Economics: In defense of Smith--it's not like he didn't warn us

Darkfrog submitted, created time 2 months 1 week (www.nature.com)

I really liked reading this article. Ostensibly, it's about how all the pro economists know that there are flaws in the traditional economic models, but no one talks about them to intro students or in the media. Even undergraduate economics students are taught the traditional models in their basic classes, but they graduate and go into financial professions without anyone ever mentioning the points at which these models fail to work.

The public is left to assume that the models are wrong and that the economists must have some spooky ulterior motive. In this economy, conspiracy theories can be very tempting. It's so much more satisfying to attribute a set of problems to another human being or beings than to accept that it's really these big systemic problems. The ideas are neater, fit into narratives, and are easier to fix--defeat the villain and all is well.

What I like about this article is that it allows me to draw a parallel between Adam Smith and Albert Einstein.

Adam Smith wrote a book called "Wealth of Nations" in about 1775 or so. He's credited with inventing capitalism. Today, people associate him with the greed and ruthlessness of modern captains of industry, but that wasn't remotely what he was about. Adam Smith was the a peace-and-love hippie of his age!

No, I haven't gotten into the year-old Halloween candy. To understand where I'm coming from, take a look at the economic philosophies that were around before Smith. Mostly, it's mercantalism. Mercantilism is the idea that wealth is based on precious metals. This makes sense on the surface. After all, you can spend a gold coin, but it's not destroyed in the process. If a country has a lot of gold and silver in it, mercantilists supposed, then it is wealthy. More importantly, mercantilism said straight-out that economics was a zero-sum game. That meant that every unit of good or service had an arbitrary value and that, in every buy, sell, and trade, the parties involved would either break even, win, or lose. Either you beat the other guy or he beats you. There's no such thing as a win-win situation and there's no getting around it, so don't even try.

It is possible to say that mercantilism is what led the Spanish to send their ships across the ocean to conquer the Americas and take the Aztecs' gold and silver back to Spain and to not bother trying to even things out, but that might be reaching. Still, it's a good illustration.

Adam Smith, on the other hand, said that a nation should be considered wealthy not if it has a lot of shiny metal, but if it has a lot of the things that its people need--if it has a lot of commodities. Gold is a commodity, but so are apples. So is electricity. So are clothes and toothpaste and tennis lessons and television shows.

Smith he also introduced the idea that commodities can have different values to different people. Lots of Asian cultures think that drinking milk is gross--bleh! Americans are creeped out by the invasive snakehead fish infesting their southern rivers. But the Chinese, as my coworkers have assured me, think that snakeheads are delicious, and some of my fellow Americans can manage to down milk and not puke. Adam Smith would say, "Let the Chinese trade their 'worthless' milk for Americans' 'worthless' fish and everybody wins!" The mercantilists would shake their heads, hide all the sharp objects, and mutter, "That boy i'n' right."

So where does the Einstein stuff come in? What most of us remember as a flaw in Adam Smith's view is that he also believed that a completely free and unrestricted market was the best way to go. Yep. No regulation, no government interference. Reward innovation and let the best company win. Now, in today's economic crisis--not to mention the savings and loan debacle of the 1980's--it seems that Smith was just flat-out wrong. Industry DOES need regulation. Government DOES need to interfere, and yes, sometimes that means lopping off the best rewards of the most successful to mitigate the worst follies of the least successful (someone stop me before I bring Epicurus into this).

Here's the part that the history books leave out: Adam Smith anticipated all of this. Think back to physics class. Think back to all those point-line drawings and cube-shaped pendulums. There was a reason why we did those experiments on paper and not in real life. There was a reason why the professor said things like, "Assume a frictionless surface." No, the equations wouldn't work exactly the same way in the real world because, in the real world, anything from a breath of wind to an imperfection in the shape of the instrument could throw things off, and our puny human brains just don't have the computing power to predict things on that level. But that doesn't mean that the equations aren't sound.

Galileo accepted that air resistance threw a cog in his gears. Einstein warned us that his predicitons about the behavior of the universe would not work inside black holes. Adam Smith knew his limits too. Adam Smith's frictionless surface was called "perfect information." Adam Smith believed that a completely lassais-faire economy would work ONLY IF EVERYONE KNEW EVERYTHING ABOUT EVERYTHING. And this was before the Internet!

If Adam Smith's models are any less sound in theory than Galileo's or Newton's, then the world has yet to prove it. Smith did warn his readers that if a merchant hid information from the customers, then the system would break down. If mortgage companies fudge records on their customers' credit histories or income levels, then the investors don't have the information they need to decide whether to buy those bundled securities. If Enron executives double and triple up the books, then the employees still think that putting all their 401(k) investments into company stock is a really nifty idea.

I don't know if Adam Smith's ideas will ever get a real test in the real world. Even with the amazing communication technologies that we have today, it's still pretty hard for an ordinary person to know everything about the economy, even when there aren't any other ordinary people actively trying to hide things. Here's an example: You probably think that I'm pretty good at this financial stuff, right? Well I get sent a prospectus now and then and it all just looks like friggin' gibberish. Yes, the information is there, but it doesn't have much meaning for me. No one's trying to hide it; I just don't speak the language.

And maybe that's the problem. Some restructuring of some kind is in order. At the very least, economics majors should be required to learn about the flaws of the traditional models, even if it's as simple as the, "Newtonian physics doesn't work on the submolecular level, but it's a great approximation for anything that's bigger than a speck of dust and slower than a zooming electron. You'll have to use Einstein for that stuff" that kept me from trying my Big Five equations on electron clouds when I was a high school student.

But what sort of systemic change should it be? Maybe we could just allow the government to take a hand and regulate the economy, and accept that with less risk there will come less reward. Maybe we need to shift from the Chinese characters of economic speech to some kind of hangul-simplified form that ordinary people can learn easily. Maybe we need to make some kind of economics for citizens a required course in high school, like drivers' ed.

I don't know. It's not a small answer with a conspiracy and a villain. It's big and sweeping and my puny human brain doesn't have the computing power to predict it all.

Keywords: conspiracy theories human behavior history science and culture education economists economics finance