Why Capitalism Doesn’t Work
ChatGPT explains why neoclassical economists are proposing that capitalism fails
Why Capitalism Doesn’t Work: The Theory of Incomplete Financial Markets
If capitalism is meant to be the engine of efficiency and prosperity, why does it often feel like we’re riding a roller coaster, where the highs are euphoric, but the lows leave us hanging? The answer lies in something economists call the theory of incomplete financial markets. It’s not just a technical concept—it’s a lens through which we can understand why capitalism, left to its own devices, sometimes leaves people behind and why government intervention is not just helpful but necessary.
Let’s break it down in plain terms: in a complete market, we would all have access to financial tools to insure ourselves against every possible risk or uncertainty. Job loss? There’s an asset for that. Sudden illness? Covered. Economic downturn? No problem, the markets have us all hedged.
In this ideal world, people could smoothly navigate life’s financial risks without worrying too much. Every choice you make, from how much you save to how much you invest, would be optimized. No one would ever be worse off because they were blindsided by a risk they couldn’t predict. In technical terms, this means we’d achieve Pareto efficiency—an allocation of resources where no one can be made better off without making someone else worse off. Sounds perfect, right?
How Incomplete Markets Affect Your Life
But here’s the rub: in the real world, we don’t have markets for everything. Incomplete markets are our reality, where many of life’s biggest risks are uninsurable, either because it’s too difficult to create financial products for them, or because doing so would be far too expensive or complicated.
Let’s take an example. Imagine you’re a middle-class worker trying to save for retirement. Ideally, you’d want to insure yourself against losing your job, future health expenses, or even a stock market crash that could decimate your savings. But guess what? Not all of these risks are easily insured. In fact, many of them aren’t. Job loss insurance is patchy at best, health costs can spiral out of control, and if the market crashes, you’re left scrambling with little recourse.
Without the right tools to hedge against these risks, people tend to over-save “just in case” or under-consume because they’re unsure about future income. This behavior is known as precautionary saving—people save more than they normally would to protect themselves against risks they can’t insure. This leads to suboptimal decisions—not just for individuals, but for the whole economy.
In asset pricing, this means that investors demand higher risk premiums for assets because they can’t hedge all their risks. This, in turn, distorts how assets are valued and creates market inefficiencies. If financial markets were complete, we would see much more stable prices and a more even spread of risk across society. But in incomplete markets, risks are concentrated among those least able to bear them.
The Problem of Coordination Failures
A more subtle problem arises from coordination failures. Incomplete markets can lead to situations where individuals’ actions, while rational on their own, result in suboptimal outcomes for everyone. Think of a recession: if individuals expect the economy to worsen, they might cut back on spending and increase saving as a precaution. This makes sense for each person, but when everyone does it simultaneously, it leads to a sharp drop in aggregate demand, causing the economy to slow further.
This creates a feedback loop: as demand falls, firms cut back on production, leading to job losses, which in turn makes people save even more, worsening the recession. The failure to coordinate actions exacerbates the very risks individuals were trying to protect against.
In this sense, incomplete markets not only force individuals into precautionary behavior, but they also magnify economic downturns through self-fulfilling crises—where everyone’s attempt to insure themselves against a downturn creates the downturn itself.
Adam Smith and the Invisible Hand: Why It Falls Short
This brings us to Adam Smith, the father of classical economics, and his famous concept of the “invisible hand.” According to Smith, individuals, acting in their own self-interest, will naturally lead to outcomes that are beneficial for society as a whole. The market, through this invisible hand, would allocate resources efficiently, maximizing social welfare without the need for central planning or government intervention.
While Smith’s ideas were revolutionary, the theory of incomplete markets challenges the very foundation of this thinking. The invisible hand works well only when markets are complete—when individuals can trade and insure against every possible risk. In such a world, private actions would indeed lead to socially optimal outcomes. But in the real world of incomplete markets, where many risks remain uninsurable, the invisible hand falters.
Here’s why:
Precautionary Savings Distort Efficiency: Incomplete markets force individuals to save more than they would in a world with complete markets because they cannot fully insure against future risks. This means that resources that could be used for consumption or investment are instead stockpiled in precautionary savings. While this is rational behavior for individuals, it leads to inefficient outcomes for society as a whole.
