06/08/2009 - 00:00

In theory, more of the same won’t work

06/08/2009 - 00:00

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Economic theorists can’t be blamed for the global financial crisis and, for the situation to improve, we may have to start thinking about things in a radically different way.

THE world economy is still in the grip of a major financial crisis. It has become fashionable in some circles to say that one of the underlying causes is that we have been led astray by the sort of thinking promoted by contemporary economic theory and, in particular, by the mathematical models that are the backbone of much academic research.

This is a mistake. Like it or not, the only understanding we have about complex economic, or more accurately political-economic, phenomena are those given by our theories. Unfortunately, these don't offer a lot of support for a great deal of what passes for economics in popular discussion.

Instead of seeing recent events as a failure of contemporary theories, it would be a better reading to see the period leading up to the crisis as, by and large, characterised by a fairly selective and distorted application of these theories. This is perhaps most obvious when it comes to complex propositions about market efficiency and equilibrium.

It is a sign of serious intellectual malaise when grown-up newspaper editors and commentators use terms such as 'the magic of the markets' as if this were part of an argument, or an analytical position, that justifies privatisation, or bankers' salaries.

In many such cases, what is being expressed is an article of faith, rather than a serious intellectual position. It's no surprise, of course, that many institutions become advocates for those parts of existing theories that promise to maximise their profits.

Nonetheless, to then blame the failure of these institutions on theories that were misapplied or misunderstood in the first place isn't helpful.

Similarly, much of the response to the current crisis is still dominated by the view that the market is always the most appropriate mechanisms for ensuring that institutions are properly managed.

We are being told, for example, that after things have been set right by the taxpayers, there is no alternative to returning banks to private control and privatising public utilities on grounds of efficiency. All we need is something that looks like what we've had, but with a little more transparency and a little less greed.

This sort of claim confuses the proposition that a perfect market is an effective mechanism under some conditions with the proposition that a market is the most effective mechanism under all conditions.

In order to be perfect, a market requires very strict conditions - this is what the mathematics tells us.

When these are not available, it may not work well at all. In these cases it is worth taking seriously what our theories tell us and exploring the alternatives. What this means is that, rather than simply thinking of more of the same, it might be worthwhile considering some radical departures from the way in which we currently do things.

Among the bodies of theory that might help in this task is that which addresses the problem of how to design institutions that will effectively serve the goals of the public. This is usually referred to as mechanism design.

It must be stressed that mechanism design cannot be brushed aside as something outside the mainstream. It is a major component in game theory and political-economy research.

Leo Hurwicz, Eric Maskin and Roger Myerson won a Nobel Prize for work in this field in 2007. There have also been a number of Nobel prizes in game theory and economics for related work.

The problem that mechanism design tries to solve is that of determining the rules and incentives that will best ensure that institutions work to serve whatever purpose is required. Within the institutions, individuals need to be given an incentive to behave in a way that is consistent with the desired end.

Democracy and markets are mechanisms in this sense. They are sets of rules, or games, intended to produce outcomes that are collectively desirable. Mechanism design theory includes cases where there is uncertainty and where relations are not based on buying and selling.

What mechanism design tells us is that the only important questions are: what information is available to a planner or regulator and what mechanism can be designed to achieve the desired outcomes?

So far, these lessons have not been well understood. The most prominent attempt to apply mechanism design has been to auctions of public goods and tendering for government contracts. One example is the design of an auction of telecom licences in Britain in 2000 to prevent collusion among large bidders.

These examples are fairly isolated and the free market remains the default setting for the commonsense policy maker. If anything is learned from the crisis it should be that it is a mistake to simply pick those bits of our theories that are easiest to understand, or most ideologically acceptable.

n Alex Coram is a professor of political science and international relations at UWA.

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