Robert Solow on Markets and Their Limitations

His review of Cassidy’s book How Markets Fail in the New Republic a couple months ago is superb. He clearly describes basic economics, what a free market can do, and where it falls short.


…in the course of producing and distributing goods and services, market outcomes generate incomes, wealth, status, and power. Any modification of market outcomes modifies the allocation of incomes, wealth, status, and power. So it is no wonder that the discussion has become thickly encrusted with ideology. And one convenient way to turn subtle argument into ideology is to create dichotomies where there are originally fine gradations of more and less. For example: are you for or against “the free market”?

He also touches in passing on the issue I’m sure the more introspective workers in the finance industry must ponder: How much good am I doing in the world?

I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move. Deep pockets in a large market can make a lot of money out of tiny advantages…A lot of high-class intellectual effort naturally goes into trying to invent ways to find those tiny advantages a few seconds before anyone else.

Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

And so: “…our poorly regulated financial system is not only dangerously unstable, but also too big and too complex, absorbing talent and resources that could be better used doing something else.”

Imagine a world with 50% fewer bankers / brokers and 50% more entrepreneurs.

7 comments on “Robert Solow on Markets and Their Limitations
  • Entrepreneurs make money by discovering opportunities others miss. The problem with Goldman and many of its ilk in banking and Wall Street is that they are Crony Capitalists or Corporatists, NOT FREE MARKET CAPITALISTS. They make some, perhaps much, of their money actively seeking government conferred monopolistic privilege (rent seeking)that comes from forming partnerships or alliances with government.

    Don’t conflate crony capitalism with free market capitalism.


  • I think the second passage’s author has a flawed notion of what investment banks do. High frequency trading doesn’t represent the bulk of their revenues, only a mere fraction. Last year’s fixed income trading however did represent a larger percentage of revenue than in previous years. As a “diversified investment company” (Yahoo’s words, not mine) that’s expected as some years allow certain businesses to shine more than others. In fact M&A, private equity, and structured finance, not trading, were all the main drivers in the years previous to 09.

    To your question on “how much good am I doing?”, I believe that the many talented people on Wall Street think, as Warren Buffett did, that they should use the skills that they were given and/ or developed to accrue the capital that they can then give away to the causes that they believe in. I think that’s why we observe so many former Wall Street bigwigs that become full-time philanthropists after they retire.

  • This is why the best justification for free markets is not that they work, but that they are free. Free markets are just a special case of free people.

    The drive to gain a temporal advantage in finance has existed ever since there has been money – it’s just that the timeframes have compressed.

    And I do agree with @Travis that much of what occurs on Wall Street is cronyism, not free markets. But, get used to it – this is what happens when there is value in having cronies in the government (i.e., when the government is so involved).

  • Yes but they are only philanthropists for a few years, and even then just
    give away money. Their brainpower and creativity for the first 40-50 years
    of life is on finance.

  • In the case of Buffet, you could argue that he also did good on the way up, by ensuring that good companies could raise capital

    I’ve heard arguments that high frequency trading provides much-needed market liquidity, but I suspect that’s BS.

    I wonder what portion of intelligent human time is spent trying to win transfers of wealth, as opposed to creating wealth. Does that dichotomy even make sense, with everything as entangled as it is?

    If you work in finance, it seems like you can’t know your effect on the world as surely as if you were a carpenter, doctor, gardener, entrepreneur, etc

    Even sensible-looking financial activities are sometimes wealth-transfer games in disguise, due to agency problems, time delays, and complexity — like a bank packaging bad loans and selling them off

    In my mind, markets are for people. Markets work when profits reflect utility. Markets fail when they provide profit without utility, or utility without profit.

    Wouldn’t it be wonderful if you could know that no matter how you made money, you’d also created a proportional amount of utility?

  • In January 2008 I asked, “Why do we Americans participate in the mass delusion that an economy so sensitive to fluctuations in the housing market can expand infinitely, in perpetuity?

    “Whatever the carrying capacity of the Earth really is, surely it would be prudent for humanity to plan for a collapse of the present world economy or even for its simple decrepitude.”

    In January 2009, Tim O’Reilly wrote in his blog post, The Biggest Ponzi Scheme of Them All:

    “Since Bernie Madoff has put Ponzi schemes back onto the front pages, it’s worth considering whether we are all complicit in the biggest Ponzi scheme of them all, the idea that the global economy can grow indefinitely.”

    O’Reilly continues:

    “Former World Bank economist Herman Daly wrote a vivid piece on the subject of the Ponzi economy back in October, entitled The Disconnection Between Financial Assets and Real Asssets:

    “The current financial debacle is really not a ‘liquidity’ crisis as it is often euphemistically called. It is a crisis of overgrowth of financial assets relative to growth of real wealth— pretty much the opposite of too little liquidity. Financial assets have grown by a large multiple of the real economy— paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities.”

    Even Thomas Friedman has seen the light, as he shows in his article in the New York Times The Great Disruption:

    “Let’s today step out of the normal boundaries of analysis of our economic crisis and ask a radical question: What if the crisis of 2008 represents something much more fundamental than a deep recession? What if it’s telling us that the whole growth model we created over the last 50 years is simply unsustainable economically and ecologically and that 2008 was when we hit the wall— when Mother Nature and the market both said: “No more…

    Finally Solow says:

    “The market evangelists, who tend to claim more for unregulated markets than solid theory can justify, are ideologically motivated. They dislike and distrust governments so much that they overlook the exceptions and the implausible assumptions, and simply propose the blanket principle that the market knows best…

    “The argument against regulating hedge funds, private equity firms, and the like was that the participants in those markets were expert, knowledgeable managers of wealth. Since they had a lot at stake, they would be motivated and able to estimate risks fairly, foresee pitfalls, price accordingly, and keep each other honest.

    “In fact… incentives were often perverse, short-run greed overcame long-run caution, information was hidden or badly processed, and the complexity of financial engineering outran the capacity for rational calculation. ‘Rational irrationality’ and herd behavior led to disaster.”

    To rephrase Tim Dickinson writing in his article The GOP’s Dirty War, if government policies were a martini, regulation of the financial sector is the vermouth — it’s barely there.

    Meanwhile, the Supreme Court has decided to allow unlimited corporate spending in American elections, the Republicans are stonewalling regulation of Wall Street, and US economic policies still cater to Wall Street banks and hedge-fund billionaires.

    And, as always, there are no nachos in Mexico.

  • It would be interesting to see what would have occurred with regards to the banking professions had the bailout of Wall St. not take place after the Lehman collapse. Save all of the other implications of such a massive market failure, my guess is that this imbalance would have swiftly been removed as excess bankers would have filled the remaining demand at regional banks and the economic incentive of working on the street was removed with man y of the major banks collapsing.

    The question that also remains is that even with the incentives to work on Wall St. removed or diminished, how many of the “best and brightest” would find their calling in entrepreneurial pursuits. Although I think that the 50/50 outcome would be an incredible exchange, I believe that the risk/reward ratio for entrepreneurship is poorly defined and you would likely see many of those in finance jump ship for other, secure professional careers such as law, accounting and consulting. Conversely, there is the possibility that many ex-bankers-to-be would want to mirror the bonus system found in the financial world and would turn to entrepreneurship as a result.

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