All of us in the investment industry place a great deal of faith in the role of free markets. No other mechanism for organizing production and distribution of goods and services has proved as successful at generating affluence and prosperity. However, in recent decades, we have relied heavily on free markets to make our important financial, economic, and—increasingly—our social decisions as well. This has started to result in some seriously negative consequences and to raise the question of how markets should be used in a democratic society. How can we experience the benefits of markets without being exposed to their disadvantages?

A market-driven economy and society

Oscar Wilde declared that a cynic is a man who knows the price of everything and the value of nothing. Some would argue that a great many securities traders, quantitative investment managers, central bankers, and market fundamentalists would fit that definition. A number of prominent free market proponents have been learning from the recent global financial and economic crises. The high priest of market fundamentalism, former U.S. Federal Reserve Board Chairman Alan Greenspan, admitted in October 2008 that he was shocked that his confidence in the self-correcting forces and capital allocations of markets turned out to be misplaced. In January 2009, ex-Treasury Secretary and Goldman Sachs Co-chair Robert Rubin described mark-to-market accounting as a cause of terrible, vicious cycles in asset prices and a great deal of damage. Anyone observing stock and bond prices while the financial crisis raged would have had to agree that fluctuations in liquidity, much more than any reasoned capital allocation decisions, were behind the enormous gyrations in prices. And certainly many legislators and regulators, along with millions of investors, have been chastened by their experiences in 2007−2009.

But what has really changed since then? What has been done to address the shortcomings of free markets? Arguably, the reliance on market values in everyday life today has never been stronger. In fact, some would say that today we have a market society as well as a market economy.

Defects of market thinking

In his 2012 book What Money Can’t Buy, Michael Sandel, Professor of Government at Harvard University, decries the persistent prestige and power of market thinking, even in the aftermath of the worst market failure in 80 years, and the absence of serious public debate about the role and reach of markets. Sandel argues that financial incentives—the stock-in-trade of modern economics—are only one of many motivators of human behaviour and that we should not rely on them when their benefits are outweighed by the erosion or crowding out of morals and other non-market norms. Sandel states that we need to ask whether there are some things that markets do not value very well and that money should not be able to buy. He notes that markets reflect the ability to pay, not just the willingness to pay, as free market theorists like to think. As a result, they are not perfect indicators of who most values or most needs a particular good or service or of the relative values of goods and services to an economy and to a society. Nor do markets tell us how resources should be allocated to optimize overall economic and social well-being. Who really believes that a Birkin handbag by Hermès priced at $30,000 has the same economic worth as a Toyota Camry?

Sandel suggests that the reluctance to come to grips with arguments for including the quality of life and moral values in politics and business paves the way for “market triumphalism” and the overriding hold of market reasoning. He attacks the two tenets of market faith: that commercializing an activity does not change it and that ethical behaviour cannot be relied upon, so we must harness self-interest through markets to achieve a better economy and society.

The skyboxification of life

Sandel states that over-commercializing a good or service changes the meaning of the acts of providing and acquiring it, and that the more (or less) altruism, generosity, solidarity, and civic spirit are expected of people, the more (or less) of these qualities they will demonstrate. In the U.S., for example, blood banks that pay for blood have more trouble obtaining supplies than those that do not. One of the defects of a market-driven society is that it allows—even encourages—human virtues to languish. Sandel argues that in order to renew the quality of our society and politics, we need to expect and exercise these virtues more strenuously. He cites many examples of markets intruding where they do not belong: a prison cell in Santa Ana, California, can be upgraded by a prisoner to a cleaner, quieter jail cell for $82 per night; access to car-pool lanes can be purchased for $8 in Minneapolis; the right to shoot an endangered black rhino can be purchased in South Africa for $150,000; the right to pollute can be purchased by buying carbon emission credits; and lobbyists can purchase the right to attend U.S. Congressional hearings through companies that hire unemployed people to stand in queues for them.

