Winning Progressive

(By NCrissie B)

This week I consider Yves Smith’s 2010 book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. Today I look at the economic theory that enabled the Great Recession. In the next post, I’ll examine how blind faith in that theory led to deregulation, looting, and the shadow banking system collapse. Then I’ll conclude with Smith’s proposed remedies and our ideas for talking with median voters like our archetypal Fred.

Yves Smith is the founder of Naked Capitalism and has over 25 years experience in finance. A graduate of Harvard College and Harvard Business School, she has worked in corporate finance for Goldman Sachs, was the head of mergers and acquisitions for Sumitomo Bank, and currently heads Aurora Advisors in New York City. She has written for The New York Times, The Christian Science Monitor, and several other print and online publications.

Beyond the Search for Villains

Economists have a mystique among social scientists because they know mathematics. They are quite good at explaining what has happened after it has happened, but rarely before. I don’t think of myself as an economist at all. — Daniel Kahneman, Nobel Laureate

There is no shortage of theories to explain the Great Recession. Villains abound: greedy bankers, bought-off ratings agencies, clueless pension fund managers, shady mortgage brokers, and the working poor living beyond their means. Some blame policies and political actors: regulation, deregulation, taxes, tax cuts, deficit spending, spending cuts, Congress, the SEC, the EPA, Fannie Mae, Freddie Mac, lobbyists, and public employee unions.

Each of these theories has elements that seem plausible, and parts of each may be true, yet Yves Smith argues that none addresses the deeper issues: a flawed theory – neoclassical economics – and the almost unchallenged acceptance of that theory by business and political leaders.

Dr. Kahneman’s statement nicely encapsulates the opening three chapters of Smith’s book. Applying rigorous, scientific-seeming mathematical equations and logical proofs, neoclassical economics claims to offer a comprehensive theory of how markets work. By implication, it also claims to offer a policy roadmap for government. Create the conditions described in the theory – the neoclassical argument goes – and markets will work as the theory proves: efficiently and to the benefit of everyone. Yes, some will benefit more than others, but even the poorest and most vulnerable will still be better off than they would have been under any other system.

Storytelling with Mathematics

Given the conditions that serve as premises for neoclassical theory, that ideal outcome would happen. The equations prove it. Yet however much neoclassical economics looks like a science, Smith writes, as applied to Realworldia the theory is little more than “storytelling with mathematics.”

The break point between science and storytelling, she argues, exists in those “conditions that serve as premises.” Specifically, neoclassical theory presumes:

• Rational economic actors – This means that every actor seeks to maximize his/her utility (most gains, least costs) as predicted by game theory equations that include calculable benefits, risks, and probabilities.
• Individual, equal actors – All economic actors act as individuals, each with equal market influence.
• Efficient markets – This refers to information about transactions, and proposes that every actor quickly has access to (or that prices already reflect) all relevant information about any transaction.
• Zero transaction costs – This means a frictionless market where it costs nothing to conduct a transaction, such that any buyer can shift from seller to seller, and any seller from buyer to buyer, with no loss in utility.
• Liquid, continuous, uniform markets – This means that any good or service that anyone might want can be bought or sold, that the market will remain open indefinitely such that a buyer can resell any unused good or service, that any specific good or service is indistinguishable from others of that type, and that all buyers want and will accept an equal quantity of any given good and service.

If all of those conditions (and a few others I didn’t list) exist, the equations of neoclassical economics prove that every buyer will find one or more seller, every seller will find one or more buyers, and the result will be a Pareto optimal equilibrium where no actor can improve his/her position without harming one or more other actors in the market, who would and could act within the market to block that attempt.

What happens if one or more of those conditions does not exist? In ‘free market’ ideology, the answer is that all of those conditions would exist, if only government would get out of the way. As is said so often, “It’s Economics 101!” Welcome to Marketopia.

Economics 102: Meet Lipsey-Lancaster

Meanwhile, back in Realworldia, we know that not all of those conditions do exist. Indeed not all of them can possibly coexist. Humans are not entirely rational – in game theory terms – nor do we act only individually or have equal market influence. Even if humans could and did act with perfect game theory rationality, we would still need all of the relevant information about a given transaction. Goods and services are rarely if ever identical to others of the same type, and sellers often know more than buyers about the advantages and disadvantages of the goods and services they offer. As rational actors, sellers could and would (and can and do!) try to conceal some of that information, and profit on the resulting information asymmetry.

What’s more, any attempt to ensure every actor has all relevant information about each transaction will inevitably create transaction costs (to research and ensure full disclosure of that information). It is not possible – not even as a theoretical exercise – for markets to be both information-efficient and transaction cost-free.

And here’s the kicker: back in 1956, economists Richard Lipsey and Kelvin Lancaster showed – with the same rigorous mathematical equations and logical proofs – that if you can’t meet every required condition for a Pareto-efficient outcome … you cannot assume the next best strategy is to ‘perfect’ each of the remaining conditions. Indeed, the next best possible outcome almost always requires moving one or more of the other conditions away from the theoretical ‘ideal’ states.

In plain language: if not every human will be a rational actor, or if not every human will act as an individual and have equal market influence, or if not everyone will have all relevant information about every transaction, or if their are transaction costs, or if not every market is liquid, uniform, and continuous … trying to push the other conditions to their ‘ideal’ states will almost always make the system worse.

There’s good news. Economists know the weaknesses of neoclassical theory, and that’s why only 3% of economists are “strong supporters” of ‘free market’ solutions. Alas, too many other, louder economic voices – pundits and business and political leaders – keep yelling “It’s Economics 101!” … and tomorrow we’ll see how their blind faith in the flawed neoclassical theory guaranteed the Great Recession.

(Crossposted from Blogistan Polytechnic Institute (BPICampus.com))

Tags: Bush Recession, Daniel Kahneman, ECONned, economics, Efficient Market Theory, Great Recession, Kelvin Lancaster, Lipsey-Lancaster Theorem, Naked Capitalism, neoclassical economics, Pareto Efficiency, rational actor, Richard Lipsey, Yves Smith

This entry was posted on Tuesday, August 7th, 2012 at 7:33 am and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.