Posts Tagged ‘failure of economics’

There are times when I feel we need to question the ‘received wisdom’ to see if it is still properly based on a realistic and rational foundation. And when the US Treasury Secretary, Jack Law, recently called on countries, especially Germany, to boost economic growth via boosting consumer demand, I had a “that’s weird, let’s look at that again” moment.

There is a well known economic theory of efficient markets that is, broadly speaking, based on the idea that if the supply of goods matches the demand for those goods then everyone is happy and prices are stable, and if they are misaligned then either the price will go down as goods become abundant, markets might collapse and the suppliers become poor (too much supply), or prices will rise as goods become scarce and the suppliers will get rich (too much demand). But what is forgotten is that this is a ‘zero sum game’ in which there will be winners and losers, so let’s look at the theory the other way round. When the supply of goods is greater than the demand, then prices collapse as a result of greater abundance of goods and the consumer gets to save more of their money and so they become ‘richer’, and when there is too much demand, prices rise and the consumer has to spend more of their money for scarcer goods and so becomes ‘poorer’. Of course, the intrinsic value of the goods does not change in either scenario but the price does as suppliers manipulate it to maximise return – in other words, because they are greedy!

So, in simple terms, if the supplier is getting richer, the consumer is getting poorer; conversely, when the supplier is getting poorer, the consumer is getting richer. So if the supply and demand are not in balance, then is it better that the supplier gets richer or that the consumer gets richer? The answer to that is almost certainly that it depends on whether you are a ‘supplier’ or a ‘consumer’.

Because greed seems to be a fundamental of human economic behaviour, suppliers almost always try to manipulate the situation so that consumer ‘demand’ rises and the supplier gets richer at the expense of the consumer. What also happens is that government policy of whatever shade of political belief also tries to manipulate the situation to make the suppliers richer and the consumers poorer – the ‘poor’ are always far easier to control as they are often dependent on the government.

Now back to Jack Law. For most of the two decades covering the end of the last century and the beginning of this, we have been ‘demand’ led in that consumers have been demanding more and more of all types of goods ­– which they usually do not need and frequently dispose of before the end of their useful life – and paying for them with cheap credit that, six years ago, suddenly ran out. Consumers found themselves in severe debt and unable to pay it off while being equally unable to re-schedule their debts with new credit lines: having made themselves believe they were ‘rich’, consumers all over the developed economies were spending money they did not have and the dawning of reality has been painful.

During those same two decades, the suppliers of goods saw cheap credit as a cornucopia and grabbed it with both hands making huge sums of money in the process. And now that the credit taps have been turned off and ‘the consumer’ has realised they were living a false dream, the suppliers are hurting (read: going broke) and are demanding that ‘government do something’ to get the consumers to spend again: after all, they reason, the consumers are merely the tethered milk-cow to be milked and bilked out of their money for the benefit of the suppliers. Jack Law was merely doing his bit to help the suppliers make money and to keep the consumers poor, thus clearly positioning himself on the side of business and opposed to the good of the people.

The materialistic, consumer-driven society that exists in its purest form in the USA and almost as purely in the UK is a very individualistic, greed-driven and selfish model, and is neither in the rational self-interest of the consumer nor in the interest of the greater society. However, for the last half-century there has been an assumption amongst those who think they know what-is-what that the consumer society is the only viable economic model that will deliver growth and prosperity. But what has happened over the last six years is that the consumer has finally, perhaps irrevocably, discovered that consumerism using other people’s money is great fun, but when the owner of the money wants it back the result is extreme and sometimes insupportable pain: they have discovered that there is no such thing as a ‘free lunch’, and no such thing as a right to prosperity.

The trouble is, in societies that are not consumerist (the vast majority of the world) and are significantly less individualistic than the USA and the UK (see the work of Geert Hofstede), prosperity is based more firmly on supply and demand being balanced – thus in those economies, suppliers make and supply only what they can sell and consumers only buy what they genuinely need; everyone is happy with less but there is a more equal division of the wealth of the society. The balance is restored between the consumers and the suppliers, and neither is pursuing a ‘beggar thy neighbour’ policy.

But the USA, and to a lesser extent the UK, are finding the change very difficult, simply because it involves a fundamental change in attitudes, behaviours, and fundamental beliefs, leading to a profound change in the way the society operates. Instead of the unrestrained pursuit of personal gain at the expense of all others, Americans and Britons in particular will have to once again learn the value of cooperation with others – a cooperation based on trust rather than contract law; based on mutual interests rather than self-centred, self-interest; based on being a good neighbour rather than the bully boy on the block. There is plenty of evidence that, at the grass-roots level of ‘Everyman’, this is already happening: cooperatives are forming, and neighbour-help-neighbour groups, barter markets and the like are springing up. But this reality, this need to change, has yet to reach the company strategists, the corporate leaders and the governmental policy makers. Entrenched pork-barrels, fat-cat remuneration packages, and a gut-wrenching fear that they’ve been wrong all along are all contributing to an evident ‘denial of reality’ that change has to begin at home, that beggaring the consumer citizen for the benefit of the suppliers is not a viable or sustainable solution and that ‘the people’ have had a enough. Jack Law’s call for other countries to push up demand (essentially to push up demand for US goods) so that the USA need not change its ways is just the latest example of this sense of denial.

