Why Free Markets Make Fools of Us

Cass R. Sunstein in the New York Review of Books:

ScreenHunter_1413 Oct. 07 10.26Very few economists foresaw the great recession of 2008–2009. Why not? Economists have long assumed that human beings are “rational,” but behavioral findings about human fallibility have put a lot of pressure on that assumption. People tend to be overconfident; they display unrealistic optimism; they often deal poorly with risks; they neglect the long term (“present bias”); and they dislike losses a lot more than they like equivalent gains (“loss aversion”). And until recent years, most economists have not had much to say about the problem of inequality, which seems to be getting worse.

There is a strong argument that within the economics profession, these problems are closely linked, and that they have had unfortunate effects on public policy. Most economists celebrate free markets, invoking the appealing idea of consumer sovereignty. If people are buying potato chips, candy, and beer, or making risky investments, that’s their business; they know their own values and tastes. Outsiders, and especially those who work for the government, have no right to intervene. To be sure, things are different if someone is inflicting harms on third parties. If a company is emitting air pollution, the government can legitimately respond. But otherwise, many economists tend to believe that people should fend for themselves.

It is true that companies might try to take advantage of consumers and investors, perhaps with outright lies, perhaps with subtler forms of deception, perhaps by manipulating their emotions. But from the standpoint of standard economic thinking, that’s nothing to panic about. The first line of defense is competition itself—and the market’s invisible hand.

More here.