Coordination Failures: Smith’s invisible hand assumes that individual decisions, even if made independently, will aggregate to benefit the broader economy. But in the case of incomplete markets, individuals’ attempts to protect themselves (such as cutting back on spending during a downturn) actually exacerbate the very problems they are trying to avoid. This creates coordination failures where the collective outcome is far worse than what individuals intend.
Inequality and Concentration of Risks: Smith’s model doesn’t account for the fact that incomplete markets often concentrate risks among the least wealthy. Incomplete markets mean that wealthier individuals, who have more access to financial tools, can hedge against risks more effectively, while poorer individuals are left more exposed. This exacerbates inequality, creating a system where the invisible hand works primarily for those already well-off, leaving others behind.
In short, Adam Smith was right to celebrate the power of self-interest and decentralized decision-making, but his model of capitalism assumes a world of complete markets. The real world, however, is filled with missing markets, uninsurable risks, and coordination failures that hinder efficient outcomes.
The Macro Picture: Why It’s Not Just You
On a macroeconomic level, incomplete markets amplify the booms and busts of the economy. When recessions hit, many households can’t fully insure themselves against unemployment or falling income. Their response? Cut back on spending, creating a vicious cycle where demand falls even further, deepening the downturn. This isn’t just a personal problem—it’s an economy-wide one. When millions of people pull back at the same time, the economy grinds to a halt.
Meanwhile, wealthier individuals or firms with more access to financial markets can weather these downturns better. They’re able to hedge against certain risks and even take advantage of market conditions. This contributes to growing inequality because those with more wealth and access to financial tools thrive, while those without are left more vulnerable.
Why Capitalism Alone Isn’t Enough
Capitalism’s beauty lies in its ability to allocate resources efficiently, but only under ideal conditions. The incomplete markets theory exposes a critical flaw: when markets don’t exist for certain risks, the system doesn’t function efficiently. People and businesses make suboptimal decisions, social welfare suffers, and inequality worsens. The more risks we can’t insure against, the worse these inefficiencies become.
This is why capitalism, on its own, doesn’t work. Without mechanisms to insure against risks, the promise of “market efficiency” is broken. People are left to fend for themselves against risks that they have no way of preparing for or managing. The system, in other words, is incomplete. And that’s where government comes in.
Enter the Government: Capitalism’s Quiet Partner
Contrary to the idea that government and capitalism are at odds, the truth is that government plays an essential role in making capitalism work better. Think of it as providing the safety net that catches what the markets can’t.
Public Insurance: When private markets fail to offer insurance against certain risks (like unemployment or healthcare costs), the government steps in with programs like unemployment benefits and social security. This doesn’t just help individuals; it stabilizes the economy by ensuring that people continue spending and investing, even in tough times.
Redistribution: Through taxation and social welfare programs, governments can mitigate the inequality that incomplete markets exacerbate. By redistributing wealth from those who have more to those who are more vulnerable to uninsurable risks, governments help smooth the playing field.
Macroeconomic Stabilization: During economic downturns, the government can use fiscal policy (like stimulus spending) and monetary policy (like lowering interest rates) to prop up demand when private markets are in freefall. This helps prevent recessions from spiraling out of control.
Market Innovation: Governments can also promote the development of new financial instruments that help fill in the gaps. By encouraging innovation in financial markets, governments can help “complete” the market and give individuals more tools to manage risks.
Conclusion: Capitalism + Government = A Working System
The theory of incomplete financial markets shows us that capitalism is not a self-sufficient machine. It can create enormous wealth and drive innovation, but it leaves cracks in the foundation—cracks that can grow into deep fissures if left unaddressed. Without government intervention to fill in these gaps, the risks that capitalism can’t manage pile up, leading to inefficiencies, inequality, and crises.
Capitalism needs a partner, and that partner is government. Far from being a hindrance, the right kinds of government intervention can make markets more complete, more efficient, and—most importantly—more just. A world where everyone can manage the risks they face is a world where the economy works better for everyone.
So, the next time you hear someone touting capitalism as a flawless system, remind them: Capitalism only works if we complete the picture. And for that, we need a strong safety net, intelligent regulation, and a government that understands its role in making the markets work better for all of us.