Human Failure Isn't Market Failure

Robert A. Sirico
The Wall Street Journal
November 18, 1998

The meltdown of Asian markets, combined with a high-profile hedge fund failure at home, has revived the familiar charge that capitalist greed and pervasive market failure are the sources of economic crisis. What happened to Asian economies and to one hedge fund has become a metaphor for the systemic moral failings of capitalism itself.

"It is beginning to be accepted that global capitalism is in serious trouble," writes John Gray in The Nation, echoing sentiments widely shared on the political left. In apocalyptic tones, he predicts the coming "breakdown of global laissez-faire." Even more bluntly, the editor of the National Catholic Reporter wrote recently that given this year's events and the plight of the poor everywhere, "one thing seems clear to me: capitalism doesn't work."

Both editorials are symptomatic of a resurgence of old-fashioned anticapitalist moralizing, consisting primarily of flawed economic analysis and a generous dollop of redistributionist ethics. Their solutions are predictable: They desire more regulatory control and redistribution of the world's resources by means of government policy. It's an old story but with a postsocialist twist. Clearly, the left (secular and religious) is hoping that recent financial troubles will serve as a rejoinder to everyone who crowed about the failure of central planning after 1989.

The problem is that it requires ideological blinders to regard the Asian meltdown and the failure of a hedge fund as a crisis of capitalism. These events have explanations having to do with mundane issues of money and finance. Economists who have looked carefully at the issue have concluded that the Asian failures are due to preferential lending policies that boosted some economic sectors beyond the point the market could sustain. These policies were sustained by financial subsidies and leaky banking supervision that allowed lenders to underestimate risk and overestimate consumer demand. This is not a market failure. Indeed, since markets entail both profits and losses, it is a demonstration that the market is working as it should.

As for the hedge fund Long-Term Capital Management, its investment strategy was based on a mathematical model formulated to notice small yield and price discrepancies in bonds and currencies, with programmed buying and selling based on certain assumptions about the future. The model was constructed based on historical patterns that held well for two years, generating returns upwards of 40%.

It so happens that not all price patterns from the past hold in the future, contrary to the assumptions of the model. During the dark days of August and September, when the prices and yields took a wholly new turn, the risk that had earned the firm such spectacular profits came back to devour it.

What we see in this case is not institutional failure but human failure. Successful investors sometimes forget that the future cannot be known with certainty by anyone. It is a peculiar trait of human nature that we are, time and again, inclined to believe our inherent ignorance can be overcome.

There is nothing wrong with speculation, and, indeed, if making good judgments about an unknown future helps coordinate economic maladjustments, that's all to the good. The problem arises when arrogance tempts us to believe in our own infallibility. It is this very hubris that leads some intellectuals to embrace the folly of central planning.

What does any of this have to do with corporate greed or the failures of the capitalist system? Nothing. Critics who say it does have confused human error with a social structure of sin itself. We must focus the penalties for failure more particularly on those firms that are responsible. This is the system called profit and loss, one that has been compromised in an age of bailouts and loan guarantees and investment houses that are declared too big to fail.

In short, there is nothing wrong with the market economy that an enhancement of market signaling cannot correct. That's not a very earth-shattering conclusion, and it certainly doesn't feed the desire for revolutionary upheaval to avert a financial apocalypse.

No economic system can rid the world of human fallibility, and none should try. But major elements of the left have not yet accepted the reality that the market economy, whatever its flaws, is no longer merely an option. It is not capitalism that is in crisis but the remnants of state planning, which those on the left still defend with misguided moral passion.