I don't know enough about economics to judge this piece.... any
insights offered on the list would be greatly appreciated!
Barry
http://www.theatlantic.com/business/archive/2012/02/are-brick-and-mortar-economists-leading-us-astray/253480/
Are Brick-and-Mortar Economists Leading Us Astray?
By Bill Davidow
Feb 23 2012, 12:22 PM ET
Increased levels of connectivity are rendering economic rules obsolete.
amadorgs / Shutterstock
Bookstores, newspapers, travel agencies -- add economists to the list.
What do many economists have in common with these enterprises? They
have clung to beliefs and strategies that no longer work in an
overconnected world.
Much of the economic theory that guides government policies and the
actions of business -- developed when the world was far less connected
than it is today -- is out of date. Theories that were once right are
now wrong.
Adam Smith's "invisible hand" provided invaluable guidance to markets
and did an excellent job of allocating resources in a less connected
world. As long as the markets were local, externalities less
important, and moral and government authority policed unsavory
behavior, there was no better system.
Moral authority is the powerful thumb of the invisible hand.
In Smith's time such authority was exerted by the church, local
institutions, government, and citizens. Most people conducted their
business affairs in the communities in which they lived. As a result,
control rested with one's neighbors, the people one saw in church,
local business organizations, and local and national government.
During the Depression, Smith's invisible hand functioned in the
following way: The mortgage business began in 1932, in response to a
liquidity crisis. Back then, a 20 percent down payment was considered
the minimum a bank would approve. And for this, the largest investment
of their lives, borrowers would travel to their local bank and sit
down with a loan officer who probably knew them, whose kids played
baseball with theirs.
In those days, the banks owned the loans. If the loan went bad, the
banks lost the money. If you knew the man and he fell on hard times,
it was difficult to put his wife and kids out on the street on Friday,
only to see him in the next pew that Sunday. Faced with that potential
embarrassment, bankers were careful to make only those loans borrowers
could afford. When customers had problems, the bank was much more
likely to work with them to find a solution.
In today's overconnected world, banks externalize the costs of bad
loans by creating Collateralized Debt Obligations and passing the
losses off to endowments and pension funds. Some shadow entity takes
the losses, the banks make a profit on the transactions, and bankers
get the added benefit of never having to look the bankrupt person in
the eye.
John Maynard Keynes's ideas worked splendidly when the world was less
connected. Economic and fiscal policies that stimulated demand created
local factory jobs. When those workers spent their paychecks, other
jobs were created -- the multiplier effect. Today, stimulus creates
more spending but the jobs and the trickle-down are in China.
The mathematically elegant formulas that win Nobel Prizes for modern
economists are based on assumptions that no longer apply, and on
historical data that is no longer meaningful in our overconnected
environment. Unfortunately, those formulas are shaping much of the
advice being dispensed. They were right for a less connected world but
are wrong now.
Consider Robert Merton, who won the Nobel Prize in economics for his
work on the Black-Scholes Model. Merton's model enabled people to
assign the appropriate value to exotic financial instruments such as
futures contracts and plain vanilla stock options. Merton became a
victim of his own invention. He was one of the founders of Long Term
Capital Management, which based its derivative trading strategies on
the Black-Scholes Model. In 1998, "fat tails" that the model failed to
take into account caused the bankruptcy of the firm and nearly
triggered an international financial contagion. The slavish devotion
to the model persists; it raised its ugly head again during the 2008
financial crisis.
The improper application of the theory is one of the things that
fueled the spectacular growth in over-the-counter derivatives, from
$60 trillion in 2000 to more than $600 trillion in 2008. This growth
took place while the economists and regulators using bricks and mortar
logic were arguing that derivatives distributed risk, when in fact
massive amounts of derivatives concentrated risk.
The fat tails played a starring role in the bankruptcy of Lehman
Brothers and the $182 billion bailout of AIG. Merton's theory was
right when certain assumptions held, and wrong when they were applied
in an overconnected environment.
Economists, policy makers, and presidential advisors have to get it
right. Their influence is so great that when they get it wrong,
tragedy often ensues. As Robert Heilbroner explained in his classic
book, The Worldly Philosophers, the impact of Adam Smith, Karl Marx,
John Maynard Keynes, John Stuart Mill, Thorstein Veblen, and Joseph
Schumpeter has been immense. Heilbroner argued that "he who enlists a
man's mind wields a power greater that the sword or the scepter" and
that they "left in their train shattered empires...undermined
political regimes: they set class against class and even nation
against nation...because of the extraordinary power of their ideas."
The crisis in Greece offers convincing evidence that the "shattered
empires" and events that "set class against class and even nation
against nation" has not come to an end. Greece was a victim of the
bricks and mortar design of the euro and is about to suffer the pain
of a bricks and mortar solution.
Today's brilliant economists still exercise Heilbroner's extraordinary
powers. All too often, they are enlisting politicians' minds based on
a great deal of theory that was right then and wrong now.
Amazon has already killed off Borders, as well as thousands of
independent booksellers. Blogs and online news outlets are replacing
print media. Expedia and Orbitz are reinventing the travel business.
Increased levels of connectivity are rendering economic rules
obsolete. In posts to follow, I will be discussing some of the new
rules for a virtual world.
It is time for the worldly philosophers who advise us give up their
obsolete bricks-and-mortar ideas and develop economic theory for an
overconnected world. President Obama and the Republican presidential
candidates alike would be well advised to demand a different way of
thinking._______________________________________________
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