Economyths - ten ways economics gets it wrong Part 11

That's entertainment.

The next example is the vexed issue of bankers' bonuses. After the crunch, these were defended by bank executives on the grounds that bankers are like entertainment stars, and firms have to pay whatever it takes to get the best talent. Their activities also make a significant contribution to GDP. Stuart Gulliver from HSBC compared his team to Hollywood actors. John Varley, the chief executive of Barclays, preferred the soccer a.n.a.logy. "There is simply no higher priority than to ensure we field the very best people. That in a sense is exactly the same as a football [soccer] manager if they are going to win. Our obligation is to ensure we pay appropriately."16 Bill George, a director of Goldman Sachs, went for both: "It's much like professional athletes and movie stars."17 Perhaps fearing an AIG-style backlash, the London Investment Banking a.s.sociation - which represents firms including Goldman Sachs, Morgan Stanley, and JPMorgan Chase - criticised a plan to publish bonuses on the grounds that it would "create the potential for ill-informed and populist public commentary on reasonable remuneration practices."18 This topic might seem like a distraction, but it does bring up a number of interesting technical points that also apply to other aspects of the economy:* The salaries of bankers do follow the same dynamics as those of CEOs or entertainment stars (Chapter 7). That doesn't mean they are appropriate or reasonable. According to one UK survey, 96 per cent of people believed that premier league soccer players are overpaid.19 * We are a little more willing to tolerate high salaries in the case of actors or sports stars because they are entertaining and don't crash the economy. Important hint: bankers don't get asked for autographs.

* Nonetheless, many sports leagues such as the National Football League and the National Hockey League in North America have inst.i.tuted salary caps to level the playing field.

* In England, professional soccer players today do earn ma.s.sive salaries similar to those of top bankers. But they don't play that well as a team. The last time England won the World Cup was 1966, when salaries were orders of magnitude smaller.

* Mathematical models predicting movie box office returns have shown that actors and directors play a surprisingly small role in determining ticket sales.20 Salaries therefore say more about the Hollywood star system than about profitability. Harrison Ford became famous because of Star Wars, not vice versa.

* Banks have an important positional advantage in the economy. For example, the fractional reserve system sanctions them the power to effectively produce money by lending out more than they have. Such rights and benefits are a property of the financial network as a whole, rather than individuals.

* Companies are also reliant for success on inst.i.tutional reputation, not just lone stars. Lehman Brothers, for example, was founded in 1850 and had a formidable reputation that helped it attract business.

* In finance, skill is important, but so is luck. If 100 traders take high-risk leveraged bets over a period of several years, there will be a big spread in results by chance alone. That doesn't mean the winner is a genius.

* Large bonuses incentivise traders to make reckless decisions, resulting in "negative externalities" such as global recessions.

* In the UK, the financial sector did make an outsized contribution to GDP before it had to be rescued following the credit crunch.21 However, its growth coincided with a decline in manufacturing and technology - not surprising when the default destination for talented science students is finance - along with a rise in problems a.s.sociated with social inequality.22 Instead of needing protection, maybe it's just too big.

Finally, you don't need to be the Pope to see that there is an ethical dimension to all this. Although as it happens, the Pope did speak out against the culture of greed, saying that: "He who builds only on visible and tangible things like success, career and money, builds the house of his life on sand."23 As discussed in Chapter 4, when sand piles get too high they have a tendency to fall down. Rowan Williams, the Archbishop of Canterbury, told the BBC that bonuses should be capped, and said: "What we are looking at is the possibility of a society getting more and more dysfunctional if the levels of inequality that we have seen in the last couple of decades are not challenged."24 When a sector like finance or natural resources becomes too large, it also fosters rent-seeking behaviour (extracting income without contributing to real productivity) and the growth of a corrupt and dependent political cla.s.s.

At a speech to a banquet of dignitaries in 2009, the Lord Mayor of London, Ian Luder, said: "It is banking activity, international banking activity, which makes the world go round."25 But the reality is that banking is just one of many vital services supporting the economy. The main thing that makes it unusual, for such an important profession, is its failure to develop sound ethical standards. Doctors and engineers have ethical codes; bankers have dress codes.

