Adam Smith the 18th century scholar the father of modern economics authored "The Wealth of Nations", it ensures that private undertakings benefit society as a whole when three conditions are met. First, economic actors, meaning people, must always make economically rational decisions. Second, people must be fully informed: they must have all knowledge relevant for making a decision. And third, there must be perfect competition – meaning an infinite number of producers and consumers. In the real world, and especially in financial markets, none of these conditions are met. People do not act in an economically rational manner: social, psychological, biological and cultural factors also influence behaviour.
Also, the banking sector is not particularly competitive: in many countries there are only a limited number of players, big banks that hold a large part of the market. And it may be difficult to prove, but it often appears that there are tacit agreements to limit competition – for example, by not competing too aggressively on the interest rate paid on savings or the interest charged on loans. The most important inhibiting factor for markets “doing their work” is that many operators, from small consumers to governments, lack information. Most people not only have no idea of how our monetary system works but also lack understanding of all kinds of financial products. Many even have trouble understanding their own financial situation. For example, a study estimated four out of five people in the Netherlands were unable to judge the benefits and risks of financial products and that was the best score among the 13 countries surveyed.(1)
In short, the basic conditions for the proper functioning of markets,
established by economic science itself, are not met for financial
markets.Yet the belief prevails that the
market, in the form of a system of profit-oriented private banks, is
the best way to control money creation and allocation.
(1) Study discussed in the Dutch newspaper De Volkskrant, December 23, 2009