1.3 A Slight Of Hand
Now re-read Samuelson’s passage, only this time look out for the slight of hand in the final sentence:
What is true of the markets for consumers’ goods is also true of markets for factors of production such as labor, land, and capital inputs.
The passage provides a convincing explanation of how equilibrium is established in the marketplace for goods, but when it comes to the markets for labour, land and capital inputs, there is no explanation of the mechanisms through which equilibrium is established. For these markets we are offered nothing better than proof by assertion. This logical trick is pervasive in economic teaching: we are first persuaded that the markets for goods are efficient, and then beguiled into believing this to be a general principle applicable to all markets. As the failure of Northern Rock and Bear Stearns show it is unsafe to assume that all markets are inherently stable.
1.4 The Market For Bling
We can easily find a counter example to Samuelson’s well-behaved supply-and-demand driven markets. In the marketplace for fine art and luxury goods, demand is frequently stimulated precisely because supply cannot be increased in the manner required for market efficiency: Who would pay $140,000,000 for a Jackson Pollock painting if supply could be increased in proportion to demand? The phrase “conspicuous consumption” was coined by the economist Thorstein Veblen to describe markets where demand rose rather than declined with price. Veblen’s theory was that in these markets it was the high price, the publically high price, of the object that generated the demand for it. Veblen argued that the wealthy used the purchase of high-priced goods to signal their economic status. (Footnote: “The Theory of the Leisure Class” Thorstein Veblen, first published 1899.) Veblen was the original economist of bling – if you’ve got it you want to flaunt it.
Fortunately for the high priests of market efficiency, Veblen’s observations can be dismissed as minor distortions within an overall economic environment that responds in a rational manner to higher prices. That is to say, even at a price of $140,000,000, the market for Jackson Pollock paintings is irrelevant to the wider economy.
1.5 When The Absence Of Supply Drives Demand
While the markets for bling can be dismissed as economically irrelevant, there are other much more important markets which also defy the laws of supply and demand, as described by Samuelson. While Veblen identified the rare conditions in which high prices promoted high demand, we can also consider the much more common situation in which low or falling supply promotes high demand.
Today’s oil markets are a case in point, where constrained supply is prompting higher speculative demand. While consumers of oil are reducing their oil purchases in response to supply constraints and higher prices, speculators (investors) in oil are moving in the opposite direction and increasing their purchases.
This simple observation of how consumers and speculators respond in different ways to supply constraints gives us the first hint that a fundamentally different market mechanism operates in the markets for assets to that which dominates the markets for goods and services. This effect is not confined just to today’s unusual oil market: Who would invest in the shares of a company if that company were in the habit of issuing more stock whenever its share price rose above a certain level?
As a rule, when we invest we are looking for an asset with a degree of scarcity value, one for which supply cannot be increased to meet demand. Whenever we invest in the hope of achieving capital gains we are seeking scarcity value, in defiance of the core principle that supply can move in response to demand.
To the extent that asset price changes can be seen as a signal of an asset becoming more or less scarce, we can see how asset markets may behave in a manner similar to those of Veblen’s market for conspicuous consumption goods. In Veblen’s case it is simply high prices that generate high demand, but in asset markets it is the rate of change of prices that stimulates shifting demand.
Frequently in asset markets demand does not stimulate supply, rather a lack of supply stimulates demand. Equally price rises can signal a lack of supply thereby generating additional demand, or, conversely, price falls can signal a glut of supply triggering reduced demand.
George Cooper, The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy, (Petersfield: Harriman House Ltd., 2008), 6-8.