One positive aspect of the controversy over banker compensation was that it helped destroy the illusion that salaries accurately reflect a person's contribution to society, and showed the importance of ethics and fairness. A more important issue is of course the salaries earned by the bottom 50 per cent of the world's population. In terms of the movie a.n.a.logy, they are currently the equivalent of the extras in a Hollywood film who get their appearance cut from the final scene. They are the children playing soccer on the Brazilian beach who don't get spotted by talent scouts and sold to Manchester United. But if we change our definition of economic efficiency to that of the Happy Planet Index - in which the aim is to be happy while consuming few resources - then they have more to teach us than our financial elite. A suitable subject of study, perhaps, for a multi-disciplinary Inst.i.tute of Systems Economics.26

Dirty oil.

The third example of an ethical quandary is from Alberta, whose boundaries happen to include the planet's largest reservoir of bitumen - a form of crude oil mixed with sand, minerals, and water. Companies including Suncor, Syncrude, and Sh.e.l.l have found that they can extract the crude oil, either by first sc.r.a.ping up the land or by using newer in situ techniques, and sell it on the open market at a profit. By normal economic accounting procedures, the operation makes a lot of money and boosts GDP. On the negative side, it also destroys vast swaths of the boreal forest, consumes incredible quant.i.ties of water, emits equally incredible amounts of pollution in the extraction process, and has blackened Canada's reputation as a green country.27 The expression "low-carbon economy" is not what comes to mind.

There has long been local opposition to oil sands development from environmental organisations, indigenous groups, academics, and others. 28 In August 2009, though, the oil sands became a hot political topic in, of all places, Norway. The Norwegian company Statoil started a $2 billion project in Alberta in 2007. But during the 2009 election campaign, most of the Norwegian political parties came out against the involvement. An editorial in the main newspaper Aftenposten wrote that Statoil and the government were showing a "collective denial of responsibility" for oil sands emissions. The leader of the Christian Democrats party, Dagfinn Hoybraaten, said that: "in our view, this is more than a regular business issue. It's an overall ethical issue."29 The response of Alberta premier Ed Stelmach was: "I'm not aware of Statoil. All I know is these last couple of weeks there has been just a huge renewed interest ... more and more news [is] coming from large pension fund managers that are looking at Alberta as a great place to invest."

Albertans are famously resistant to suggestions from outsiders on how to manage said resources. It is also probably true that oil sand emissions are less of a threat to the planet than, say, Chinese or American coal. But two things are clear. First, Hoybraaten is right - there is an overall ethical issue, which needs to be discussed. Second, pension fund managers aren't paid to make ethical decisions or enforce standards. That's one of the jobs of governments. So when we delegate sensitive decisions to pension funds, there is a problem. Why should fund managers argue that we cap the rate of oil sands production, give the land time to repair, or spend money on improving the technology, if these harm short-term profits? Again, market norms are no subst.i.tute for ethics.

Nor can we delegate ethical decisions to our role as consumers or investors. One property of ethical violations is that their impact seems to decay with distance and separation. If we all bought our clothes directly from the people who made them, then their working conditions would probably loom somewhat larger in our consciousness than they presently do. With global supply chains, it's rarely clear where the objects we consume even come from, and we can't factor ethical decisions into judgements of price. We therefore need strong inst.i.tutions and laws that enforce ethical standards at source in a uniform and democratic fashion.

It is encouraging that developments like the oil sands or climate change are increasingly being framed in an ethical rather than a purely market context, because once ethical judgements are established, in the form of laws or social taboos, they tend to be long-lasting and will eventually outweigh even the profit motive.30 Market forces may not be able to pick up the opinions of future generations, but our sense of ethics can.

