flippers and “investors” and speculators. Time to tax the value the community created back into the community and not into speculators pockets.
    There are very few examples of somebody creating new land – it was worthless before we moved in and it will be worthless to us after we are gone – value is human generated concept.

    1. jake chase

      Henry George suggested this in 1879. Nobody has ever refuted his analysis in the book, Progress and Poverty. They simply ignore him and call him a crank.

      Hundreds of millions have been made by people who understood the relationship between progress and land value, notably John Jacob Astor, who built his family’s fortune in the early years of the nineteenth century, by selling NYC ‘inner city’ lots and buying outlying land with the proceeds.

  8. ivansml

    Although individual firm may have excess capacity in the short-term, that doesn’t necessarily imply that industry supply curve, which is aggregated from many individual firms, is perfectly elastic wrt. price as you claim (some empirical evidence would be in order, perhaps?). And even if it was, it doesn’t contradict supply-and-demand theory – only difference is that price will be completely determined by supply, and quantity completely by demand. This what you say as well, so I don’t see how any of this contradicts neoclassical economics.

    As for the markup pricing, you’re correct that it contradicts competitive theory of the firm which equals marginal costs and price. But it doesn’t contradict Dixit-Stiglitz model of monopolistic competition, which is widely used e.g. in studying international trade or in New-Keynesian models of business cycle. When speaking about “last century” of mainstream economics, paying attention to last couple of decades as well would be nice.

    Your second example with housing makes even less sense. Basically you’re saying that supply of housing is perfectly inelastic, so changes in demand will cause only changes in prices, which will thus fluctuate more than if supply was elastic. This is all very standard and taught to undergraduates, and moreover, it has nothing to do with bubbles, which refer to price changes _not_ justified by fundamentals. Key difference between refrigerators and houses is not the slope of their supply curves, but the fact that housing is a long-term asset, and thus expectations about future play much larger role in determining its price.

    1. Philip Pilkington

      I was waiting for the standard “What you say is all well and good, but this does not contradict neoclassical theory…”. While I’m glad there’s already consensus on this issue (!), I’ll just say this: New Keynesian models are constructed in such a manner that perfect competition is assumed and then rigidites are added. This is a totally superfluous and silly approach and generates complete confusion. Also:

      “…it has nothing to do with bubbles, which refer to price changes _not_ justified by fundamentals.”

      If you take anything from this piece take this: that your word “fundamentals” — which means, OF COURSE, supply and demand — means absolutely nothing in the real world. Because that’s not how markets work.

      The beauty of neoclassical theory is that it can be made to say anything and everything. The tragedy is that, in doing so, it says absolutely nothing. Just like every good metaphysics.

    2. Philip Pilkington

      “And even if it was, it doesn’t contradict supply-and-demand theory – only difference is that price will be completely determined by supply, and quantity completely by demand.”

      Which means that supply and demand working in equilibrium do not set price/quantity. Seriously, neoclassicals barely understand the point of their own theories. It’s embarrasing. The point of MC=MR is to show that price and quantity are through the process of supply and demand meeting at a market-determined equilibrium point.

      Also, I did provie evidence: namely, Blinder’s study.

      1. ivansml

        “New Keynesian models are constructed in such a manner that perfect competition is assumed and then rigidites are added.”

        No, they are not. NK models explicitly assume that producers are monopolists (within their industry/product), set their price at markup over their costs and then supply whatever quantity is demanded until they can set prices again.

        “f you take anything from this piece take this: that your word “fundamentals” — which means, OF COURSE, supply and demand — means absolutely nothing in the real world.”

        That’s just silly. Increase in demand for housing caused by immigration would be clearly justified by fundamentals. Increase in demand caused by expectation of higher price in the future might be caused by a bubble. Your example makes no distinction between the two, and thus is worthless for explaining bubbles.

        “Which means that supply and demand working in equilibrium do not set price/quantity.”

        Yes they do, supply sets price and demand sets quantity. This is an extreme case from the point of view of standard theory, but it’s possible.

        “Also, I did provie evidence: namely, Blinder’s study.”

        Blinder’s book deals with decisions of individual firms; your argument depends on aggregated, industry supply curve. There is a difference.

