Private vice to public virtue? Re-examine the basic economic dictum

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back… soon or late, it is ideas, not vested interests, which are dangerous for good or evil.”

John Maynard Keynes

This often quoted Keynes’ insight is a constant reminder to us on the power of economists’ ideology in the modern production system. The impact of this ideology, more than anything else, is well manifested in the current economic and environmental crisis.

It is in human nature to look for some justification to our actions. Economists traditionally provided justification to a mode of production that then becomes accepted without question until flaws start to emerge. Centrally planned economies drew justification from Marxism until its eventual demise. Free-market economies draw justification from neoclassical economics. The present economic crisis and on-going environmental degradation have alerted economists to question the received wisdom of neoclassical economic theory. Alan Greenspan admitted that his view of the free market was flawed. George Soros questioned the usefulness of the theory of market equilibrium “…that the defect was inherent in the system – contradicts the prevailing theory, which holds that financial markets tend towards equilibrium.” Dani Rodrik blames economists, not economics, for relying on highly unrealistic mathematical models that sacrifice relevance for technical rigor.

In fact, the problem runs much deeper; the problem lies with the basic economic dictum itself. The basic economic dictum of neoclassical economics states that when selfish, self-interested individuals try to maximize their own welfare in a free market environment they unknowingly bring about a “virtuous” world where everyone becomes materially better-off. Although it is true that free-market capitalism has produced an unprecedented amount of material wealth in the world and lifted many out of poverty, the overall outcome has not been all that virtuous.

Two assumptions underlie the basic economic dictum. The first is that humans are selfish. The implicit second is that when selfish individuals engage in their rational optimizing calculus they can ignore the larger social, cultural, and natural environment that surrounds them. Quite contrary to some prominent gurus of unregulated free-market capitalism, assumptions are not innocuous. This cuts across disciplines. A good example comes from immunology. Before Polly Matzsinger, a fascinating lady, made a paradigm shift by proposing the danger theory of immunology, medical prescriptions relied on the so called self-nonself model that assumes that our immune system knows what is foreign to the body and what is not and responds accordingly. The outcome of this assumption has been that patients under certain medical procedures such as transplantation have to undergo heavy immuno-suppressive medications that expose them to other risks. Such prescriptions may find their way out under the danger theory once its full implications are understood.

Let us examine the two assumptions that underlie the basic economic dictum. The first – that humans are selfish – leads to a debatable philosophical and scientific question:  “are humans innately selfish?” Those who align with Darwinian morality may argue that the altruism we observe all around us is an outcome of selfishness; reciprocity is needed for individual survival. It may well be the case that societies codified certain values in the form of religions and other social norms and customs to prevent them from disintegrating into chaos as a result of the inherent drive in humans to promote their self-interest above all.  But one may also make a case that every individual possesses both selfish and altruistic characteristics and what society and the prevailing economic system promotes at any one time becomes the dominant trait.

Neoclassical economists have emphasized the selfish end of the scale and formulated their theories that turned the old norm “private virtue leads to public virtue” into the notion that “private vice (greed) can lead to public virtue (material well being).” The negative impact of this belief is well manifested in the current crisis. In an intriguing article entitled “Dilemmas of an economic theorist” and published in Econometrica in 2006 Ariel Rubenstein, a prominent (disillusioned) economic theorist, reports how economics training contributes to shaping a rather unpleasant “economic man”.

Even if it is granted that the assumption of selfishness cannot easily be replaced by any other assumption, it is the second assumption – that we can ignore the effects of individual selfishness on the macro environment – that turned out to be most damaging.  When the subject matter called macroeconomics was born, many economists were not very happy with it because it dealt with synthetic aggregates like gross domestic product and the price level. So they started looking for what is called the micro-foundation of macroeconomics because microeconomics is meant to deal with real people. The objective here is to eliminate the micro-macro distinction because everything macro is nothing but an aggregation of micro components. So far economists have not succeeded in this unification; macro phenomena are qualitatively different from their micro constituents. This is a pervasive problem across many disciplines; as Andy Ho puts it “life is more than the sum of its parts”.

The main problem here is that in the process of focusing on atomistic individuals, economists completely ignored the macro-constraint. Here, by macro I mean the larger social, cultural, and natural environment. The most illustrative example of this ignorance is the global warming problem. Although economists have long talked about externalities or spillover effects of private economic activities they were never an integral part of the basic economic dictum. As a result, economists have to recommend solutions to market failures on an ad hoc basis which are usually not well implemented.

In traditional societies, social customs, norms, taboos and reverence for nature acted as a macro-constraint on individuals even if they were internally self-interested. This macro-constraint withered away during the industrial revolution and there was no regulatory mechanism to enforce something similar on self-interests. The result was over-production (and over-consumption), environmental degradation and global warming. The current economic crisis is also a manifestation of this over-production in the financial sector.

The solutions that economists offer to the problem of over-production are likely to be less effective. What they propose is to make producers pay for the cost of bad spillover effects they create on others, but these are typically unenforceable and hence, not enforced. It should be noted that solutions obtained subject to constraints could be very different from those obtained by equating marginal (additional) costs to marginal benefits. Constraints are binding. In the absence of constraints, it is always possible to bring down costs through technological advancements and still over-produce. In this production process certain things get accumulated as stocks, for example, the stock of pollution. These stocks, unfortunately, do not play a direct role in economists’ marginal analysis.  Until new theories emerge we have to go on tinkering with the current system to resolve the pressing problems we face.

A shorter version of this article appeared in The Straits Times, Singapore, on December 2, 2008. The first part of the title of the article is from an interesting article by Ali M Khan, “On trust as a commodity” that appeared in the Journal of Banking & Finance in 2002.

Tilak Abeysinghe, Department of Economics, National University of Singapore

2 Responses to "Private vice to public virtue? Re-examine the basic economic dictum"

  1. Guest   April 26, 2009 at 8:51 pm

    Absolutely excellent, I hope this gets more attention!!!!

  2. Jacques René Giguère   April 27, 2009 at 11:45 am

    In his essay “Can economics become a science” Challlenge 26 Oct-Nov 1986, R Eisner put it bluntly ” Economic man is well-known to psychiatrists and detectives : it s a criminal psychopath” ( I quote from memory)Jacques René GiguèreProfessor of economicsCollège de Sept-ÎlesSept-Îles Québec Canada