Markets are enormously powerful tools for making a number of economic decisions. As someone who works for a small company, I'm as involved in markets as most people. However, their strengths are overrated by ideologues. Markets by themselves are not responsible for innovation. Many of the technological advances of the 20th century - including the decades of development that led to the internet - actually took place in government labs or in heavily subsidised military programmes (economists should know this, given that the development of neocla.s.sical economics also owes much of its success to funding by the US government during the ideological battles of the Cold War).31 We live longer and healthier lives in large part because of work done at publicly-funded hospitals. Research and development is often best carried out in less compet.i.tive, less bottom-line, more cooperative environments. What markets excel at is selecting the best new technologies and turning them into successful products. The public, private, and non-profit sectors have synergistic roles - we need them all.

In fact, modern technology would be nowhere without the basic tools of mathematics and physics, which were also not developed by markets or private corporations. This points to the role of universities in shaping our att.i.tudes towards the economy.

Breaking the piano.

The NeoCla.s.sic Logic Piano owes its continued existence in large part to university academics, who keep it buffed and maintained and protected for the next generation. This involvement goes well beyond the economics departments. Universities divide subjects into minute specialities and have traditionally tried to keep them separate (there are signs that this is beginning to change).32 Economic decisions affect most aspects of life in one way or another, though, so everyone else should at least have an opinion.

Some pending questions:.

How does the physics department feel about economic ideas masquerading as laws of nature?

Do the humanities departments agree with the story that society is made up of individuals who act independently? If not, how is that being reflected in the education of future business leaders?

Is the mathematics department OK with the kinds of models used in economics cla.s.ses? Are a.s.sumptions of things like stability plausible?

What do mechanical engineers think of the safety margin used by "financial engineers"?

Is the gender studies department cool with the definition of h.o.m.o economicus?

Do sociologists agree that societies always behave rationally? Do neocla.s.sical tools make sense in an increasingly networked society in which one of the most valuable commodities - information - can be distributed at near zero cost?

Are political scientists sure that economics is politically neutral? Are historians convinced that neocla.s.sical economics is an objective science and not a cultural artefact shaped by a certain period of history ? What will be the impact of the rising consumer power of women, or of non-Western countries with different political and economic ideas and agendas?

Do ecologists think that the environment is taken seriously enough in economics textbooks? If they seriously believe that we are in danger of a survival-threateningly huge environmental crisis, is the introductory economics cla.s.s at their inst.i.tution increasing or decreasing the risk?

What does the psychology department think of the definition of utility, or the economics of happiness?

Are philosophers in agreement that markets can make ethical decisions?

And finally, how do elite inst.i.tutions like Harvard University, Oxford University, Ma.s.sachusetts Inst.i.tute of Technology, or California Inst.i.tute of Technology feel about the fact that in 2007, 20 or 30 or more per cent of their graduates went straight into the financial sector? Are these inst.i.tutions being used as a filter or barrier of entry to select talented students for this over-paid and socially under-productive area?33 If that is the case, shouldn't the universities at least revise their teaching to better reflect new theories and approaches, not to mention ethics?

Until university departments break down the artificial divisions that separate their subjects, the NeoCla.s.sic Logic Piano will be safe. The best hope for change probably comes not from university administrators, but from the ones with most at stake - the students. They are the ones who are being fed the story about the economy. If they decide not to buy in, then that will be it.

One excuse heard for the lack of progress in economics is that academia changes only slowly. But that isn't true at all. Nothing much happens for a long time, but when change comes, it is often sudden and violent - like an earthquake, or indeed a financial crash. Early in the last century, physics was completely rewritten in the s.p.a.ce of a few years. Biology has been revolutionised by recent technological advances such as the human genome project.

So: students. Decision time. You live at what many believe is a bifurcation point in human history. You've seen all the graphs with lines curving up like a ski jump. Human population. Gross domestic product. Species extinction. Carbon emissions. Inequality. Resource shortages. You know that something has to give. You've got an idea that the price isn't right. Maybe you're even suspicious that, if the world economy does turn out to be a Ponzi scheme, you or your children are a little bit late in the game.