        1. Philip Pilkington

          “Yes they do, supply sets price and demand sets quantity. This is an extreme case from the point of view of standard theory, but it’s possible.”

          The point of supply and demand analysis is that they will meet at equilibrium when left to themselves. When you use the words like I have above they lose this meaning altogether and become completely independent variables.

          “That’s just silly. Increase in demand for housing caused by immigration would be clearly justified by fundamentals. Increase in demand caused by expectation of higher price in the future might be caused by a bubble. Your example makes no distinction between the two, and thus is worthless for explaining bubbles.”

          Let’s leave that to other readers to decide, shall we? My feeling is that I’m explaining speculation as a normal behaviour in scarce markets. You’re assuming that it’s an “abnormal” behaviour. Where you’re insisting on normative judgements, I’m insisting on none.

          You think that expected future price rises are “abnormal” and that “real” demand issues are “normal”. Anyone who has spent any time in the real world knows that this distinction is total garbage. Speculation is always there in markets where the price is not administered. It’s just a matter of degree.

          “Blinder’s book deals with decisions of individual firms; your argument depends on aggregated, industry supply curve. There is a difference.”

          Individual firms make up the aggregates. There is no necessary distinction from the point-of-view of my analysis.

          As to NK models and monopoly, these are different from the assumptions made by Kaldor etc. which have to do with increasing returns to scale etc. I’m not getting into this here.

          Anyway, if we get rid of a lot of these fundamentals, then the entire structure of economics as it is taught and written about should be changed. Using the old framework is like using caloric theory to explain engineering problems. Plenty of things can be explained through a redundant framework, but it stifles thought and requires too many ad hoc assumptions to be introduced.

          If your type of defence is the best that neoclassical economics has to offer then I predict it may not exist in 100 years time. But only posterity can be our guide. In the meantime, I’ll write as I write and you keep building “models” using ad hoc assumptions.

          1. ivansml

            Let me just comment once more on one thing – different people understand different things as bubble. But one of key elements in all those explanations is that bubble involves self-fulfilling dynamics – prices rise today only because they’re expected to rise tomorrow. This is not the same as speculation (though obviously speculation plays role in development of the bubble), and, as many of readers would probably agree, it’s not the same as shifts in demand or supply caused by objective factors either. If you deny this distinction, the term becomes meaningless, and I don’t see how that could be useful. Of course, you’re free to use your own terminology if you want, but since your post is framed as critique of neoclassical economics, it is natural to expect that you use terms as they’re usually defined.

          2. Philip Pilkington

            The piece is not explicitly framed as a critique of neoclassical economics. It’s framed as making the point that “free markets” accomodate and may lead to speculative excesses, where administered markets do not.

            You’re just picking up on some of my comments on neoclassical markets, which are taught to all economics students and which are pushed by pro-free market types, because you know I dislike neoclassical economics, think it’s propaganda and outmoded metaphysics and take every opportunity I can to criticise it. Fine. But that’s not what this piece is about — or at least it’s only secondary to it.

            Do bubbles involve self-fulfilling price dynamics? Yes. And what is speculation? For free market types it means risk taking plain and simple. By this definition, opening a new business is “speculation”. More realistically, it should be thought of as guessing where prices might go in the future in order to make money — that is: gambling on price dynamics. That is how bubbles form. And that is why bubbles can only form in markets where prices are not administered — which is, all this argumentative meandering about New Keynesian stuff aside, the point of the piece.

            Now, you say that if I deny the distinction between speculation and “objective factors” the term “speculation” becomes meaningless. But I’m not denying the distinction between them — look back over my comments carefully and you’ll see this. I’m saying that “market fundamentals”, that is supply and demand meeting at equilibrium, do not drive free markets in the real world. You implicitly assume this and then chalk up speculation as an abnormal factor “disturbing” free markets. I claim that speculation is ALWAYS built into prices in non-administered market and thus is totally normal to these markets.

            As I said above: in the real world, the fantasy “fundamentals” that you draw into your models and then assume are “disturbed” by “evil” or “abnormal” speculation, mean nothing. They’re just a normative judgement made by neoclassical economists who adhere to an outmoded metaphysical view of the world as being in equilibrium until “outside” (malign) forces interfere. It’s just a theological view of the world masking as scientific terminology. Totally backward and superstitious.

