This is the second piece in OurKingdom's "Uneconomics" series.
Last week I sat next to a tutor in Political Geography at dinner at an Oxford college. He told me that when his students first come to him, they all believe that human behaviour is simply that of individualistic profit-maximisers. If this is the belief of young geography students, what hope is there that young economists will think otherwise?
Neo-liberal ideology has entered the received wisdom of much of the developed world to an extent which must surely exceed the wildest hopes of Friedrich Hayek, or Milton Friedman, or Margaret Thatcher. This ideology is based on amnesia about three simple propositions.
The first important thing which many economists have forgotten is that human beings, even in their economic behaviour, are social animals, collaborative as well as competitive. Secondly, they have forgotten that intended actions have unintended consequences. Thirdly, they have forgotten that markets operate only according to the rules that people set for them. And the popular version of this amnesia leads to the simplistic mental model of my dinner companion’s students. Each of these propositions, taken alone, is almost banal. Their consequences are far-reaching.
We now know enough about human nature to know why and how the concept of individualistic, self-seeking ‘economic man’ is grossly inadequate. Behavioural economists have shown that people are not always ‘rational’ in the sense used by economists, and indeed that they usually cannot know what their ‘rational choice’ might be. Neuro-scientists, anthropologists and social psychologists have learnt a great deal about the determinants of human behaviour in different institutional settings.
The broad outline of their results is unequivocal and has far-reaching implications for the ways in which society is organised. People, as social animals, take note of what they are told by people whom they trust. They often collaborate rather than compete, and are influenced as much by social approval and by habitual relationships as by any apparent price incentive. Their behaviour is strongly influenced by the nature of the institutions of the society in which they live.
The implications are far wider than just the suggestion that policy-makers should ‘nudge’ the public to behave in suitable ways. One of their results is to show that people are not only happier, but also work better, in more constructive ways, if they feel that their views are fully taken into account. It follows that co-operative, collaborative ways of organising work are likely to be more constructive, more productive and indeed more innovative than authoritarian top-down systems. It also follows that people, as citizens, prefer to have their views properly discussed. Where there is insufficient consultation, protest is the natural response.
A further implication of the deep-seated need for people to communicate with one another brings us nearer to the traditional areas of economics. Over the past couple of centuries, we have seen the ‘commodification’ of one area of activity after another. The benefits of smoothly functioning markets really do arise when simple commodities - standard goods - are exchanged in a market transaction. But the commodification of more unusual goods - things that people buy only a few times in their lives and about which they therefore do not know much - and still more, the commodification of services – things that people do for one another, is quite a different matter.
People prefer to make such transactions in discussion with other people whom they can trust, who have better knowledge than they do of the product or service in question, indeed who have a degree of professionalism. Think of mortgage brokers, or doctors or teachers or solicitors or even car dealers. The purchaser’s knowledge of the properties of the good or service is always imperfect – and the seller’s knowledge is much better, even though there are inevitable gaps and uncertainties. So it is unhelpful to try to de-personalize transactions where professionalism and a relationship of trust are crucial to the customer’s (or the citizen’s) satisfaction.
Finally, there are important consequences for policies to promote innovation. Steven Johnson has drawn on neuro-science to describe how new connections within the brain – the fundamental physiological basis for innovation – seem to come about by sharing ideas with others and then brooding on the ‘hunches’ to which such stimuli appear to lead. It follows that what he calls a ‘coffeehouse environment’ is the best way to encourage innovative ideas. Small groups who bounce their ideas off each other produce more innovation than the solitary inventor in his study or his laboratory. Innovative performance depends in large part on the culture within which the innovators operate.
The governance challenge
Economic policies, like management policies, must always take account of all the foreseeable significant effects. A banal way of expressing this is as the need for ‘joined-up thinking’. Another way is to say that firms, and governments, and economic actors of all kinds, should take account of all their ‘stakeholders’ when they take their decisions. Only a body which has authority to influence the behaviour of the economic actors can make sure that these spillover effects are taken fully into account. The frame for the decisions may be delineated by local bye-laws, or national or international legislation, or simply the influence of a strong shared culture. An overwhelmingly important frame, which has been taken for granted for far too long, is of course the world environment.
We face unprecedented shortages and threats. Climate change, of course. But there are other, equally sinister, threats. A growing population – 7 billion now and an estimated 9 billion by 2050 – places an intolerable strain on scarce water and land resources. There is simply not enough land in the world which can be used for growing crops, nor water to irrigate them. Industrial production uses land and water too. Climate change leads to growing volatility of weather - there are already more floods, more tornados and more droughts. These strains, plus the general heating effect of climate change, provide a threat to biodiversity which, if unchecked, is likely to lead to an extinction of species greater than any since the end of the dinosaurs.
Despite the desperate rate at which carbon is being pumped in to the atmosphere, the growing water shortages, the shortage of arable land amid increasing desertification, the decline of fisheries and the burgeoning populations, especially in India, the Middle East and Africa, there may still be time – just – to avert the worst disasters. Lester Brown estimates the cost of a programme to arrest the deterioration of the soil, to restore fisheries and to protect biodiversity and to achieve basic social goals which would allow people in the poorest countries to adopt improved ways of life at little more than one quarter of the US military budget.