You therefore stand at a fork in the road. You can take the orthodox route - and risk ending up with a qualification as impressive as a degree in Marxist ideology right after the fall of the Berlin Wall. Or you can take a chance on regime shift, by speaking up, questioning your teachers, being open to disruptive ideas, and generally acting as an agent of change.34 You can insist that the economy is a complex, dynamic, networked system - and demand the tools to understand it.

You can point out that the economy is unfair, unstable, and unsustainable - and demand the skills to heal it.

You can tell the oracles that they have failed.

You can go in and break the machine.

And then you can do something new.

A new economics.

Of course, there's a risk to taking such a path. But it is no bigger than the one taken by those maverick outsiders Jevons, Walras, and Pareto when they developed neocla.s.sical economics.

For a theory to last almost 150 years is a triumph, of sorts. For it to last one more decade will be a disaster. It was perhaps the right story for a certain period of history, or the one that people wanted to hear, but it has far outlived its usefulness.

Since the credit crunch, the world economy has sprung back quite well, in most places. Stock markets have made back much of their losses. Unemployment has apparently stabilised, as has the US housing market. Bank profits have recovered. However, at the time of writing no such rebound has been seen in the bee population. There is less oil in the ground, and more carbon in the sky. Private sector debt has been replaced by public sector debt, raising the spectre in some countries of sovereign default. The financial sector is more concentrated than before. The real problems haven't gone away, only intensified slightly.

Where there are plenty of green shoots appearing is in the new economic ideas being developed by a range of scientists and thinkers and pract.i.tioners. Their theories may look scattered and unrelated, but if this book has one message, it is that they are all part of a semi-coherent movement. Instead of seeing the economy as an efficient, deterministic machine, running on automatic, they see it as a living thing that we can consciously influence, for better or worse.

The world economy has grown up, and the ancient myths are losing their power. The new story that's emerging isn't simple, or particularly flattering - we're less rational or efficient or fair or good in this version. It turns out that we're not all super-heroes with the ability to look far into the future and make perfect decisions. (Which is a shame, because those powers would be quite useful right now.) We will never be able to perfectly model the economy, or eliminate the chance of another financial disaster. But we're living in a bubble, and we need to address our debt. I'm loath to make predictions, but in my opinion the next big crash won't be about money. It won't be triggered by bankers or mathematicians. It will be about something much more real. We have a line of credit with the rest of the planet, and it's flashing red. Soon it's going to get called in. We can't grow our way out, or work more hours. We can't hand back the keys and walk away. It's our home.

We need some household rule. We need a new economics.

NOTES.

Introduction.

1 Thoma.s.son, Lynn (2009), "Strategists See 17% S&P 500 Rise on Fed Cuts After Saying 'Buy', " Bloomberg.com, 5 January 2009.

2 Whitehouse, Kaja (2007), "One 'Quant' Sees Shakeout For the Ages - '10,000 Years' ," Wall Street Journal, 11 August 2007.

3 Tett, Gillian and Gangahar, Anuj (2007), "Limitations of computer models," Financial Times, 14 August 2007.

4 Giles, C. (2008), "The vision thing," Financial Times, 25 November 2008.

5 Barabasi, Albert-Laszlo (2003), Linked: How Everything is Connected to Everything Else and What it Means for Business, Science, and Everyday Life (Cambridge, MA: Plume), p. 211.

6 "It appears scandalous," notes Taleb, "that, of the hundreds of thousands of professionals involved, including prime public inst.i.tutions such as the World Bank, the International Monetary Fund, different governmental agencies and central banks, private inst.i.tutions such as banks, insurance companies, and large corporations, and, finally, academic departments, only a few individuals considered the possibility of the total collapse of the banking system that started in 2007." Taleb, Na.s.sim Nicholas (2009), "Errors, robustness, and the fourth quadrant," International Journal of Forecasting, 25, 744-759. See also: Mihm, Stephen (2008), "Dr Doom," New York Times, 15 August 2008; Taleb, Na.s.sim Nicholas (2007), The Black Swan: The Impact of the Highly Improbable (New York: Random House); Galbraith, James K. (2009), "Who Are These Economists, Anyway?" The NEA Higher Education Journal, Fall 2009.

