Markets and Stability

Tell you straight, no intervention
To your face, no deception
--Eurythmics

A common claim is that free markets are inherently unstable, and are therefore in need of government intervention in order to keep them on even keel. The Fed's charge for 'price stability,' for example, presumes price instability were markets to do their own thing.

Let's set aside the question of precisely how a bureaucrat is capable of recognizing instability and competently reducing it--this issue merits dedicated discussion elsewhere. Here, let's consider unhampered market behavior and whether it is indeed likely to trend toward instability.

Unhampered markets are places of voluntary exchange. Exchange occurs because people seek to satisfy needs, and because people perceive that they can better satisfy those needs by trading with others than by acting independently.

Axiomatically, people will engage in trade to the extent that both sides perceive benefit from exchange. If one side of a potential exchange does not judge a favorable situation, then trade will not occur.

Assessing the attractiveness of a trade requires an estimate of the degree of benefit (i.e., Am I likely to gain? How much am I likely to gain?) versus what must be given up in trade (i.e., How much will this trade cost?). The greater the likelihood of gain perceived by both parties ex ante, the greater the likelihood of trade.

Errors in judgment are possible, of course. A perceived benefit does not occur to the extent that it was forecast, and the trader experiences a loss of material resources. More benefit may have been possible than was estimated ex ante, and the party that passed on a particular trade experiences loss of economic opportunity.

It is the assessment of risk versus reward that shapes behavior in unhampered markets. Balancing the potential for gain against the potential for loss attenuates market behavior, keeping it from getting lost in extreme conditions of either risk seeking or risk aversion.

Pro-interventionists sometimes argue that human wiring defects (e.g., overconfidence bias, confirmation bias, loss aversion) cause risk:reward assessment to be less than rational which drives errors in calculation that necessitates a mediator. Cognitive biases surely exist, but in free markets errors of bias sting with the penalty of loss, which is likely to drive behavior in the other direction. Moreover, cognitive biases must be systemic rather than random in order to impact overall market stability. Even in such cases where 'herds' might move toward extremes under the auspices of systemic cognitive bias, the penalty of loss still stings, which once again motivates a reversal of behavior--even if it is the behavior of a crowd.

Indeed, it seems more likely that the cognitive bias problem is likely to be much more consequential in a hampered market, where biases and their influence are concentrated with the mediator, rather than distributed and buffered among many actors in a free market.

Claims of inherent instability in free markets are not supported by reason. Natural laws regulating human behavior administer rewards and penalties that keep greed and fear in check. Fundamental forces governing free markets are inclined toward equilibrium rather than disorder.