            Anyway, a secondary point of this piece — as you can read in the first few sentences — is to debunk this mythic view of the world. Given that you adhere to the metaphysics behind the myth, you focused on how the metaphysics could be bent to accomadate reality. But all the while you had to throw up normative judgements — about “fundamentals” vs. “outside forces” — to do so. More moralising. Yawn.

            The conclusion of my view is that free markets will always have a speculative component that may lead to instability if left unchecked. The conclusion of your view, implicitly, is that REAL free markets actually tend to equilibrium and it’s only OUTSIDE forces that lead them to instability. I claim that your conclusion is normative while mine is positive.

          3. ivansml

            I haven’t made any normative statements, neither am I the one who keeps bringing into discussion good and evil, free-market propaganda, metaphysics and myths, so please don’t project your ideological prejudices on me.

            You say that “market fundamentals, that is supply and demand meeting at equilibrium, do not drive free markets in the real world.” This makes no sense. Fundamentals are not “suply and demand meeting in equilibrium”, they’re underlying factors that influence supply or demand (tastes, technology, weather, etc.). Your whole post is based on supply and demand logic, and all your arguments could be illustrated with supply and demand diagrams straight from econ 101 textbooks. Shifts in demand will result in changing quantitites if supply curve is horizontal, and in changing prices if supply curve is vertical, that’s all there is to it. Of course, written this way, how such trivial restatements of basic microeconomic theory can support any of your strong claims about markets, mainstream economics and metaphysics is a mystery.

            Rest of your responses are nothing but fights over semantics of terms either made-up (administered price), or used in nonstandard way (fundamentals, bubbles, speculation), and frankly I have better things to do than explain the differences (again).

        2. UnlearningEcon

          “Yes they do, supply sets price and demand sets quantity. This is an extreme case from the point of view of standard theory, but it’s possible.”

          Time for some introspection. When demand for a firm’s products increases, what do they do? Do they put up prices or open new stores? The only time they won’t is with a positional good like the Mona Lisa, or when one factor is well and truly fixed – like land (olive oil exhibits increasing MC).

          The funny thing is that horizontal supply curves in the long run actually follow entirely from the neoclassical theory of the supply curve. Goods are presumed to be perfectly divisible, which is incompatible with the economies of scale/diseconomies of scale rationale for the decreasing then increasing MC found in most textbooks.

  9. Tom

    I could buy a shack on an acre lot next to a lot that has a mansion. – my incentive to live in the shack – lower taxes on the structure – lower insurance premium and the fact that I get the same services (water, sewer, electricity, roads, access to business, police and fire protection. Further, if others build more mansions on other lots in the area receiving the same service – I would be the benefactor of the increased value of my lot that others created. Hell, I am incentivised to live in a shack where those larger, more efficient buildings are dis incentivised by higher taxes, higher insurance, higher general costs – yet a better built house with better energy efficiencies, fire protection etal have less incentives to need the services provided – why? because we refuse to recognize that land value is the driver of high cost because it is the one thing that there is a static amount. speculation in real estate and a bubble in real estate (presupposed on the value of the built environment) fails to recognize the basis of value and the contribution that humans bring to that land via the government supplied infrastructure (we are the government) and fails to capture the increased value of land through taxes of land but penalizes the input of labor used to producing wealth (land is required for this)through taxation of labor and improvements (unsound revenue system) subject to Mr. Rich hiding assets from the tax collector.

  10. jerry

    Great article Philip, thanks! You read my mind completely, I was about to bring up stocks and other types of asset bubbles but then you beat me to the punch.

  11. Stallworth

    bank credit creation + mark to market accounting + debt financed financial markets + scarcity driven demand + prices driven demand => positive feedback cycle of ineffiency distorting the “fundamentals”

    1. SomethingSomethingComplete

      That’s good but maybe if you try putting into an actual theory it might seem like more than just an opinion.

      Also, while actually sweating and struggling for days or weeks or months to construct a real argument/theory you might find that the world is more complex than you seem to believe it is.