Sandel believes we are making major mistakes by not considering what can be done to address the negative outcomes of over-reliance on free markets. He states that the more things money can buy, the fewer the occasions when people from different walks of life encounter one another, a phenomenon he dubs the “skyboxification” of life. Democracy, he contends, does not require equality, but it does require that citizens share a common life. Was this perhaps one of the poorly articulated messages of the “99% demonstrations” in 2011?

Economic shortcomings

There are certainly many drawbacks to completely free markets when it comes to the financial world. We have seen several times in the last 30 years how overly free markets, with inadequate controls on computerized/high-speed trading, derivatives, shorting, and other speculative activity, have created extreme volatility and cycles in share prices. And in 2008, they caused a collapse in the liquidity of the global financial system. These occurrences have been damaging to the primary function of capital markets—raising funds for productive enterprises and providing access to investments and liquidity for savers—as well as damaging to economic output.

“One of the defects of a market-driven society is that it allows – even encourages – human virtues to languish.”

Completely free lending markets have vividly demonstrated their shortcomings in the subprime mortgage debacle in the U.S. in the last decade, the fallout from which is still with us.

Takeovers and buyouts (part of the free market for shares in public companies) may provide short-term benefits to those with the capital and know-how to restructure companies, but such short-term actions may not be in the longer-term best interests of shareholders, employees, and customers, and they may come at the cost of great economic and social disruption.

Outsourcing (reducing corporate costs by taking advantage of the free market for goods and services) may save money in the short run, but over the long term, they can sometimes hollow out the internal control and capability of an organization, reduce the morale of its employees, and leave it open to the vulnerabilities of its outsource suppliers.

Globalization (the trend towards free markets for goods, services, and labour throughout the world) can serve to increase the demand for, and reduce the costs of, goods and services globally. But if countries fail to win very much through free trade and global competition, is there not a case to be made for maintaining some important industries that protect national independence, security, and pride through protectionism?

When employed to meet the demands of the market, new technologies increase our productive capacity but often drastically reduce our need for labour. High levels of unemployment in developed markets demonstrate that new technologies create extreme wealth for the few that control and participate in them while producing rising and perhaps chronic unemployment and poverty among the masses. Do we really understand the effects on society of the large-scale replacement of human interaction with technology?

What limits should be placed on capital markets to ensure they play their important part in allocating resources without harming moral and civic values? How can we tame markets in order to experience their benefits without their destructive tendencies? And how can we protect the social and ethical qualities that free markets do not respect? The answers to these questions are not easily identified, hence the wide disagreements that surface whenever these issues are discussed. In the absence of agreement, the tendency is to allow market forces to continue unchecked.

Sandel acknowledges that there will be much disagreement over such issues but maintains that a better understanding will emerge at the end of the day. Imposition of a rigid ideology that favours one group over another cannot last forever. Equally, endless debate and intransigence when action is necessary can lead to cataclysm. There are seldom any easy solutions, but we must be prepared to do our best and not simply leave our fate to the vagaries of markets.

How do we want to live together?

The financial crisis of 2007−2008 would have bankrupted the world’s financial system and caused a global depression were it not for swift intervention by governments, spearheaded by U.S. authorities. Few people today believe that the world’s financial markets have been sufficiently reformed to avoid future cataclysms. Reversion to market fundamentalism is not a solution. Sandel concludes that, in the end, the question of markets is really a question about how we want to live together. It is in everyone’s interest to fully appreciate the negative aspects of markets and debate them democratically, rather than simply accept that “the market is always right.” In the investment world, we need to ask whether we want to relate to our clients primarily as counterparties to transactions in a market or whether our relationships should be broadened to include greater recognition of such human virtues as honesty, integrity, and prudence, in addition to fiduciary duties, transparencies of interests, and other disclosures. In the long run, the well-being of the financial industry, our economy, and our society depends on it.