The problem with “free” market systems

There is a fundamental flaw in all so-called “free” market systems. Most of the well-known failings of free market systems are due to this.

Perhaps the simplest model of macro economics is to see the economy as consisting of firms who employ all the workers and produce all the goods and households who provide all the workers and consume all the goods.

This gives us two circular paths. In one work goes from households to the firms and goods go from the firms to the households. The other path is that money earned by the workers goes from the firms to the households and, at the same time, money goes from the households to the firms to pay for the goods bought.

The outcome of this is that the total value of all the goods produced in a year must, roughly, balance the amount of money acquired as income in this year.

Another way of looking at this is that everything produced in the society in any one year has to go somewhere. It can either be consumed completely, for example, food is eaten and is gone. It can be partly consumed, for example, a car is consumed over a period of time so, eventually, it is completely gone. Or it can be saved. Saved can be seen as being stored for use later or invested so as to produce a return of some sort. One way or another everything produced will be consumed directly by everyone or it will be invested.

If, for some reason, there is not enough money to buy all the goods that have been produced, the producers would like to reduce the prices but they can only do that if they can reduce their costs. One of these is labour. So if there is a shortage of money to buy the goods produced this will tend to reduce the demand for workers as well as the wages of workers.

Income that is not spent on something that is consumed will, one way or another, be invested. This is because most money only exists as electronic records in bank accounts. Even if people wanted to put their savings under their mattresses there is just not enough hard cash in the world for them to do this on a significant scale. If money is kept in a bank account it will invariably end up being invested.


In this simple model, all of the money that is invested is taken out of the income that the people earn. The rest of their income can be seen as being spent on goods that are consumed.

Everything revolves round the meaning of the word “invested”.

If someone starts a business all of the money he spends will go into paying people to do things, it will be used to buy materials, pay rent and, possibly, buy machinery. Machinery does last but eventually it wears out and is replaced. All of these forms of expenditure are various forms of consumption. This can be regarded as “real” investment.

Usually when someone says he has invested some money in something, for example, he has bought some shares, this is quite different. In the vast majority of cases like this, when he bought these shares, he bought them from someone else. The other person has “divested” himself of his investment. It is significant that the word “divestment” was so little used it has been hi-jacked to mean selling a politically embarrassing investment. Similarly if someone buys a house it is usually one that is being sold by someone else. In both of these cases, no extra “real” investment has been made. We might refer to these as being “fake” investments. This is still true even if the price paid was higher than the previous price for the same piece of property.

This means that most investments can be seen as being either “real” or “fake”. The difference is that “real” investments consume products that are produced by workers who earn money from doing this. “Fake” investments consume almost nothing and as such provide no work for anyone, except, possibly, estate agents.

But there is another very important difference. “Fake” investments are, by their very nature, made in things that are risk free, for example, houses or established businesses. On the other hand, “real” investments are risky. They often involve new processes or technologies that are difficult for the investor to evaluate. If they go wrong the entire investment may have to be written off.

These differences between real and fake investments have two major effects upon the economy. Firstly, all of the money invested in fake investments is money that is not being used to buy products that have been produced. This means that there is a chronic shortage of demand for goods in the economy.

Secondly, if the amount of existing assets, eg, houses, land, businesses, is relatively fixed but the amount of money available to buy them, ie “fake” investments, is significant then the price of these assets will rise even though they have not themselves changed at all. This will be referred to as “asset price inflation”.

In some case, for example housing, the rise in the price of the asset is sufficient that the asset can still be a profitable investment even when it is left empty.

In an economy where there are large differences in wealth the problem is made worse because the really rich cannot possibly consume even a fraction of their income. One might think they can and do buy houses and yachts but, of course, these are mainly “fake” investments. This surplus income is used to buy existing assets thereby, overall, increasing the value of these very same assets.
If these people were forced to spend their money on goods and services that were then consumed the economy would flourish.

A system like this occurred during the second world war. The government did whatever was necessary to produce as much as possible so that the entire productive potential of the nation was involved in production of goods. Almost everyone was employed. Almost everyone earned enough money to live on. Vast amounts of goods were produced even though most of this was almost immediately destroyed.

To sum up:.

Firstly, if large sums of money go into fake investments then this money is not going to buy products that have been produced. This causes a shortfall in the demand for products.

Secondly, whereas real investment carries a significant risk of loss, fake investment carries almost no risk. Consequently, all else being equal, there is a tendency for fake investments to be more attractive to someone intending to “invest” money than investing in a real investment.

These two factors also interact in a very negative manner. The key parameter for making a real investment attractive is that there will be a demand for the product that will be produced by this investment. If there is a shortage of demand then this makes a real investment even less attractive than a fake investment.

Consequences of deficient demand

The most obvious sign that there is a shortage of demand is that there is always plenty of anything anyone might want to buy. The other side of this is that most of those who might like to buy more stuff do not have enough money to do this. This not only includes individuals but also the state.

The need for credit

This leads to a vast industry of lending money not only to individuals but also to the state. Of course, this cannot, in the long run, solve the problem as we have seen in the recent crash. History is full of schemes whereby “credit” is created but, in the long, inevitably fails.

The need for advertising

On the other hand enormous energy is put into selling the stuff available. The most obvious part of this is advertising. We do not have people advertising that they want to buy something. There is no need. All advertising is about selling. It only happens because there is not enough money available for buying the goods that have been produced – insufficient demand. .

