The reality is that the market mechanism is a very flawed one and it departs significantly from the text-book equilibrium, writes Michael Casey

IT MUST come as a shock to those who believe in the market mechanism that the US, the heartland of capitalism, is in the process of nationalising private-sector institutions, increasing regulation and supervision and may lay down new rules for the governance of private corporations. The head of the US Treasury has recently stated that "raw capitalism is dead". Several countries, including Ireland, have banned short selling, a perfectly legitimate market activity.

Whether we look at the dot.com bubble, the property bubble which followed on its heels, the sub-prime market which was the financial equivalent of mad cow disease or the securitisation and onward sale of mortgage-backed securities, there is only one conclusion: several markets have failed hopelessly in their main task of optimising the allocation of resources.

It will be interesting to see how market fundamentalists "explain" what went wrong. With bizarre understatement, US President George Bush, probably advised by neocons, recently said that the markets "made a mistake".

The reality is that, in practice, the market mechanism is a very flawed one. It may be better than bureaucratic central planning, but it is far from perfect and it departs significantly from the text-book model of competitive equilibrium. It comes nowhere near the theory is because the conditions necessary to achieve competitive prices are hardly ever met in practice.

The essential condition of "perfect information" is not met in the real world. Can Joe Citizen figure out which bank gives the best mortgage deal, let alone engage in derivative trading? The second condition of "atomistic suppliers" is rarely met in practice either. In most markets there are usually a few large suppliers who can influence the price. Finally, there is not always free entry into every market. For instance, can Joe Citizen really become a barrister overnight and thereby help reduce legal fees he incurs?

Market fundamentalists have never recognised the huge gap between theory and practice. Reagan, Thatcher and the neocons were and are idealogues who believed in the right-wing "Washington Consensus" but who failed to realise that Adam Smith was far more nuanced than the brutal Hollywood creation of Gordon Gekko.

These ideologues also believed Milton Friedman's dictum that all speculation is stabilising. According to Friedman the speculator bought low and sold high; therefore there was an automatic stability built in. Prices couldn't fall too low because speculators would start to buy and prices couldn't go too high because speculators would start to sell.

Unfortunately, Friedman did not pause to reflect on what happens to speculators when mania sets in. Look at how low bank shares are now, yet no one is buying. Look how high they were in the dot.com boom, yet no one was selling. The trouble is that terms like "high" and "low" can mean anything. Even if speculators had perfect information - and they haven't - there remains the question of their reaction to that information. Would it be one of herd instinct, confirmation bias, panic or mania?

It will be interesting to see how market fundamentalists react. Will such organisations as the Adam Smith Institute, the Institute for Economic Affairs, the Cato Institute and the neocons come out with their hands up, admitting they got it wrong, or will they retreat into their bunkers? They may try to "explain" the present crisis as a form of creative destruction which is part and parcel of the capitalist model.

However, there is nothing creative about what is happening. What we are dealing with are complete market failures with dreadful knock-on effects which threaten many different economies. The equity market and the property market developed huge bubbles and the foreign-exchange market overshot. The latter is perhaps the closest to the text-book model and it has not performed well. The inter-bank market has seized up and the retail credit market is only a shadow of its former self. Globalisation has made matters much worse.

Whether the idealogues recognise the realities probably doesn't matter as long as policy-making is done on a pragmatic basis. However, there is a danger that the pendulum will swing too far in the other direction, towards excessive government intervention. Recent government rescue packages create genuine worries about moral hazard in the future. A political backlash could lead to excessive re-regulation and more equity participation by the state.

There could even be an adverse reaction to the bells and whistles of financial derivatives. To the extent that these products serve a useful purpose, are they worth the costs involved?

Will the rapid growth of financial services slow down and, if so, will we see a return to more traditional forms of economic activity?

There is an entire menu of possibilities. One that cannot be ruled out is that, after some initial reaction, the zeitgeist will revert to the status quo. While this would suit free marketeers, it would also mean that no lessons had been learned.

We have to find a middle way between unfettered capitalism and state intervention.

There is one positive aspect worth mentioning in conclusion - the development of "behavioural" economics which depart significantly from the old model of competitive equilibrium and try to embrace psychological concepts like irrational behaviour and herd instincts. Will this development be to free-marketeers what Darwinism was to creationists?

Michael Casey is a former chief economist at the Central Bank and a former member of the board of the International Monetary Fund