Alasdair White is a business school professor, writer and publisher. He is the author of five management books and a thriller novel as well as writing the Management Blog. He lives in Belgium.

 It’s not that the main economic theories are wrong, but that they are incomplete. Trying to explain how markets work at a micro level without taking into account human behaviour is to ignore the fact that humans are the main economic actors. And trying to explain how the world economy works at a macro level without taking into account the political objectives of individual countries is to assume, some how, that all nations pursue the same ends. However, mathematically modelling human behaviour and national objectives is profoundly difficult, and so most economic theory simply ignores them and thus their explanations are simply wrong.

Let’s focus on human behaviour. The dominant schools of economic thought hold that humans will behaviour rationally and in their own self-interest and that when this happens en masse, the outcome works to the advantage of all. This appears true in many cases and it is the basis of the way many economies actually work – the most successful economic model, capitalism, is based on this principle. The trouble is that as soon as we factor in actual human behaviour, then the model is under strain – in capitalism, too much self-interested behaviour leads inevitably to cycles of boom and bust, to asset bubbles forming and then exploding, and to the type of greed-driven behaviour exemplified by the ‘rogue traders’ who have caused banks to lose billions of dollars, euros and pounds.  

But is it true to say that people behave in a way that is rational? There are certainly times when this might be true, especially at a subconscious level, but almost all human behaviours actually seem to be driven by two things: emotions and habits.

As I argued in a previous blog, the dominant emotion in economic terms appears to be ‘greed’, the desire to obtain more of a good than is either ‘needed’ or ‘desirable from a group perspective’. Greed distorts the ‘zero sum game’ model in which for every winner there is a loser (or, in economic terms, for everyone that has a good, there is someone who does not have it). A few individuals seek to dominate the market for a good so that there are a few who have the good and a lot that do not. Such behaviour is often driven by a desire to control the supply of a product (a good) so as to drive up its value due to scarcity – a behaviour that displays greed in its rawest sense and is entirely self-interested, and which benefits only the person involved and disadvantages society as a whole. It is greed that is behind the trading behaviours of many in the banking and finance sector although other emotions such as desire for recognition, craving for attention, and even fear of failure also play a part – and this greed is encouraged by the corporate cultures of the institutions involved because greedy traders make bigger profits (in the short term) and that benefits the institution and fulfils a basic reason for its existence. However, when allowed to occur in an unregulated way, it also creates a sense of being beyond risk with the inevitable collapse as a result.

Greed is also behind the asset bubbles that regularly and frequently occur in free-market economies. Take housing as an example: the true value of a house is, in capital terms, the cost of replacing it (purchase of land, materials and building work). There is also an intrinsic value, which is determined by supply (how many such houses are available) and demand (how many people are prepared to pay to own one). But why should anyone want to ‘own’ a house? Sure, as Maslow theorised, there is a need to have a place to live, to provide protection from the elements and other threats to survival, but that can be satisfied by renting, so why own? The normal answer is that the house is an asset and an investment but this suggests that the house owner is prepared to sell when the market price rises to a level that provides the return they want – but then they would have no where to live and, anyway, only a very small percentage of house owners would sell their house because pride (an emotion) of ownership and the fact that house ownership conveys recognition of status in some societies more or less forces them not to sell. By refusing to sell, the market becomes inelastic and reduces the supply side of the equation and if demand holds up, then the perceived intrinsic value of the house rises as people will be prepared to pay more to obtain one. Thus in an inflexible housing market in which demand is sustained, house owners think they are making money.

But, I would suggest, we need to look deeper at why anyone would want to ‘own’ a house. House ownership causes the population to become more static and less flexible in terms of movement to where jobs are – if a good job is available in a distant part of the country, then the family will have to move, the house has to be sold, a new house has to be obtained and although this is, in theory, very simple, in practise it can prove to be incredibly difficult to achieve. Partners don’t want to move: they like it here, the children are in good schools, fear of the unknown pushes them outside their comfort zone and a rational economic decision is impossible due to emotional reasons. The result is often disharmony in the relationship, a decision is made that is not in the self-interest of the individuals concerned, and everyone loses.

And then there is the culture of the society and the habits this engenders. In many societies, people are encouraged to own a house because house ownership is a cultural norm and it becomes habitual for people to abide by the norms of the culture even when such norms and habits are clearly (from an economic perspective) not in the self-interest of the individuals.  