  12. beene

    Anyone interested in fact on free trade should read this book, it only short but to the point of what helps a nation and what causes failure; plus it short and humorous.

    Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism [Paperback]
    Ha-Joon Chang

  13. heresy101

    Any engineering student can tell you that the equilibrium market and its wonderful mathematics taught in neo-classic economics are bunk. A static market can go for a long time adhering to the textbook example until the dynamics of the real world (climate, speculation, ability to price set, etc) intervene to make the model come apart.

    A graphic example of this collapse is the beautiful Tacoma Narrows Bridge that met all the equilibrium design criteria but failed to account for the changing dynamics (wind, aerodynamics, and resonance) with catastrophic results (much as Greenspan’s handling of the economy):

    1. SomethingSomethingComplete

      By the way, I feel like you think engineers have some kind of special math knowledge that economists don’t.

      Most economists at the Top 50/60 departments have gone at the very least through real analysis and many of them have topology, functional analysis, and in at least some cases differential topology out of the way before they even start their PhDs.

      In that background, differential equations and dynamic systems aren’t exactly foreign.

      So I am not sure why you think that economists don’t understand these things.

      Also, given that many of them have physics backgrounds, I highly doubt that they are unaware of the things you think they are unaware of.

      1. Yves Smith Post author

        “Many economists have physics backgrounds?” Please, prove that one. Many Wall Street quants have physics backgrounds. They aren’t economists. I know a lot of academic economists personally and by reputation, and I can’t name one that has a “physics background” save some of the folks at Santa Fe Institute, and they are critics of mainstream economics.

        Steve Keen disagrees with your characterization of the mathematical skills of economists:

        Most introductory economics textbooks present a sanitised, uncritical rendition of conventional economic theory, and the courses in which these textbooks are used do…

        The minority which continues on to further academic training is taught the complicated techniques of economic analysis, with little to no discussion of whether these techniques are actually intellectually valid. The enormous critical literature is simply left out of advanced courses, while glaring logical shortcomings are glossed over with specious assumptions. However, most students accept these assumptions because their training leaves them both insufficiently literate and insufficiently numerate…

        They are insufficiently numerate because the material which establishes the intellectual weaknesses of economics is complex. Understanding this literature in its raw form requires an appreciation of some quite difficult areas of mathematics-concepts which require up to two years of undergraduate mathematical training to understand.

        Curiously, though economists like to intimidate other social scientists with the
        mathematical rigour of their discipline, most economists do not have this level of mathematical education. Though economics students do attend numerous courses on mathematics, these are normally given by other economists. The argument for this approach – the partially sighted leading the partially sighted – is that generalist mathematics
        courses don’t teach the concepts needed to understand mathematical economics (or the economic version of statistics, known as econometrics). As any student of econometrics knows, this is quite often true. However, it has the side effect that economics has persevered with mathematical methods which professional mathematicians have long ago transcended. This dated version of mathematics shields students from new developments in mathematics that, incidentally, undermine much of neoclassical economic theory.

        One example of this is the way economists have reacted to ‘chaos theory’. Most economists think that chaos theory has had little or no impact-which is generally true in economics, but not at all true in most other sciences. This is partially because, to understand chaos theory, you have to understand an area of mathematics known as ‘ordinary differential equations’. Yet this topic is taught in very few courses on mathematical economics – and where it is taught, it is not covered in sufficient depth. Students may learn some of the basic techniques for handling linear difference or differential equations, but chaos and complexity only begin to manifest themselves in non-linear difference and differential equations’. A student in a conventional ‘quantitative
        methods in economics’ subject will thus acquire the prejudices that ‘dynamics is uninteresting’, which is largely true of the behaviour of linear dynamical systems, but not at all true of non-linear systems. This prejudice then isolates the student from much of what is new and interesting in mathematical theory and practice, let alone from what scientists in other sciences are doing.

        Economics students therefore graduate from Masters and PhD programs with an effectively vacuous understanding of economics, no appreciation of the intellectual history of their discipline, and an approach to mathematics which hobbles both their critical understanding of economics, and their ability to appreciate the latest advances in mathematics and other sciences.