7 Clark, Andrew (2009), "Ma.s.sive bet on RBS and Lloyds helped financier earn $2.5bn," Guardian, 22 December 2009.

8 Bouchaud, J.-P. (2008), "Economics Needs a Scientific Revolution," Nature, 455, 1181.

Chapter 1.

1 Burnet, John (1920), Early Greek Philosophy (3rd edn; London: A. & C. Black Ltd).

2 As economists M. Neil Browne and J. Kevin Quinn note, "perhaps unlike any other social science, economics does have an orthodoxy that is so dominant that few economists see themselves as even having a perspective or as being part of a school of thought." I will describe this dominant strain variously as mainstream, orthodox, or neocla.s.sical. Browne, M.N. and Quinn, J.K. (2008), "The Lamentable Absence of Power in Mainstream Economics," in John T. Harvey and Robert F. Garnett (eds), Future Directions for Heterodox Economics (University of Michigan Press), 240-61.

3 Housing data from the Financial Times House Price Index. See: http://www.acadametrics.co.uk/ftHousePrices.php; inflation data from http://www.statistics.gov.uk 4 McCauley, Joe (2004), Dynamics of Markets: Econophysics and Finance (Cambridge University Press), p. 25.

5 Taibbi, Matt (2009), "Inside The Great American Bubble Machine," Rolling Stone, 1082-83.

6 Bernanke, Ben S. (2009), "Commencement address at the Boston College School of Law" (Newton, Ma.s.sachusetts): http://www.federalreserve.gov/newsevents/speech/bernanke20090522a.htm 7 Kerr, R.A. (2004), "Second thoughts on skill of El Nino predictions," Science, 290, 257-58.

8 Source: http://www.cgd.ucar.edu/cas/catalog/climind/TNI_N34/index.html#Sec5 9 For cancer therapy, see for example: http://www.physiomics-plc.com/virtual_tumour.htm 10 Orrell, David and McSharry, Patrick (2009), "A Systems Approach to Forecasting," Foresight, 14, 25-30. See also the commentary in the same issue by Paul Goodwin and Robert Fildes.

Chapter 2.

1 See Nelson, Robert (2002), Economics as Religion: From Samuelson to Chicago and Beyond (Pennsylvania State University Press).

2 Cooper, George (2008), The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy (Petersfield: Harriman House), p. 11.

3 Anonymous (2006), "Dismal science, dismal sentence," Economist, 9 September 2006.

4 Soros, George (2008), The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means (New York: PublicAffairs), p. 216.

5 See Putnam, R.D. (2000), Bowling Alone: The collapse and revival of American community (New York: Simon & Schuster).

6 Wilkinson, Richard and Pickett, Kate (2009), The Spirit Level: Why Greater Equality Makes Societies Stronger (London: Bloomsbury), p. 4.

7 See Orrell, David (2007), Apollo's Arrow: The Science of Prediction and the Future of Everything (Toronto: HarperCollins), p. 242.

8 Makridakis, Spyros, Hogarth, Robin M., and Gaba, Anil (2009), "Forecasting and uncertainty in the economic and business world," International Journal of Forecasting, 25, 794-812.

9 Surowiecki, J. (2004), The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations (New York: Random House). Prediction markets such as Betfair provide a systematic means of tapping into collective knowledge.

10 US-Canada Power System Outage Task Force, Final Report on the Implementation of the Task Force Recommendations, Natural Resources Canada, US Department of Energy, September 2006. http://www.ferc.gov/industries/electric/indus-act/.../09-06-final-report.pdf 11 Anonymous (2009), "House proud?" Economist, 3 October 2009.

12 Bianchi, Stefania (2009), "Dubai Debt Freeze to Hit Property Recovery," Wall Street Journal, 27 November 2009.