The failings of the rating agencies in evaluating synthetic financial products and the rising opacity of financial markets have reminded me a famous debate in economic thought.

The calculation debate took place among several leading economists during the interwar period, in the last century. One camp fielded, among others, Ludwig von Mises and Friedrich von Hayek, who stressed that free markets and clearly defined property rights (private property) are essential for proper calculation of costs and benefits and economic development; these were very dear tenets of the Austrian school of economic thought. Hayek highlighted also the ubiquity of information/knowledge in society and, in this context, the role of entrepreneurship (like Joseph Schumpeter did) in promoting technical change. The other debating camp used the intellectual guns of Oskar Lange. The latter, while being against private capital, acknowledged the importance of markets in economic development and tried to build on them a mechanism of “market socialism” (which relied on social property). But Lange’s model had its own major flaws. One originates in the inadequate pricing of capital, which undermines its accumulation as a source of economic growth over the long run. Moreover, entrepreneurship could not blossom in conditions of market socialism, where capital and risk-taking are not properly rewarded.

What came closest, in modern history, to an implementation of market socialism was the texture of socially owned firms in the former Yugoslavia, which has brought some prosperity to its citizens as against what occurred in the typical command economy in the former soviet system. Goulash communism in Hungary was also an attempt to introduce market reforms in a socialist economy. Much worse than “market socialism” was the command (communist) system. While having the power to mobilize resources for major projects it suffered from fundamental original sins: lack of proper valuation of factors of production and stifling of innovation (apart from the suppression of political liberties). The collapse of the command (communist system), as well as the market economic reforms in China and, later on, in Vietnam, have proven, in a spectacular way, which camp of economic thought won the debate.

To put more emphasis on this victory and make the hook-up with the current financial crisis I would recall something of great significance. There was a group of soviet economists –Leonid Kantorovich and V.V. Novojilov among them-- who thought that quantitative models can replicate markets and offer scarcity valuations to capital, labor and land. They tried hard to work out general equilibrium (input-output) models and came up with so called “shadow prices” as substitutes for free market prices. Interestingly, Kantorovich got a Nobel prize for his work. But his models were far away from being able to help the command system --for nothing can substitute real markets and clearly defined property rights as foundations for an efficient economy. In addition, entrepreneurship cannot be simulated, or stimulated by decree; it has to happen in reality, as a result of incentives and economic freedom. That there is need for a public sector (that supplies public goods) in a modern economy and that markets have their own failings which need to be addressed is another serious matter for discussion and public policy response.

Above I have linked the calculation debate to the current financial crisis. A financial system which has been increasingly based on capital markets (securitization) –as it has evolved in the last couple of decades— has brought the key issues of transparency and proper valuation to the fore. Ironically, these are exactly some of the main negative traits which have brought the command system down. As a matter of fact, models which were used by leading investments banks (brokers) and rating agencies in assessing risks, and the ratings that were assigned to new (synthetic) financial products, have proven to be highly erroneous. Likewise, a certain type of securitization, which has distanced lenders from the consequences of their actions more than dangerously, has obfuscated risks (the counterparty risks) and enhanced the opacity of markets. The non-existence of effective markets for derivatives (OTC) has compounded the diminishing transparency of markets and added to inadequate valuation. The credit crunch could not be avoided due to an overwhelming lack of transparency and trust. The bottom line is that missing genuine markets (for various derivatives) and highly questionable valuation of securities pushed toward a freezing of credit markets.

The causes of the current financial crisis should prod many to remember the lessons of the famous calculation debate: we need genuine markets, transparency and proper valuation of factors of production and products (services). Simulation and models cannot be but a very imperfect and insufficient substitute of actual markets. And the transparency and smooth functioning of markets need to be propped up by adequate regulations and supervision. For, markets, by themselves, cannot protect themselves against their inherent weaknesses and the public good needs, sometimes, the work of a visible hand.