The above example is just one of many that can be used to understand that emotions can get in the way of rational (economic) decision making and even the ‘bounded rationality’ I discussed in my previous post. The trouble is, emotions and their impact on human behaviour are not conducive to being mathematically modelled and so economists simply ignore them with the result that their vaunted economic models are bound to produce only approximations and are thus extremely unreliable foundations for political policy making. It is not the greed of bankers that produced the current global financial crisis but the habitual greed and self-centred self-interest of all those involved: potential owners, the society that pushes house ownership as desirable, politicians who fail to regulate correctly, bankers that see easy profits, and a culture that encourages the consumption of goods to excess.

And just in case you are wondering whether I am proposing abandoning a market economy for a socialist ideal, the answer is no, I am not! Market economies do appear to be the best solution to the development of the world but unregulated market economies are bound to a cycle of boom-and-bust and politicians should be wise and light in their regulation, but regulate they should to ensure the good of society. Unfortunately, such wise politicians are not to be found amongst those who seek political power – they, too, are driven by greed and self-interest and so the cycle continues.

In the next post, I will look at the impact of habits on economic decision-making and how observing the change in habitual behaviour can smooth out the ups and downs of economic life.

Alasdair White has been a business school professor and management development consultant  for over 20 years. He has written five best-selling management books and a thriller. He is currently writing a second thriller. 



Alasdair White is a business school professor based in Brussels, Belgium where, for 20 years, he has taught management from a behavioural perspective with, he has to admit, a bit more than a passing nod towards free-market economic theory.

A little over 100 years ago, the world of science was faced with a radical challenge to its most basic and fundamental belief: that the laws of physics were Newtonian and immutable. For nearly 250 years, the law of gravity and all that Newton and others drew from it had ruled the scientific world and to seriously question those laws was to invite ridicule, disbelief, and charges of scientific heresy. But that’s exactly what a number of scientists were doing at the begining of the 20th century.

Through careful thought and analysis they concluded that while the rules of Newtonian physics were true and immutable, they were ONLY true and immutable in certain circumstances, and that they did not apply – indeed, could not apply – at the sub-atomic level. As a result, quantum mechanics (or quantum physics) was born. It is interesting to note that they were not claiming that the laws of Newtonian physics were wrong but that a different, parallel set of laws applied as the mass of any body became smaller and more fundamental.

This idea that the two sets of laws of physics were so radically different but equally true was almost unthinkable, and many initially argued that somehow the laws of microphysics, such as quantum mechanics, could be aligned with and explained by the ‘more robust’ laws of Newtonian physics. But this was soon shown to be wrong: microphysics was engaged with matter at a very different and more fundamental level; a level at which Newtonian laws were an over-simplification. Now, a hundred years later, the education system is still teaches Newtonian physics as though it were the only truth, rather than one of a number.

I believe that something similar is about to happen in the world of economic theory.

What was first called political economy by Adam Smith way back in 1776 when it was the study of how economic agents interacted to create the ‘wealth of nations’, economics has become one of the most powerful areas of study, one that its practitioners claim affects every aspect of our lives, but one that is profoundly flawed.

In the 250 years since Newton, scientists have unravelled the secrets of the universe with surprising accuracy and with profound impact on everything we do and use in our lives. They have examined the universe all the way back to its origins, they have examined matter down to the fundamental particles that make up everything around us, they have used that knowledge to create things for both good and evil, and few, if any, now question the ideas that once appeared so radical. (Einstein showed that space and time curve and are relative to each other and to the speed and position of the observer, Heisenberg showed in his uncertainty principle that one cannot at the same time define exactly where something is now and where it will be in the future, while particle physicists at the Large Hadron Collider at the CERN Laboratories in Switzerland have shown that some fundamental particles can be in two places at the same time.)

In the 250 years since Adam Smith, on the other hand, economists have done little to explain how the economic activity of the world is organised. They have invented, proposed and imposed a huge number of theories that have rapidly been shown to be incomplete, inaccurate or plain wrong; and they have based it all on the fundamentally flawed idea that the macro and microeconomic world operates with the same rules: that there is only one economic truth. Economic discourse, certainly at a political, financial and commercial level, is littered with statements that start with “Of course …” followed by some wild idea presented as an absolute truth.

In the last 50 years, we have had Marxism, Keynesian economics, monetarism, and free-market economics, and while they may all shed some light on how the economy works at a macro level, they are none of them wholly correct, but neither are they wholly wrong – although the adherents of each school will vehemently promote their own theory and decry those of others. However, what bothers me is this: none of the theories makes any rational sense when the economy of the world is considered at a micro level – the level of the individual man, woman or child.

In the next few blogs we’ll explore these ideas further and look at the underlying fallacy of most economic theory – the subject of full knowledge and rationality – the behavioural aspects of microeconomics and whether business schools are partially to blame for the current economic problems by teaching, without critical analysis, theories based on fundamentally flawed ideas.