Economics and Its Critics

Here and elsewhere, ideology causes conceptual confusion. For example, Smith viewed competition as a basic condition of the invisible hand's operation, because monopolies and oligopolies exploit consumers and restrict production. But only competition among providers of similar products is beneficial. Competition among providers of complementary goods or services is harmful, and can be even worse than a monopoly. (That is why train drivers and pilots, for example, should be forced into monopoly unions that represent all of the other employees of their respective companies.)
The market failures that initially give rise to public-sector intervention tend to recur internationally, which means that competition between states is usually not efficient, either. Examples include competition between welfare states to deter economic migrants, the race to the bottom in taxation, and regulatory rivalry in the banking and insurance sectors. Competition, contrary to what many on the right believe, is not always good.
Of course, ideology often overwhelms terminology on the left as well. Consider “neoliberalism,” a term of derision for many because it has come to be viewed as a doctrine of deregulation and pure laissez-faire. But in Europe, at least, neoliberalism has a very different meaning. It was coined by Alexander Rüstow, who in 1932 proclaimed the end of old liberalism and called for a new liberalism featuring a strong state that lays down a solid legal framework within which firms operate.
Homo economicus, the rationally acting egoist who populates economists' models, has recently attracted criticism as well, because all too often he does not represent the real behavior of individuals. Behavioral experiments have shown conclusively the limited predictive value of this artificial construct.
But homo economicus was never intended to be used for forecasting; its real purpose is to make it easier to distinguish between market failures and mental failures. Economists seek to detect collective irrationality, and economic models that assume individual rationality facilitate that. By ensuring that policies respond to flaws in the rules of the game, not to individuals' fallibility or irrationality, this “methodological individualism” saves us from dictatorial paternalism.
Banks that grant risky loans on too little equity illustrate the analytical value of homo economicus particularly clearly. Their profits are privatized, but any losses exceeding their equity are dumped on their creditors, or, even better for them, on the taxpayers.
This asymmetry turns banking into a casino: The house always wins. Banks choose particularly risky investment projects, which may be profitable but are economically damaging.
The problem is not caused by human irrationality; on the contrary, it arises precisely because bankers are acting rationally. As we know from environmental regulation, preaching common sense or ethics to bankers will not help; but changing bankers' incentives – by, say, requiring higher equity-asset ratios – would work wonders.
Copyright: Project Syndicate 2015 - Economics and Its Critics

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