Changing Economic Paradigms, 2014

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Since the eighteenth century, when modern thinking about economics got underway we have been through four economic paradigms.

The first was Adam Smith and Classical Economics, of the power of the ‘invisible hand’ to find the most efficient market solution, regardless of the desires or the intents of the participants. Nevertheless, it is clear from Smith’s views on the importance of sober business, on rentiers, and on usury (see panel Investment: From the Sober to the Profound), and from the combination of The Wealth of Nations and The Theory of Moral Sentiments that he favoured intervention where market solutions fell short of the best that society might achieve.

Then came Keynesian Economics in the twentieth century, following financial crises starting in the late nineteenth century and climaxing in 1929. From this it was clear to Keynes that markets were not necessarily self-correcting, at least in time frames that were useful to society. Keynes also understood that economies could have cyclical fluctuations (alternating between unsustainable fast growth, and depression), but also that governments could counteract this, for example through infrastructure investment during periods of depression, when they could only lift the economy out of depression, but got a bonus of being able to borrow for investment at low cost. But Keynes diverse output also includes highly readable essays such as Economic Possibilities for our Grandchildren which still stimulates responses amongst top economists today, including Nobel laureate Joseph Stiglitz.

Then, by the late 1960s it was clear that classical Keynesian wasn’t providing all of the answers either, with periods of ‘stagflation’ (high unemployment, no economic growth and inflation). In addition, state monopolies (nothing to do with Keynesian economics, but associated with it anyway — the problem is monopolies, whether State or private) were clearly not efficient, and not serving the customers well.

So, there was a revival of ‘Neoclassical’ economic theory. Some of this is reasonable enough. Much is based on elaborate theoretical assumptions with limited empirical evidence or testing. Some of it was to a specific set of value judgements, some would say a political agenda, arguing for less regulation and less taxation of the wealthy, asserting that this would motivate them to work harder, and their additional spending would trickle down to make everyone better off. This was difficult to maintain, with increasing amounts of wealth tied up in “socially useless” speculative financial investment of the type that Adam Smith abhorred, levels of inequality were increasing to levels not seen for a century, and its fundamental economic assertions were increasingly disputed. Neoclassical economics, fairly or not, became associated with Greed is Good, and with having helped create the conditions for the 2007-08 banking crash, and seen as discredited, most creatively and challengingly so in Kalle Lasn/Adbuster’s Meme Wars.

The most recent paradigm shift, and interest, centres on Behavioural Economics, which is founded on observation and experimental tests of hypothesis about how people really act as individuals and collectively in an economy. The results are producing some very different prescriptions for how to generate economic prosperity and stability for the greatest number, and as part of that appears better equipped to deal with the challenge of the trend bending agenda. The New Economics Foundation summarised the implications of Behavioural Economics as:

  • Other people’s behaviour matters—people copy behaviour and do things when they feel others approve;
  • Habits are important, and hard to change, even when people may want to;
  • People can be motivated to ‘do the right thing’ without financial reward. Indeed, payment can undermine intrinsic motivation (think how you would react if your friends offered to pay you to visit them);
  • People want their actions to be consistent with their values;
  • People are loss-averse, hanging on to what they consider ‘theirs’ even if it is not rational to do so;
  • People are bad at quantifying—they put undue weight on close events and too little on far-off ones, and are strongly influenced by how information is presented; and
  • People need to feel involved and effective to make a change—simply giving incentives and information is not enough.

Any Social Darwinists still believing that economics and business practice is based on simple competition red in tooth and claw, needs to be aware that the underlying science has moved on. Behavioural Economics builds on Robert Axelrod and William Hamilton’s classic 1981 Science paper, followed by Axelrod’s Evolution of Cooperation, which confirmed that cooperative strategies can penetrate selfish societies and maintain themselves against selfish counter-strategies. Evolution is now understood to be the result of a ‘creative tension’ between competition and mutually beneficial collaboration — something that, as Andy Gardiner and Kevin Foster have pointed out, would not actually have come as surprise to Darwin. Indeed, at the most basic level, as Lynn Margules (then Sagan) first realised, in 1967, every cell in our bodies is a mutually beneficial collaboration between at least two life-forms, and ‘higher’ plants have added another, and their roots host and swap nutrients with fungi. And economists aware of behavioural and social science, such as Nobel Prize wining economist Eleanor Ostrom have given us a better understanding that the best economic returns from common resources also come through collaboration. Mathematical ecology, with its understanding of networks, flows, and the conditions that create stability or instability in communities is now also influencing economics, with ecologist and ex UK Chief Scientist Robert May and Andy Haldane, now Chief Economist at the Bank of England, publishing a joint paper in Nature drawing upon ecological network theory to analyse stability threats to the global banking system.

So what’s all this got to do with Long Finance? In each of these phases, economic theory has influenced investment practice directly and indirectly through government policy. To cut a long and important story short with one dramatic example (well told in Akerlof & Shiller’s Animal Spirits (the phrase itself borrowed from Keynes)), two neoclassical economists Scholes and Merton used their Nobel-Prize winning mathematical theory to set up a hedge-fund company in 1994 called Long Term Capital Management, LTCM which was supposedly a one way bet to fortune. By 1997 the fund had $7 billion of funds with a heavy commitment of major US financials, and made $2.1 billion profit. Unfortunately it required, among other things, investors to retain neoclassical detachment through the massive fluctuations in value that the theory exploited to make its ultimate profit. Unfortunately for Scholes and Merton, not all investors, nor the wider world, are neoclassical stoics. If they start panicking, a chain reaction results in a fund collapse. Indeed, as relayed by Hersh Shefrin, Behavioural Economists Shleifer and Vishny had, before the fact, incorporated the likely behaviour of markets into the model, predicted the outcome and communicated the results to Scholes and Merton, although there was not much by then that the latter could do about it. Later in 1997 the real world went off model limits with a Russian and Asian currency crisis resulting in panic, leaving the major financial institutions with catastrophic future commitments which they assumed would never materialise. The US Fed gave $3.65 billion to these institutions, nominally to buy-out LTCM, but in reality to prevent a financial collapse of US core institutions. It is only because this was rapidly followed by the dot.com bust, the US real estate crisis, and the 2007/08 financial crash that this dramatic event has already faded from memory. In a final irony, the Nobel Prize was awarded to Scholes and Merton in 1997, just before the collapse.

The direction that economics is heading is likely a creative and nuanced fusion of (at least) the best parts of Keynesian, Neoclassical and Behavioural economics — perhaps lying at some as yet undefined point between Meme Wars and CoreEcon (Slogan: “teaching economics as if the last three decades had happened” — although, in the beta, there are still masses of neat two dimensional neoclassical style graphs, without accompanying sections called ‘Testing the Theory: Empirical Evidence’ with lots of messy real world data).

The defining features of this new paradigm, we believe, will recognise the creative tension between competition and collaboration and address the STEPS-3D agenda. So it will underline the importance of maintaining diversity and flexibility, and avoiding monopolies and ‘too big to fail’ institutions. It will pay more attention to the distribution of wealth, recognising that inequality reduces and slows the creation of well-being. Also — as resource and social issues become increasingly obvious — economics will focus more on direction: pointedly asking “What is the point of innovation?” to which we think there is no better answer than creating the world where nine billion can live well.

From Future Business, Long Finance, updated 2014, MMG