Of Fools and Free Markets

Think back to 2007. The world of finance was on a roll. Even people with bad or no credit history could borrow money to buy a house, see it gain value, sell it, and make a quick profit. "Subprime mortgage", "bullet repayment", and "house flipping" were part of the middle-class vernacular. Somehow, Wall Street bankers had found a way to "package and slice" these loans and make them riskless. Well, we all know how that ended. What we don't know is how we -- as a society -- believed that the magic would last, and went along with it. Now think about buying a car or house that it is too big for you, or paying outrageous interests on your credit card just to wear designer labels, or playing slot machines that are designed to beat you, or eating things that are proven to hurt your health? Why do we, rationale as we think we are, fall for all this?

Because markets are full of swindlers-in-waiting who talk directly to "the bad monkey" which each of us carries on our shoulders -- that is, to the part of our self that is driven by emotion or biases, not reason. With only a bit of oversimplification, that is the main message of a new book called Phishing for Phools: The Economics of Manipulation and Deception. Before you roll your eyes, you should know that the two authors of this book, George Akerlof and Robert Shiller, are both Nobel laureates and, frankly, rank among the most respected economists alive. What are these two academics up to?

A lot. They combed through tons of evidence from social psychology, behavioral economics, and industrial history to show example after example of how humans are fundamentally weak -- we can be duped into doing things which we know are not in our best interest. All it takes for us to give in to our lower material instincts is manipulated information delivered through smart marketing -- a.k.a. "phishing". In a free market, sellers will try to sell as much as they can by whatever means they can -- including, if nothing stops them, phishing. If they didn't, someone else would, and would drive them out of business. Competition ensures that, if we can be "phished", we will. It is, in technical parlance, a market equilibrium.

So, to keep us safe from the "phishers", governments need to intervene and regulate the market -- at least to curb the most blatant excesses. This is why public agencies like the Securities and Exchange Commission, the Food and Drugs Administration, or the Bureau of Consumer Protection exist. It is also what many private organizations try to do -- from those that give us consumer reports to those that warn us against blood diamonds. Akerlof and Shiller rightly call these people "heroes".

Of course, all of this is borderline blasphemy to those who believe markets work best when people are "free to choose" -- as Milton Friedman, another Nobel laureate and legend of economics, put it thirty-five years ago. Leave them alone, and consumers will learn from their mistakes and begin to shun dishonest sellers. Over time, reputations will matter. You need no government intervention. After all, what do bureaucrats know about business? Regulators are no match for the likes of Enron and Bernie Madoff, anyway. And why should a civil servant choose for me? As you can see, this conversation can get very ideological.

But, ideology aside, there are two aspects of Akerlof and Shiller's view of markets that make you scratch your head. First, it smacks of a rich man's problem. Their examples, and their hinted solutions, fit developed countries, especially the US, well. But they feel a lot less relevant for the developing world. When you live on two dollars a day or less, as almost one billion human beings currently do, you cannot afford to listen to the monkey-on-your-shoulder. Almost all your income goes to food. There is no freedom to choose, simply because there is no money to choose with. Period. When living in misery, you want government intervention, not so much to scare off potential phishers, but to give you whatever help it can. The key word here is "can". Among poor countries, not all governments have the capacity to provide basic nutrition, education, and healthcare, and to regulate markets. What do you do then?

Second, one would suspect that generations get smarter -- or are at least better informed -- over time. Progress in educational attainment, access to information, and social activism ought to count for something -- our monkey is not the same monkey that our grandparents carried. Today, a tweet, a post, or a blog is enough to alert millions in seconds of a dreadful restaurant, an unsafe toy, or a polluting car company. We can share our market experiences in real time. This narrows the space for phishing.

Still, the flaws of governments and the spread of the internet do not invalidate the central point of this book: our veneration of free markets -- and, its counterpart, our distrust of government -- assumes that buyers always know what they want and sellers are always honest. Recent evidence has proven that assumption to be, at best, naive. And we, as individuals and as societies, pay a huge price for our naiveté -- in terms of financial instability, healthcare costs, environmental degradation, and many others. Economic freedom, it turns out, is not free.

[Disclaimer: When Akerlof and Shiller deftly presented their book in Washington D.C. on October 19, I chaired the event, which you can watch at live.worldbank.org/phishing-for-phools ]