        1. Bert_S

          I think they should make economists work on a farm for 5 years. Then they could experience sloping pigs, using a milking machine and driving a tractor. They would then know what a private sector paycheck is, and appreciate the value of food and energy much more than they do now.

          But most importantly, we should make them model the dynamics of a tractor suspension system, and probably make them develop the physical constants and coefficients used too, before we can conclude they are ready to mathematically model the global economy.

        2. SomethingSomethingComplete

          Maybe Steve Keen and you are right though.

          I hadn’t thought about it, but maybe economics needs MORE math.

          Economists are good at complex math, if we define “complex” as complex for an undergraduate business, engineering, or chemistry student.

          Never doubt that. If you do, try taking functional analysis.

          But maybe you and Keen are right in that the math economists learn, while complex by most people’s standards, is actually pretty simple by modern physics and theoretical math standards.

          Perhaps economists have fallen behind.

          Perhaps they need to increase their math training so they can start using more of the modern theory in complexity and complex dynamics, solutions to non-linear systems, partial DEs, etc.

          Perhaps the fact that the math economists know stops at the real/functional analysis level (again- very high by most people’s standards) has actually prevented economists from building new, more accurate theories because their math tools are nonetheless outdated by modern mathematical standards.

          It’s possible. It really is.

          I am usually deluged by arguments that economists do too much.

          I was blind to the idea that they might not do enough. But now it’s definitely in my mind.

          1. SomethingSomethingComplete

            By the way, not sure how much experience Keen has with US econ students, but here ODEs are absolutely introduced and studied pretty extensively in Calc III, which is considered an elementary math course that you do as a sophomore in undergrad.

            Most economists have knocked out Calc III and therefore know ODEs as a concept (though I know actually using them appropriately and some of their solutions require much higher level work).

            Now maybe he means they haven’t gotten to differential topology, which is where you get differentiable manifolds to do serious dynamical systems work, but he is wrong if all he is saying is that econ students have no idea what ODEs are.

            That’s not right.

            Again- ODEs as a concept and many ODE forms and solutions are a part of standard Calc III sophomore year of college.

            So that’s a little something that bothered me about what he says. All in all, broader points stand.

          2. Enter Time

            “Now maybe he means they haven’t gotten to differential topology, which is where you get differentiable manifolds to do serious dynamical systems work, but he is wrong if all he is saying is that econ students have no idea what ODEs are.”

            Using terms such as “Differentiable manifolds” and “differential topology”. Are you kidding? Yves and Keen have not attributed any of that to Professor Keen’s work!

            Knowledge of those subjects are not required to understand dynamics or ordinary differential equations (ODEs), or Keen’s work.

        3. Calgacus

          Curiously, though economists like to intimidate other social scientists with the mathematical rigour of their discipline, most economists do not have this level of mathematical education. Though economics students do attend numerous courses on mathematics, these are normally given by other economists. The argument for this approach – the partially sighted leading the partially sighted – is that generalist mathematics courses don’t teach the concepts needed to understand mathematical economics
          I can vouch for & add to Keen’s statements. I have to say that my vanity was tickled the first time I taught ODE (at an Ivy League uni) when I got some econ grad student auditors who took the class because uhh, they said what I was teaching made sense & could help them pass their quals, while no one could understand the math-econ-prof – who they kind of got the feeling that he didn’t understand what he was teaching. Taught more PDE than I should have, for them, IIRC. Decades ago, but kind of the last time I thought about econ before recently.

          It’s an amusing fact about econ – the more verbal, the more it is a pile of words, the more it is truly mathematical, hiding and being integral to, explaining, fascinating & deep & trivial mathematics and philosophy, far more than these institutional/PK/MMT economists themselves understand. Gotta write a letter to Wray & tell him what kind of prose he’s been speaking all his life. On the other hand, the stuff with all the Greek symbols & graphs & equations – 99% fakery. I wouldn’t trust an economist’s proof farther than I could throw him, and I’m pretty old & weak these days. The problem is that the “mathematical economics” is so unmathematical in spirit rather than its trappings, that real mathematical ability & understanding is a tremendous obstacle to getting any understanding of what they are saying, beyond “this is stupid boring sh*t.” It’s a wonderful scam for these charlatans, they know just enough math to make their scam incomprehensible to the nonmathematicians, but they make it so mathematically malodorous that it is even harder for mathematicians to have the stomach to eviscerate it.

