Darwin & Economics

Here are bits from two articles by Robert H. Frank, an economics professor. He puts Darwin up against Adam Smith and claims that Darwin was the better economist. That fanatical free market theorists so in love with Smith's "invisible hand" will be deposed by the deeper insight of Darwin in individual versus group, and the needs for regulation to prevent extreme competition.

The first if from an article in the Guardian newspaper:

Though Adam Smith is almost universally regarded as the father of modern economics, most economists will eventually see Charles Darwin's ideas as the true intellectual foundation of our discipline. Smith's modern disciples celebrate his invisible hand theory, which says markets harness individual self-interest to serve society's interests. Smith himself was more circumspect, claiming only that self-interested actions often lead to socially benign outcomes. But that claim is remarkable enough. Competition among greedy producers often yields innovations that result in cheaper and better products for everyone.

It was Darwin, however, who better grasped the complex relationship between individual and social interest. And we must turn to his account if we are to understand the recent meltdown in financial markets. His deep insight was that natural selection favours traits and behaviours according to their effect on individual organisms, not groups. Sometimes individual and group interests coincide. But interests at the two levels often conflict.

...when individual rewards depend on relative performance. This payoff structure, common in financial markets, helps explain why those markets sometimes fail catastrophically. Wealth managers' salaries depend primarily on how well their investments perform in relative terms. Funds offering higher returns immediately attract cash from rival funds. If the invisible hand functioned as Alan Greenspan and other modern disciples of Adam Smith imagined, there would be no problem. Investors would be fully compensated for any additional risk they took in search of higher returns. But human brains forged by natural selection don't work as assumed in economics textbooks.

As our brains were evolving, immediate threats to survival loomed everywhere. Natural selection thus favoured a nervous system keenly sensitive to immediate relative payoffs, much less so to distant ones. 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. Even in the early years of this decade, many experienced analysts were warning that several mortgage-backed securities were poised to tumble. 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.

Adam Smith's invisible hand is a truly extraordinary insight. But when rewards depend on relative performance, it doesn't always deliver.

The financial meltdown that caught Adam Smith's disciples off guard would not have surprised Darwin. One of his central themes was that because much of life is graded on the curve, wasteful arms races create conflict between individual and social interests. The good news is that unlike other animal species, humans can often resolve such conflicts through intelligent regulation.

And here is an article by Robert H. Frank in the NY Times:

IF asked to identify the intellectual founder of their discipline, most economists today would probably cite Adam Smith. But that will change. Economists’ forecasts generally aren’t worth much, but I’ll offer one that even my youngest colleagues won’t survive to refute: If we posed the same question 100 years from now, most economists would instead cite Charles Darwin.

Darwin, renowned for the theory of evolution, was a naturalist, not an economist, and his view of the competitive struggle was different from Smith’s in subtle but profound ways. Growing evidence suggests that Darwin’s view tracks economic reality much more closely.

Smith is celebrated for his “invisible hand” theory, which holds that when greedy people trade for their own advantage in unfettered private markets, they will often be led, as if by an invisible hand, to produce the greatest good for all. The invisible hand remains a powerful narrative, but after the recent economic wreckage, skepticism about it has grown. My prediction is that it will eventually be supplanted by a version of Darwin’s more general narrative — one that grants the invisible hand its due, but also strips it of the sweeping powers that many now ascribe to it.

...

In Darwin’s framework, then, Adam Smith’s invisible hand survives as an interesting special case. Competition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always.

Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance, as in the antlers arms race. In the marketplace, such reward structures are the rule, not the exception. The income of investment managers, for example, depends mainly on the amount of money they manage, which in turn depends largely on their funds’ relative performance.

...

But humans can and do. 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.

Ideas have consequences. The uncritical celebration of the invisible hand by Smith’s disciples has undermined regulatory efforts to reconcile conflicts between individual and collective interests in recent decades, causing considerable harm to us all. If, as Darwin suggested, many important aspects of life are graded on the curve, his insights may help us avoid stumbling down that grim path once again.

The competitive forces that mold business behavior are like the forces of natural selection that molded elk. In each case, we see instances of socially benign conduct. But in neither can we safely presume that individual and social interests coincide.

These are excellent articles. You need to go read the originals to get all the details of the argument. Frank has given a devastating critique of the Chicago school of free market extremism.

Robert H. Frank is famous for his books The Winner Take All Society and Luxury Fever. Those are both worthy of taking the time to read them.