Column by John Kay, The Financial Times
Sixty years of division of the Korean peninsula has created two states with very different standards of living in one country. The Korean example is pathological. The division of Germany resulted in two states, both functional in economic terms, but one far richer. The less noticed comparison between the modern economic histories of Finland and Estonia had the same outcome.
There are few controlled experiments in economics, but these are as close as we get, and the results were clear. They were also unexpected. Hard though it is to believe today, in the 1960s many serious commentators on left and right believed that Russian economic progress threatened western hegemony. Those on the left were naively credulous and those on the right victims of paranoid fantasies.
A perhaps apocryphal story tells of a Russian visitor, impressed by the laden shelves in US supermarkets. He asked: “So who is in charge of the supply of bread to New York?” The market economy’s answer – that not only is no one in charge, but it is a criminal offence for anyone to seek that position – is surprising. In the words of the economists Kenneth Arrow and Frank Hahn, “the immediate common sense answer to the question ‘what will an economy motivated by individual greed and controlled by a very large number of different agents look like?’ is probably ‘there will be chaos’.” Our intuition is that a centrally planned allocation of resources will be more efficient than an uncoordinated one. In a market economy, that error constantly leads us to overestimate the economic advantages, and longevity, of large companies.
Our intuitions about the merits of scale and centralisation are generally wrong, partly because a price system can co-ordinate the decentralised decisions of many small companies and households well. Adam Smith’s insight about the invisible hand is often interpreted in this way and modern mathematical economists have established that proposition more precisely. But if co-ordination were the only strength of the market economy, a computer could do that job equally well. Computers are very good at processing information.
But the prices and entrepreneurs of the market economy are much better at eliciting the information, on preferences and products, needed to make the calculations. Prices, and entrepreneurs, manage the market’s process of discovery. A functioning market economy allows endless small-scale experimentation. When such experiments succeed, they are quickly imitated: when they fail, as experiments usually do, they are abandoned. Centralised economies, lacking this disciplined pluralism, experimented too rarely: when they did, they typically implemented on too large a scale. They often lacked honest feedback on performance. Subordinates had good reason to tell the great leader what he wanted to hear. We see the same mechanisms at work in our large corporations.
But what of profit? North Korea is hardly free of the profit motive. The Kim dynasty and the cliques around it may profess disdain for capitalism, but they understand the goal of personal enrichment as well as any Wall Street Master of the Universe. The difference between North Korea and the US is not that one society offers more scope for greed than the other. In both countries, as in many others, there are greedy people and many who are not, and those who are greedy are disproportionately represented in the controlling elite. The difference lies in the channels of greed – the degree to which the quest for profit is directed towards the creation of new wealth rather than the appropriation of wealth already created by other people.
A successful market economy emphasises the former and restricts the latter through rules and institutions, in a structure that has evolved slowly and requires constant defence against those who would use economic and political power to subvert it. Success or failure in that endeavour is the central explanation for why some societies are rich and others poor. Crony capitalism is very different from the market economy.
© 2012 John Kay, The Financial Times