        4. ivansml

          Economists are familiar with ODEs, they’re routinely covered in courses at the beginning of graduate school or in courses on economic groth where they’re most widely used. And many students coming to grad school have taken several math courses or even majored in mathematics, so they’ve seen this stuff before. If you don’t believe me, just check any “math for eonomists” textbook (e.g. Simon & Blume: Mathematics for economists, or Chiang: Fundamental methods of mathematical economics).

          One thing is true – nonlinear dynamics and chaos theory is rarely covered or used in economics (though there exist some papers applyiing it to dynamic general equilibrium models, mostly from 1980’s). The reason is however not that economists are not capable of learninng the mathematics, but more likely that they don’t consider such approach as very promising. They could be right or wrong, but that’s probably a topic for a different discussion.

          And BTW, Keen’s work doesn’t use much (if at all) of chaos theory, in technical sense, and most of his results are obtained through numerical simulations, not some fancy mathematical theorems. If economists ignore his work, it’s certainly not because it’s technically difficult.

          1. SomethingSomethingComplete

            Yes- right you are.

            I pointed this out in my own post just above yours. It’s not true that economists don’t know what ODEs are. Most schools in the US do ODEs along with Calc III- you are expected to understand the concept and the solutions to some of the standard forms in sophomore year of college.

            But I think Keen’s point in part is that economists need more math in order to advance their models.

            I am not the one to judge the validity of that claim but it SEEMS like it could be right.

            It is true, at least based on the journals I read (JPE, Econometrica, AER) that most widely cited economic work has been using the same set of mathematical modeling tools for over 30 years now (yes- there has been work on non-linear dynamics, but it has been by rather obscure authors like that guy at Leeds University- Schenck-Koppe or something).

            Note: there seems to have been big advances in econometrics even if the math used in the models appears to have been broadly stagnant. So I just want to acknowledge that.

            But there have been really big advances in mathematics in that time, at least from what I hear and gather.

            And perhaps Keen’s point is that in order to construct even better theories, economists need to keep up with these advances.

  14. john c. halasz

    Others have already dealt with the issue that rising RE prices are actually a matter of inflating the implied land rents of housing lots, (“location, location, location”), and not the actual costs of housing structures, (which, as a rule of thumb, like any other price in a capitalist economy, should resolve into its cost-of-production, plus an average rate-of-profit mark-up), and that the solution to that is a universal land value tax, to suck rents out of the market and thus reduce speculative tendencies. But just to add on a missing bit, bankers much prefer collateralized lending and an overwhelmingly large portion of the available collateral is in RE, so the other side to eliminating RE bubbles is regulation of the credit system.

    A further missing point here is that spot market prices, (i.e. short-run supply-and-demand), are actually highly volatile, which is what invites speculation. Commodity futures markets were invented as a market-based solution for stabilizing such prices for actual users, but they too have been over-run by excess lending to financial speculators. (A good example of where neo-classical, neo-liberal reforms have gotten it badly wrong in anticipating increased productive surpluses is de-regulation of electricity “markets”).

    A last point is that there is always a “speculative” component to real productive investment, given basic uncertainty about the future and the need to integrate/coordinate such investments across firms and sectors, (which is why a tendency toward over-capacity tends to arise), and so speculation in financial markets is not unrelated to booms and busts in productive investment. (The industrial boom in the U.S. 1920’s was a real productive advance, with rising stock prices, until around 1927, excess profits spilled over into stock speculation and a bubble, instead of further real productive investments, which, due to limits, had become increasingly scarce). But perhaps you need a bit more of Marx and a bit less of Keynes to make those explanatory connections.

  15. backwardsevolution

    Great article! “To administer prices” is a perfect description.

    Here in Canada, our Minister of Finance extended amortizations from 25 years to 30 years, then to 35 years, then to 40 years. Interest rates were cut, first-time home buyer credits were handed out, as well as no-doc loans, 0% financing, banks providing “cash back”…..essentially doing all they could do to keep the bubble inflating.

