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Saturday, November 22, 2008

Guess what? Self-interest is bad for the economy

Simon Caulkin, The Observer management

Sunday November 16 2008

If you thought you felt the earth shudder on 23 October, you were right. When Alan Greenspan told the House Oversight Committee 'I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms', the effect was the same as Frodo and Sam casting the Ring of Power into the fires of Mount Doom at the end of The Lord of the Rings: the edifice of 21st-century management shook to its foundations.

Self-interest as the driver that, like an invisible hand, permits individuals acting on their own behalf to benefit society as a whole goes back to Adam Smith. But Smith at least realised the drastic inequities it would cause and proposed measures, including progressive taxes, to mitigate the worst effects. No such caution has been in evidence since the 1960s as the concept has become the central belief around which all Anglo-American corporate governance, and thence management as a whole, revolves. Self-interest (and the need to guard against it) is the reason for dividing the chairman and chief executive's role, just as it is for setting executive and non-exec directors against each other; self-interest justifies and encourages individuals to demand vast pay (including in the public sector) without thought for the consequences; finally, a near religious faith in the power of self-interest to both motivate and police is the foundation on which, as Greenspan now regrets, Wall Street's rocket scientists erected the teetering superstructure of debt instruments crashing down around us.

The real-world consequences of a commercial universe with self-interest at its heart thus give the lie to previous assumptions about how individuals and organisations work. In this sense, Greenspan's mea culpa might be likened to the Vatican's admission in 1992 after a 13-year inquiry that Galileo had, after all, been right ('It's official - the Earth moves round the sun,' as the Chicago Sun-Times caustically put it at the time). Common sense suggests a number of reasons why self-interest-centred commerce is as flawed a model as an Earth-centred solar system. Self-interest contains within it the seeds of its own destruction. It drives for reward, but once rewards reach a certain size it can no longer function as a discipline. When rewards were less high, self-interest was tempered by the need to nurture the reputation a career depended on. With salaries at current stratospheric levels, however, self-interest provides no such restraint, since careers are redundant. Anyone who has done one big deal - or worked in the City for more than a few years - never need work again. Far from being a restraining influence, in these circumstances self-interest promotes a short-term focus on transactions that in turn amplifies its second baleful impact: increasing distrust. As anyone not blinded by fundamentalist zeal must see, the obverse of the coin of self-interest is lack of trust - and both are self-reinforcing. The swelling of self-interest is in direct proportion to the draining away of trust, the cumulative results of which are now visible all around us.

An interesting recent article in the science weekly Nature, signalled by a correspondent, laments how dependent economics is on unproven axioms, and how resistant to empirical observation. In the physical sciences, notes the (physicist and hedge-fund manager) author, researchers 'have learnt to be suspicious of axioms. If empirical observation is incompatible with a model, the model must be trashed or amended, even if it is conceptually beautiful or mathematically convenient'. Not so in economics, whose central tenets - rational agents, the invisible hand, efficient markets - derive from economic work done in the 1950s and 1960s, 'which with hindsight looks more like propaganda against communism than plausible science. In reality, markets are not efficient, humans tend to be over-focused on the short term and blind in the long term, and errors get multiplied, ultimately leading to collective irrationality, panic and crashes. Free markets are wild markets' - for which classical economics has no framework of understanding.

In fact, it's even worse. It isn't just that, as the author points out, economics has been remarkably incapable of predicting or averting crises such as the present credit crunch; through the medium of management based on its faulty assumptions, it has actually helped to cause it. It's an error to think that management, or even economics, can ever be a 'hard' science, not least because of their self-fulfilling premises. That doesn't mean they are unworthy of study and understanding. On the contrary. But, as Greenspan sorrowfully acknowledges, the first step on that path is to bow to empirical observation and stop trying to prove the Earth is the centre of the universe.

[It would appear the greed is not good after all. Who would have possibly imagined that?]

6 comments:

Thomas Fummo said...

I felt the earth shudder on the 23 of October, alright!
I became.... a MAN!

and Mr. Greenspan stated the bloody obvious, apparently.

CyberKitten said...

TF said: I felt the earth shudder on the 23 of October, alright!
I became.... a MAN!

Really? Congratulations.....

TF said: and Mr. Greenspan stated the bloody obvious, apparently.

Unfortunately sometimes the bleeding obvious has to be stated....

shrimplate said...

Very well said. I have long been suggesting to so-called free-market capitalist aquaintences that their beliefs should be subject to actual scietnific enquiry.

I think you know what happens when I bring that up in conversation... They insist in quite strong terms that the deck chairs must be rearranged.

Scott said...

There are a lot of people who predicted this exact mess. There is such a thing as economic law and despite Mr. Greenspan's past rhetoric he did much in his time at the Fed to interfere with the natural progressions of the economy.

As for self interest, I agree that it's bad for an economy. So clearly the solution is getting the self-interested politicians out of it.

CyberKitten said...

scott said: As for self interest, I agree that it's bad for an economy. So clearly the solution is getting the self-interested politicians out of it.

So you think that the problems of one of the most unregulated financial systems in the world can be resolved by even less regulation?

I suspect that you believe that a deregulated 'free' market would be more efficient? Where in fact it would most probably quickly degenerate into monopoly and cartel - which would hardly be free.

Personally I think that the problem with the market is the market itself. We need a completely new paradigm for the economy.

Scott said...

"So you think that the problems of one of the most unregulated financial systems in the world can be resolved by even less regulation?"

Uh, well look, I don't see how our economy or financial market could be considered the most unregulated financial markets in the world. Like most economies we have a central bank which sets interest rates artificially low in times of perceived economic stagnation, which creates a bubble as banks get lots and lots of money to lend to people and, of course, make loans they wouldn't have if there was no easy credit. When the malinvestments come to default the bubble bursts and we have bad economic stagnation. Which triggers the central bank to lower interest rates and give more liquidity to the banks to create another bubble. Which creates malinvestments. Which causes economic stagnation when the bubble bursts. Which triggers the Fed to reduce interest rates.

geddit?

Just look at that goof Paul Krugman telling Dubya to MAKE the banks loan money. Gee, when did THAT get us into trouble last? Surely not in the housing market.

"Where in fact it would most probably quickly degenerate into monopoly and cartel"

Would it now? See the only monopolies we have in this country are the ones set up and protected by the State. It takes the State's guns to protect the big from competition starting up to out perform them.

The power of cartels on the other hand is vastly over stated. Just look at Opec and it's frantic efforts to cut production to keep the price of oil from dropping. How's that going for them?

"We need a completely new paradigm for the economy."

Well see there we can agree. Centrally planed economies and Keynseyian economics have had their way for long enough. Time for an economy completely free of putting guns to peoples heads and demanding they pay for services.