Tuesday, July 14, 2009

Triumph of Darwin?

Robert Frank claims that Charles Darwin, and not Adam Smith, is the true intellectual father of economics. He feels that when rewards depend on relative performance, Smith's "invisible hand" falters, and "wasteful arms races that create conflict between individual and social interests" ensues. When relative performance becomes the determinant, relative incentive structures undermine the invisible hand.

Smith had written that self-interested actions, working through the now famous invisible hand, often leads to socially benign outcomes. Darwin's insight was that natural selection favours traits and behaviours according to how they affect the success of individuals, not species or other groups; and while sometimes individual and group interests coincide, often they conflict. In other words, traits that help individuals are often harmful to larger groups.

Prof Frank gives examples from animal species of such evolutionary changes that conflict with group interests - the large size of male elephant seals helps them in the competition (by giving them an edge in battles) to attract mates, while making them as a group far more vulnerable to sharks and other predators; a mutation for larger antlers served the reproductive interests of an individual male elk (again giving them edge in battles with other males for mating), but this becomes a fatal handicap when predators pursue males into dense woods etc.

The incentive structure in financial markets that favors imemdiate pay-offs, as against longer-term returns, means that the resultant competition favors those money managers who have a "nervous system biased in favour of short-term relative reward". But such an evolutionary development has adverse consequences for the market. Prof Frank writes,

"Anyone disinclined to seize immediate gains at the risk of having to incur costs in the future would experience low relative rewards in the short run. And when competition was intense and immediate, such individuals often didn't survive to see the long run.

In market settings, a nervous system biased in favour of short-term relative reward is a recipe for disaster. When the price of an asset like housing is rising steadily, unregulated wealth managers can create leveraged investments that generate enormous rates of return... But investors faced a tough choice - they could earn high returns by continuing to invest in them, or they could move their money elsewhere. Many rejected the latter strategy because it would have required watching friends and neighbours pass them by. Wealth managers felt compelled to offer the risky investments, since many customers would otherwise desert them. Managers also knew there would be safety in numbers when things soured, since almost everyone had been following the same strategy. The resulting collapse was inevitable."


He elaborates with more examples,

"To make their funds more attractive to investors, money managers create complex securities that impose serious, if often well-camouflaged, risks on society. But when all managers take such steps, they are mutually offsetting. No one benefits, yet the risk of financial crises rises sharply.

Similarly, to earn extra money for houses in better school districts, parents often work longer hours or accept jobs entailing greater safety risks. Such steps may seem compelling to an individual family, but when all families take them, they serve only to bid up housing prices. As before, only half of all children will attend top-half schools. It’s the same with athletes who take anabolic steroids. Individual athletes who take them may perform better in absolute terms. But these drugs also entail serious long-term health risks, and when everyone takes them, no one gains an edge."


And about the need for regulation, he writes,

"By calling our attention to the conflict between individual and group interest, Darwin has identified the rationale for much of the regulation we observe in modern societies — including steroid bans in sports, safety and hours regulation in the workplace, product safety standards and the myriad restrictions typically imposed on the financial sector."


Mark Thoma points to a talk given by Paul Krugman to the European Association for Evolutionary Political Economy on what economists can learn from evolutionary theorists.

2 comments:

Anonymous said...

You have raised two issues. Firstly that some indiidual actions are inimical to society. ( In fact Adam smith had not said that all individual actions have the invisible hand behind them.). Secondly, that we should not sacrifice long term objectives for short term goals.
Here is a take on the elephant seals issue: Maybe the herd of seals which cannot survive predatory attacks on them ought to perish! If there are more number of male seals there would be group politics and undercutting due to power struggle!

How much further can you take such analyses before it get as complicated as the initial chaos. I do admit that the hypotheses extant do not explain all occurrences. But they seem to be simple and understandable.

gulzar said...

thanks for the comments. I agree that there is a danger of over-theorizing that leaves us none the wiser.

I am sure that part of the motivation for Robert Frank in invoking Darwin was to ideologically question and unsettle the premiss behind Smith's invisble hand that underlies much of the free-market thinking. In fact, Smith had anticipated such outcomes and had therefore made the outcomes of his invisible hand conditional on a set of social and institutional frameworks that modulated its actions.

I cannot but agree that your take too appears relevant. But the underlying fact, which illustrates the contrast with Smith's arguement of self-interested actions leading to socially benign outcomes, that individual actions leads to evolutionary outcomes that conflict with the interests of the group as a whole. But then, as you write, any generalization is fraught with dangers.