Economics, Education and Unlearning

by Dirk Ehnts, Econoblog101

The Post-Crash Economics Society (PCES) has published its ‘compelling analysis of the failings in economics education and set out a road map for reform.’ The forword is written by Andrew Haldane, who is executive director for financial stability at the Bank of England. I agree with most of it, but think that some parts are worthy of being discussed in more detail. Often, it is exactly those discussions that we do not have that are the most interesting. Blogs are a great way to at least leave a record for those interested in controversies of the time. Let me discuss two points raised in the forword, which spins around the work of Adam Smith.

Here is the first quote:

‘The expectations of agents, when push came to shove, proved to be anything but rational, instead driven by the fear of the herd or the unknown. The economy in crisis behaved more like slime descending a warehouse wall than Newton’s pendulum, its motion more organic than harmonic.’

I think that it is quite possible that rational agents are driven by the fear of the herd and thus herding behavior. There is no need for people to become irrational in times of crisis for things to go wrong. For instance, the participants in the European bond markets were irrational in assuming that all bond yields on sovereign debt should be the same. Greek bonds were valued just like German bonds, for many years. Now was that irrational? Since ‘the market can remain irrational longer than you can remain solvent’, as we all seem to know a quote by Keynes (but apparently we’re all wrong: it’s not), it is rational to follow the herd and make profits by staying in the market. The same goes for reselling sub-prime assets as collateralized debt obligations (CDOs): yes, these are toxic assets, but if banks don’t produce them somebody else will. So, in a crisis I would say people behaved more rational than before the crisis, because they now understood reality better. Toxic assets were toxic assets, and not high-yielding risk-free financial assets. The absence of the market for some of these assets is rational, not irrational.

On to the second quote:

The “Ultimatum Game” is one in which a money offering – say, £100 – is shared between two parties, with one party taking the lead in the offer and the second choosing to accept or reject that offer. The twist comes in the fact that, if the offer is rejected, both parties receive nothing.

The problem with the ‘Ultimatum game’ is to prove that it has anything to do with reality. When was the last time somebody offered you £100 to share with another party, with you choosing to split up the sum? Sense of fairness is what Haldane is aiming for, and that is something which I agree with. However, I would use ethics to make the argument and not game theory. There is a lot of literature that shows that more equal societies do better, and from a humanist perspective it also makes sense to create a flourishing environment for human beings instead of a competitive one. Competition is good, but markets must be complemented with government institutions in order to work properly. A result of a market at work in a non-proper sense would lead to a ‘winner-takes-it-all’ result, and this is what changes in executive compensation and wages in the financial sector in the last 30 years have been creating. You don’t need game theory to say that this trajectory is not optimal for the general public.

Last but not least, I think that Haldane’s last paragraph, which I fully agree with, is worthy to be repeated here:

The power of economics is that it affects real lives in real ways; it matters. And it is because it matters and because it affects us all that the profession, still fledgling, needs to be in a perpetual state of renewal. The crisis is bringing about that renewal. Reports such as this, if acted on wisely, would help make that renewal permanent and on-going. I hope it is acted on and wisely.

Read the rest of the report here.