Economic elites peddle market efficiency myth to masses to justify regulatory inaction

As an economics graduate student, the questions that most interested me were seldom the “right” questions, and what I considered the best analytical frameworks and methodological tools for studying those questions were seldom the “correct” ones. (I felt economics needed a major infusion of ideas and tools from psychology and biology; the field has since moved somewhat in that direction.) Ideas were worthwhile, it seemed, only if they could be boiled down into a mathematical proof or simple econometric model. And, back in the mid-90s, studying China’s economy — or any economy other than America’s or perhaps Europe’s — was career suicide.

So I really enjoy this kind of article attacking academic economists for clinging to their bedrock assumptions that people are rational and extremely well informed (or act “as if” they were omniscient) and that human behavior can be predicted by assuming people are rational and omniscient:

one problem is that the economics profession “has gotten much more intolerant of divergence from orthodoxy,” says Philip Mirowski, an economic historian at Notre Dame. “The range in which dissent happens is so narrow. In a sense they still cannot imagine the system can operate to undermine itself. That is not a position that is allowed anywhere in the economics profession. The field got rid of methodological self-criticism. This Great Moderation stuff was just arrogance, hubris.” Indeed, the joke on economists, says one of them, Rob Johnson, is that they create simplistic models that depend on people behaving as rational actors motivated by self-interest, yet “they have a blind spot regarding themselves.” The way they squabble mulishly to defend now-indefensible positions is itself evidence of how flawed those rational-actor models are.

it was largely because the field of economics came to be dominated by “neoclassical” thought—or the idea that markets are rational and can reach “equilibrium” on their own—that so-called financial innovation on Wall Street was allowed to run amok in recent decades. That led directly to the crisis of 2007–09. No matter how crazy or complex the products got, the theory was that, with little government oversight, the inherent stability of markets would keep things from getting too out of hand. It was in large part because of this way of thinking that government intervention of any kind in the markets, including regulation, came to be seen as a kind of heresy, especially after the Soviet Union collapsed and command economies and “statism” were thoroughly discredited.

I’ve been slowly reading through old Economist magazines we received before realizing there was no way in heck we could read a steady stream of such thick magazines. (My wife ordered it. I’ve never been a huge fan of The Economist because its articles are unattributed and include virtually no direct quotations. Journalism without direct quotations irks me because I like to know who’s telling me something.) Anyhow, The Economist in March 2009 noted this major hypocrisy:

Belief in efficient-market theory made the authorities reluctant to restrain either the dotcom or the housing and credit bubbles.

…it is important not to throw out all the insights of efficient-market enthusiasts. Although it is theoretically possible to make money by outperforming the markets, it is extremely difficult in practice….

If regulators thought markets were too efficient to interfere with, how come they allowed banks to get involved in an activity which, after bonuses, was a game they could not collectively win?

My answer: market efficiency is a myth peddled by economic elites to the masses to justify government regulatory inaction (“laissez-faire”). Economic elites know it’s a myth because they profit handsomely by exploiting market inefficiencies. Even in theory, market efficiency exists only when there are MANY SMALL COMPANIES producing similar products and services. The logic of capitalism drives companies to dominate their markets and crush their competitors. Therein lies the monopolistic/oligopolistic profit opportunity… and economic elites' strong motivation to prevent government anti-trust regulations that keep markets efficient and prices and profits low.

What amazes me is not that the masses fell for the market efficiency myth but that so many academic economists do. Very simple economic models that everyone studies in first-year microeconomics show how monopoly power enables companies to get rich at consumers' expense. Yet many economists seem wedded to the idea that markets are magical invisible hands that alway fairly match supply and demand and cannot possibly be improved upon through government regulation.

Posted by James on Friday, September 17, 2010