The Ethics of Economics

This bothers me, it really does. Here is today’s column under the masthead of ‘Freakonomics’ in the New York Times: Diamond and Kashyap on the Recent Financial Upheavals – Freakonomics – Opinion – New York Times Blog

Now I understand the good intentions. The amazingly popular Steve Levitt, author of the Freakonomics column has prevailed upon two University of Chicago economists to provide a simple explanation of the turmoil in the financial markets.

Great.

But they miss the much larger and more fundamental point. This melt down is as much a melt down of economic theory as it is of practical finance.

The Chicago school of thought in economics is predominant in today’s academic circles. It provides the basis for what we learn in every major economics text book. In the trade it’s known as ‘neo-classical’ economics and is tightly associated with the University of Chicago and the late Milton Freidman amongst others.

Since the arrival of Reagan in the White House, America has run its economy increasingly according to the tenets of the neo-classical model. The basic rules of the model are familiar to anyone who has followed politics during the past three decades: government is a problem, reduce regulation, allow markets to go ‘free’, cut taxes, and generally let individuals be unfettered from restrictive laws. The idea being that once markets are free they will generate more wealth than a government controlled market can. The theory that supports this conclusion is too arcane for most people or politicians to bother with so there is a tendency to take the academics word as gospel.

The problem is that once the theory is exposed to daylight it looks very insecure. Unlike scientific theories like those of physics or chemistry, it fails to predict anything well and cannot be thoroughly tested against empirical, real world, evidence. It is more concerned with its own internal logical consistency than with explaining how economies actually work. More to the point it sets out to prove that markets are better than any other form of allocation model [that’s what a market does: it is a mechanism for allocating scarce resources across competing multiple needs]. So boiled down to its essence: neo-classical theory starts with a set of assumptions cherry picked such that the conclusion is that markets are efficient and other methods of allocation are not.

This is more ideology than theory. So it not surprising that right wing politicians the world over preach from the neo-classical playbook. It advocates unfettered capitalism. Thus the Republican infatuation with ‘market forces’.

The problem is that nowhere is there a truly free market. Nor can there be one … people are not automatons and make mistakes. The result is that the theory is hopeless in the real world.

Nevertheless we have been governed by free market ideology since Reagan. Moreover most, if not all, the wizardry on Wall Street [those fancy products called derivates] are built upon financial theories that are a subset of neo-classical economics. So here we have practical banking being distorted by fallacious modeling. Sooner or later the contrast between reality and theory was sure to show up.

Throw in the inept way in which financial markets were deregulated back in the 1990’s and it is more surprising that the current meltdown took so long arriving.

So that’s what annoys me when I read Chicago School professors explaining what’s going on without issuing a vast ‘mea culpa’ along with their opinions.

Guys: you’re what’s wrong. Maybe we need an ethics test for economics professors. Perhaps they should shut up and find a better theory. But I suspect the wait for a better theory will be a long one while the neo-classical model reigns supreme in our universities … they don’t even acknowledge that’s it’s part of the problem!

Meanwhile those of us who have to deal with the consequences of appalling theory should clean up and muddle through unguided by any support from academic economists. Maybe we can get their attention by cutting off funding for their research?