The way out of the world’s problems cannot be to go back to some Golden Age before the Industrial Revolution. The technologies of those days would simply not allow a population as large as that which we have in the world today to be fed, and housed, and kept healthy. We have to depend on modern technologies – but we have to be carefully selective in the technologies which we promote.
Our difficulties in dealing with these problems are primarily political and economic. Are countries prepared to put suitable incentive structures in place, to make people want to behave in environmentally sensible ways? Are they prepared to tackle the horrendous problems of corruption in developing countries and rich countries alike? Are governments prepared to pay for, or at least facilitate, the infrastructure developments which are needed? Are international bodies sufficiently strong to assure the international transfers which are needed? And to police them? Can anti-corruption measures such as those promoted by Transparency International be made strong enough to allow resources to be used for the purposes for which they were intended?
Solutions to these problems require enormous – but not impossible – changes in priorities and decisions at all levels – individual, local, regional, national and international. And discovering them will require recognition of my third proposition, that markets operate only according to the rules that people set for them.
No market can exist without some agreed process for the exchange of goods or services. Such an agreement implies some form of collective action. The simplest form of action is to arrange the location and time where exchange takes place. More sophisticated markets operate within a legal framework. This may include, for example, quality control of goods exchanged, health and safety regulations for their production, or measures to ensure that a ‘fair’ price is charged, whether through monopoly legislation or in any other way.
It follows that there is nothing necessarily good about de-regulation. Some regulations are good and work well, others are ineffective or worse. It is an empirical question in each particular case as to what the best balance between legislation (reinforced by administrative controls) and unfettered competition may be.
Risk and uncertainty
One particular distinction, forgotten by much neoliberal policy-making, is that between ‘risk’ and ‘uncertainty’. This particular piece of amnesia allowed the 2008 financial crisis to occur. De-regulation made possible the behaviours which led to the crash, but the particular reason why de-regulation led to disaster was because it allowed financial institutions to treat uncertainties as manageable risks. Firms as well were encouraged by the over-riding imperative of the short-term profit motive to cut corners, to assume that disasters were for other people, even in circumstances of great uncertainty like deep-sea drilling.
What then is this distinction? Risk is a statistical concept, which tells you how frequently you can expect a particular occurrence of any well-known phenomenon to occur, under normal conditions. The whole important activity of insurance is based upon such functions, and there is nothing wrong with this, provided there have been sufficient occurrences to allow risk to be calculated with confidence. If a large tsunami occurs only once in 100 years, you do expect it occasionally to happen. You take a calculated risk when you decide how high a sea wall to build.
But uncertainty is different. It arises when you do not have enough experience of the phenomenon in question to be able to calculate it statistically. It arises when you are concerned with a particular instance rather than with the generality of cases. It arises when you drill deep into a sea bed with geological characteristics about which you are uncertain. It arises when you launch a new type of financial product which packages sub-prime mortgages.
Economics as an art
How might revised ways of thinking be induced? For without revised thinking, economists can have little useful input into policy.
Let us step back for a moment and think about the nature of economics. Economists study the behaviour of individuals, organisations and institutions with regard to the production, distribution and exchange of goods and services. When they think that they understand a phenomenon, they construct a model to describe what they have found.
Until the middle of the twentieth century, such models were in large part qualitative. Neither the data – statistics – nor the tools to handle such data on any large scale yet existed. This did not prevent Adam Smith and Karl Marx, Joseph Schumpeter and John Maynard Keynes from developing invaluable insights into economic behaviour. All of them have a great deal to offer to the present day. Most economists viewed economics as a largely qualitative study, concerned in the first place with understanding the nature of economic behaviour and its determinants and only then, with a small amount of quantification, with considering possible interventions.
Gradually, as statistical data increased and quantitative methods became more sophisticated, economists became preoccupied with describing rather than understanding. Underlying assumptions tended to be taken for granted and the determinants of economic behaviour were increasingly presented in mathematical terms. The pinnacle of mathematical modelling was reached by the ‘quants’, whose cocksure modelling of financial markets played a significant part in the build-up to the 2008 crisis.
We must start by convincing people that change is possible. There is much to learn from the story of how neo-liberal ideology became dominant. To start to replace it, a far-ranging programme of public education and open debate must begin.
The teaching of economics needs to be changed from top to bottom. Students need to have a grounding in economic history, set in its social and political context. They need to learn some social psychology, drawing on insights from neuro-science and anthropology. They need training in social science research methods focussing heavily on areas which are often neglected in the training of economists – all the ethnographic methods. They need to think critically about selecting indicators; about the design of questionnaires; about the crucial importance of the assumptions when building models. They need to study the operation of current economic organisation set in its political context. And they need some understanding of the rich heritage of economic thought.
Economics went wrong when it tried to ape what economists perceived to be ‘proper’ scientific method. We need to recognise that the practice of economic policy is an art, and that it needs to be a very public art, widely debated in every democratic society. We need a public literate in a revised economics, who can take active part.
Professor Judith Marquand served in the Government Economic Service for 25 years and is now a Member of Wolfson College, Oxford and author of Development Aid in Russia: Lessons from Siberia (Palgrave, 2009)