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Monday, September 12, 2011

The Importance of Economic Theory

We live in uncertain times. Yet even in these uncertain times it is extremely easy to find economists who are certain the free market has failed. Unsurprisingly, in the wake of the latest financial crisis these economists can be found almost anywhere, abandoning economic theory in favor of fallacies economists long ago proved wrong. It is not that these individuals are unintelligent; in many cases they are brilliant. Many great men, however, fall prey to what George Stigler called the imprecision and superficial analysis more often found in journalists.

It is not surprising that to an untrained eye the current crisis may appear to be the result of greedy businessmen and the failure of capitalism. After all, banks failed and individuals invested too much in housing. But as Chicago economist Gary Becker recently pointed out, markets work extremely well and the failures we have seen are a result of government intervention, not the workings of the market itself.

So why then do some economists jump the train of economic theory? It could be that they do not see economic theory as matching the real world. Homo economicus (economic man) does not reflect reality. This maybe true at some level, but after all, these are only models. They are not supposed to map reality. Their purpose is to use abstractions to simplify and render understandable the complex world we live in.

When the real world does not match reality it is certainly easy to abandon the models, say they are not accurate enough, and move on to something else, and many have done this. The problem, though, is that since Adam Smith, much economic theory has been shown time and again to be correct. Its abandonment is likely a matter of lazy analysis and/or a lack of fundamental understanding of economic theory itself. A deeper look at what is going on often shows that economic theory is indeed correct.

John Kenneth Galbraith in the late 1970s produced a television series and book titled The Age of Uncertainty, which like many economists today abandoned much of economic theory. Today’s document is a review of Galbraith’s ideas by Chicago economist George Stigler:  “John Kenneth Galbraith’s Marathon Television Series: A Certain Galbraith in an Uncertain Age.” Stigler is rightly critical of much of what Galbraith presents and, like Becker’s recent article, shows why economic theory is being misunderstood and misused.

Take, for just one example, Galbraith’s interpretation of Adam Smith’s notion of self-interest, an idea that is constantly misunderstood even today. Galbraith seems to believe that self-interest might not lead us to the socially optimal outcome, as the invisible-hand idea would suggest. This is a terrible misunderstanding of the role of self-interest in economics.

First, self-interest does not automatically equal greed in economic theory. It is not assumed that individuals are motivated solely by selfishness or material gain. Economics is not about the particular motivations individuals have but rather is a method of analysis. It assumes individuals attempt to maximize their welfare as they conceive it, which can be selfish, altruistic, spiteful, loyal, or even masochistic. Individuals are attempting to achieve their ends with the means they believe to be the best.

Second, institutional context matters. The rules we live under will determine whether Adam Smith’s invisible hand achieves socially beneficial outcomes or not. The invisible hand guides self-seeking individuals — people who are attempting to achieve their ends — to serve the public good, but only under the correct rules. Private property, freedom of contract, and competition are all necessary to achieve what Smith envisions with the invisible hand. As Sigler says in the review, “[T]o discuss Smith’s theory without mention of competition is to discuss Napoleon without mention of war.”

As Becker pointed out in the article mentioned above, the failure has not been with economic theory but with the disruption of the competitive process that markets operate in. The failures we see are not only compatible with economic theory, but are explained by it.

Both Becker and Stigler understand that when economists talk about market failure and abandon economic theory, it is more than likely that they simply do not fundamentally understand economic theory. This is why, when it appears markets are not working, we would do ourselves a great service by stepping back and using basic economic principles to analyze what is going on, rather than abandoning them all together.

Download the Stigler review here.

  • Nicholas Snow is a Visiting Assistant Professor at Kenyon College in the Department of Economics, and previously a Senior Lecturer at The Ohio State University Economics Department. His research focuses on the political economy of prohibition.