May 24, 2011
I told my mathematician friends after: “These people ought to decide whether they want to be pure mathematicians, in which case they will have to do a lot better mathematics, or whether on the other hand they want to apply mathematics to solve real-world problems, in which case their sloppy mathematics and absurdly unrealistic assumptions will never work.”
In fact, I really think that almost anybody who is not indoctrinated in the economics profession would think there’s something fundamentally strange about the ill-constructed castles in the air that it builds to try to apply to real-world situations. I can’t reconstruct here all of the points that the coauthors make in their paper – which I recommend to anyone with half an interest, as I recommend the entire book – but I can tell you that it validates all of my first doubts about the profession as a naïve outsider.
The paper’s bottom line is that “Economists, like all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuse of their research. Currently, there is no ethical code for professional economic scientists. There should be one.”
Evidently the authors feel that economists have allowed their theoretical models to be used without communicating their limitations, at least without communicating them forcefully enough. It takes two to do this particular tango, and one could also indict those who apply the implications of the models without taking seriously enough the caveats issued by the model-makers.
The externality of the individual employee
Surprisingly, no one in this book makes what will be my final observation, and even the astute Posner, while closing in on it, doesn’t touch this point.
In economics – especially in a field I have recently taught, environmental economics – there’s a standard terminology, “externality,” or external costs, to refer to a cost imposed on a third party or parties by a transaction between two consenting parties. For example air or water pollution is an externality. It is generally recognized that to “internalize” that cost, in other words to factor it into the parties’ cost-benefit analysis, there needs to be governmental intervention in the form of regulation.
Posner absolves the banking community of responsibility for preventing systemic risk, saying that “The responsibility for preventing external costs … is the government’s.”
He should have taken this one step deeper by mentioning that within a firm, the responsibility for preventing firm risk is not the individual employee’s; it’s the firm’s. Risks that individual employees and divisions took had externalities for the wider organization, but firms were too often delinquent in addressing this problem.
Recall Acemoglu’s point that economists believed that firms would protect their brand, even if individual employees didn’t. It also comes down to the question of how employees are compensated, which before and during the crisis – and still now – provides an incentive to take risks that endanger both the firm and the entire financial system.
But besides the danger to financial firms and the financial system, there is an even broader societal issue. One of the worst features of the financial industry, as it is still set up, is that it causes large amounts of money to flow from the relatively poor masses, to an extremely rich few, getting little value in return. This occurs because so many industry providers methodically and expertly mislead buyers as to how much they pay and what they get for it. It’s a relatively recent and malignant development, one for which you can’t blame only misregulation. Something will have to be done about it, sooner or later.
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