    Rich immigrants from China (many corrupt officials fleeing their country) flooded into our housing markets, buying up multiple condos/homes purely for speculative purposes. HELOCS and lines of credit were handed out like candy.

    Our government was “administering prices”, setting up the favourable conditions.

    How about this: people actually have to save for their down payment, and make the down payment 20%. How much velocity (which is what drives prices higher) would there be if people had to save before they bought a house? And don’t you think they’d think twice, having worked so hard to save that money, about buying on speculation, buying merely because they thought prices would go up, looking at their house as an “investment” instead of a “house to live in”?

    House prices would come way down, which would mean everyone could afford a “house to live in”. You don’t have a housing boom if you don’t have a government aiding and abetting.

    How many banks would have lent money to a bad risk without securitization? None. Had there been no securitization, banks would have demanded a higher interest rate for bad risks and a much, much higher down payment.

    The problem is that the banks have been ALLOWED to pass the hot potato. Make the banks keep their loans ON THEIR BOOKS.

    GET RID OF SECURITIZATION! Without it, none of this would have happened.

  16. backwardsevolution

    The banks would cry that securitization provides investors with a good place to put their money. Too bad, let the investors invest in a particular bank’s stock. That way the risk and responsibility for good/bad lending is put exactly where it should be – on the bank and shareholders’ backs.

    No more securitization.

    The people need to step up and tell the banks what they will be allowed to do (under their Charter), not the other way around.

  17. Enter Time

    On the “theory of equilibrium” in economics:

    It has practically no basis in reality. It is just a theory. It is an assumption used as theory. Usually, it is a false assumption.

    When you look around at dynamic economics you see it is dynamic. Of course if you were learning economics with professors constantly professing equilibrium assumptions it might not be so easy, especially if you are young or know very little history.

    If none of the economic model equations do not have the variable, time (=t), then the model cannot give a dynamic result. The equations and their solutions do not change in time. The model cannot generate an account of changing in time. Thus no economic cycles can be modeled that way.

    Dynamic models have time as an (independent) variable. Look in macro-economic texts for undergraduates and you will will be hard pressed to find any variables for time in the model equations. If you are studying economics with out ever using the variable time you may not know exactly what is wrong because you never got better examples.

    This leads to ODEs. Where equations and solutions to the equations have the variable time.

  18. Enter Time

    “By the way, I feel like you think engineers have some kind of special math knowledge that economists don’t.”

    Yes! Engineers have more applicable math knowledge then most economists and additional knowledge more important than math! Engineers also have science education where the math is applied to real things and math practice is gained in addition to the math classes. All considerd the basics.

    Also, in those science and engineering classes there are laboratory classes where a bulk of the work is done, (you get a fraction of the class credit.) Engineering students work very hard in lab applying the scientific method and math. Then they work hard mathematically analyzing and reporting the result of the experiment.

    Correct math is not enough, the reality of the lab results counts more than the math. Not only is lab to instruct the science or the engineering and apply the math, but every experiment drives home that the experimental method is more paramount than the theory or the math. Hopefully the results match the theory, but that is not the most important part of the exercise.

    You could get a decent grade if you failed to do the experiment correctly, got the wrong or unexpected result, and document how you did it in your lab book. You cold even get a high grade if you do that! But woe unto the dry lab’er! The dry lab’er risks flunking the lab and the class. Dry lab’ing is totally contrary to learning the scientific method!

    Economists talk about axioms and proofs. Those are intellectual constructs. The reality is what is most accurate; no matter what the axioms, proofs and models say. Axioms and proofs are big in geometry, but are quite absent in Engineering and Sciences. Nature is the final arbiter, thus the scientific method is used.

    Even in grade school or high school labs; if you get caught “dry lab’ing” it is highly frowned upon. That would get you at least flunking grade for the assignment, and you would be introduced to the lab class(s), in case you were not already infamous!

    1. skippy

      Link to your site ref… forward by Herman Cain… Marc Rowan of Apollo – Private equity funds, credit funds, real estate funds, alternative Investment, Leveraged buyouts, Growth capital, Venture capital…

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