This leads to other industries that are paid for by advertising. Newspapers are largely paid for by the advertising they carry. Most “free” radio and TV channels are paid for by advertising. These in turn pay other industries to provide material to attract audiences. Many sports are largely funded by advertising. Large parts of the internet are funded by advertising or collecting information about people that is useful to advertisers, for example, Google, Facebook etc.

Of course, if advertising did not exist it does not mean that other services currently supported by advertising would disappear. Instead people would have more money and would pay directly for what they actually wanted.

Built in obsolescence

If the demand for goods is limited then a manufacturer producing, for example, cars, can produce cars so they have a limited life so the buyer will have to buy a new car rather than spend his money on something else.
Most of the car industry can be seen, not so much as making new cars, but as making replacement cars.
A car might have to be replaced because it is worn out but manufacturers then design new versions of their existing cars so the old ones become “out of date”.
The whole of the fashion industry is based on the same idea.

The effect of this on the environment must be obvious.


One alternative to selling an existing product when the demand for it is limited is to come up with a new product that might be a preferred way of spending money rather than to buy existing products. The motivation for most innovation can be seen as a result of deficient demand.
We might see innovation as being a good thing. But, if we consider what the very affluent can buy already we have to ask if they really need anything else. On the other hand there are very many people whose lives could be made incomparably better if only they could afford some of what is already in existence.
There are two exceptions to this. One would be the production of new medicines and medical treatments. The other would be the preservation or restoration of the environment.

Exports, colonialisation etc

Another way of getting rid of surplus goods is by exporting them. Since all economically advanced countries have a surplus of goods, great effort is put into exporting these. In the past powerful countries have found it useful to have countries they could dominate which would provide an exclusive market for their surplus goods. The outcome of this is colonisation. A colony provides a protected market for surplus goods produced at home.

The global free market

It might appear that the age of colonies has past. It has but what it used to achieve for the benefit of the richer states is now achieved by different means. This is the so-called “global free market”. Of course, a free market as conceived by Adam Smith, meant the free movement of capital, goods and labour. The global free market might allow the free movement of capital and goods but certainly does not allow the free movement of labour.

Effect on the market for labour

Another problem caused by deficient demand is that there is a continual squeeze on labour. Any producer in a market where there is deficient demand will always feel that he can increase his share of the market if only he can reduce his costs. One of his biggest cost is often labour. This leads to a continuous downwards pressure on labour.
This shows itself in two different ways. Firstly for many workers it is difficult to even maintain the level of their wages in real terms. Secondly, there is a shortage of jobs. Not having a job is serious for the individuals who are unemployed. But this has a much more invidious effect. It is that workers are often so frightened of losing their jobs that they will not only put up with abuse towards themselves but they will overlook what is often blatantly criminal behaviour by their employers.
The role of the City
The City of London is one of the world’s largest financial centers. This is based on a long history of trading where businesses providing services to these traders such as insurance and banking developed.
Over time, these activities that once existed all over the country have now been taken over by similar businesses that happened to be based in London. At the same time laws came into being that made the possibility of starting a new business’s of this sort elsewhere impossible. The headquarters of all but one of the big banks in England are in London. Over the years they have taken over all the other banks. At the same time the banks have taken over almost all of the building societies. It is almost impossible for anyone outside London to start a new bank or a building society.
This monopolisation of financial institutions means that almost any form of saved money ends up in the hands of a London based institution.
In traditional banking, it might be thought that individuals and organisations lend money to banks in return for interest. The banks then lends this money to other individuals and organisations who pay the banks interest for the use of this money. For this to be profitable the banks charges a higher rate of interest on the money it lends out than on the money it borrows.
What banks discovered, a very long time ago, is that if its customers have confidence in the bank the bank can lend out more money than has been lent to the bank. This “extra” money has cost the bank nothing, yet the bank can lend it out and get interest on it.
The next stage in banking is “investment” banking. This is not instead of borrowing and lending money, it is in addition to this activity.
The key here is that instead of borrowing and then lending money the bank uses any money it has to buy assets. The point here is that in addition to getting interest or dividend on any “investment” the bank also receives any increase in the value of the assets due to asset price inflation.
Much of the money lent out will be lent to businesses. Some money will be used to invest in developing new process or buying new machine to make new product. But much of the money will be used to buy existing assets. This might be individuals buying houses or businesses buying shares or property.
In short, the bulk of what passes for economic activity in the City is paid for by the rising price of the assets that are owned by city institutions. When one sees a room full of dealers busy buying and selling, they are mainly just buying and selling from each other. Any money they make is from the inevitable rises the value of the assets that other city intuitions hold. For one dealer to make profit another probably loses the same amount.
This explains why businesses are always complaining that banks are so reluctant to lend them money. The answer is simple. The return to the bank by buying assets is far higher than it can get by lending to business. It is also far less risky.

Even if there were no other causes of inflation in the system the existence of asset price inflation creates inflation by itself. Since most fake investment is in existing property (i.e. houses and buildings) the owners of this sort of property expect a return on it related to its continually inflated price. That is, the rent continually increases.
It is very likely that a significant proportion of the rise in the value of businesses is also due to the overall rise in asset prices.