Are Brick-and-Mortar Economists Leading Us Astray?

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Increased levels of connectivity are rendering economic rules obsolete.

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Bookstores, newspapers, travel agencies -- add economists to the list. What do many economists have in common with these enterprises? They have clung to beliefs and strategies that no longer work in an overconnected world.  

Much of the economic theory that guides government policies and the actions of business -- developed when the world was far less connected than it is today -- is out of date. Theories that were once right are now wrong.

Adam Smith's "invisible hand" provided invaluable guidance to markets and did an excellent job of allocating resources in a less connected world. As long as the markets were local, externalities less important, and moral and government authority policed unsavory behavior, there was no better system.

Moral authority is the powerful thumb of the invisible hand.

In Smith's time such authority was exerted by the church, local institutions, government, and citizens. Most people conducted their business affairs in the communities in which they lived. As a result, control rested with one's neighbors, the people one saw in church, local business organizations, and local and national government.

During the Depression, Smith's invisible hand functioned in the following way: The mortgage business began in 1932, in response to a liquidity crisis. Back then, a 20 percent down payment was considered the minimum a bank would approve. And for this, the largest investment of their lives, borrowers would travel to their local bank and sit down with a loan officer who probably knew them, whose kids played baseball with theirs.

In those days, the banks owned the loans. If the loan went bad, the banks lost the money. If you knew the man and he fell on hard times, it was difficult to put his wife and kids out on the street on Friday, only to see him in the next pew that Sunday. Faced with that potential embarrassment, bankers were careful to make only those loans borrowers could afford. When customers had problems, the bank was much more likely to work with them to find a solution.

In today's overconnected world, banks externalize the costs of bad loans by creating Collateralized Debt Obligations and passing the losses off to endowments and pension funds. Some shadow entity takes the losses, the banks make a profit on the transactions, and bankers get the added benefit of never having to look the bankrupt person in the eye.

John Maynard Keynes's ideas worked splendidly when the world was less connected. Economic and fiscal policies that stimulated demand created local factory jobs. When those workers spent their paychecks, other jobs were created -- the multiplier effect. Today, stimulus creates more spending but the jobs and the trickle-down are in China.

The mathematically elegant formulas that win Nobel Prizes for modern economists are based on assumptions that no longer apply, and on historical data that is no longer meaningful in our overconnected environment. Unfortunately, those formulas are shaping much of the advice being dispensed. They were right for a less connected world but are wrong now.

Consider Robert Merton, who won the Nobel Prize in economics for his work on the Black-Scholes Model. Merton's model enabled people to assign the appropriate value to exotic financial instruments such as futures contracts and plain vanilla stock options. Merton became a victim of his own invention. He was one of the founders of Long Term Capital Management, which based its derivative trading strategies on the Black-Scholes Model. In 1998, "fat tails" that the model failed to take into account caused the bankruptcy of the firm and nearly triggered an international financial contagion. The slavish devotion to the model persists; it raised its ugly head again during the 2008 financial crisis.

The improper application of the theory is one of the things that fueled the spectacular growth in over-the-counter derivatives, from $60 trillion in 2000 to more than $600 trillion in 2008. This growth took place while the economists and regulators using bricks and mortar logic were arguing that derivatives distributed risk, when in fact massive amounts of derivatives concentrated risk.

The fat tails played a starring role in the bankruptcy of Lehman Brothers and the $182 billion bailout of AIG. Merton's theory was right when certain assumptions held, and wrong when they were applied in an overconnected environment.

Economists, policy makers, and presidential advisors have to get it right. Their influence is so great that when they get it wrong, tragedy often ensues. As Robert Heilbroner explained in his classic book, The Worldly Philosophers, the impact of Adam Smith, Karl Marx, John Maynard Keynes, John Stuart Mill, Thorstein Veblen, and Joseph Schumpeter has been immense. Heilbroner argued that "he who enlists a man's mind wields a power greater that the sword or the scepter" and that they "left in their train shattered empires...undermined political regimes: they set class against class and even nation against nation...because of the extraordinary power of their ideas."

The crisis in Greece offers convincing evidence that the "shattered empires" and events that "set class against class and even nation against nation" has not come to an end. Greece was a victim of the bricks and mortar design of the euro and is about to suffer the pain of a bricks and mortar solution.

Today's brilliant economists still exercise Heilbroner's extraordinary powers. All too often, they are enlisting politicians' minds based on a great deal of theory that was right then and wrong now.

Amazon has already killed off Borders, as well as thousands of independent booksellers. Blogs and online news outlets are replacing print media. Expedia and Orbitz are reinventing the travel business. Increased levels of connectivity are rendering economic rules obsolete. In posts to follow, I will be discussing some of the new rules for a virtual world.

It is time for the worldly philosophers who advise us give up their obsolete bricks-and-mortar ideas and develop economic theory for an overconnected world. President Obama and the Republican presidential candidates alike would be well advised to demand a different way of thinking.

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Bill Davidow is an adviser to Mohr Davidow Ventures and the author of Overconnected: The Promise and Threat of the Internet.

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