Are Brick-and-Mortar Economists Leading Us Astray?

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policies and the actions of business -- developed when the world was far less connected than it is today -- is out of date.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.

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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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