Economics in a Value-Based Society

I am taking a break from writing a piece that requires in-depth research and instead writing about something I have already studied and thought about. I would like to explain how I see economics and ethics (philosophy) interact. I am not formally trained in philosophy, and this will be written with the strong bias of an economist. But I hope to explain why the tension between the two exists, not from an academic perspective, but from a perspective of anyone who has had an opinion on the way things ought to be in government policy (this means everyone). My favorite cartoonist, Zach Weiner, has created the perfect comic that will even better show the argument I’m trying to explain: http://www.smbc-comics.com/comics/20110929.gif 

In the world of philosophy there are arguments for many different schools of ethics and morality. These different schools or belief systems define our values, which we presumably follow in our daily lives. Some values are complicated and create debate, such as whether or not smoking is bad and therefore whether or not we should tax tobacco to lower usage. Others are not, such as whether or not we should allow baby torture. Economics should be able to exist no matter the values of a society – it can exist outside of any moral framework. In its simplest form economics is based on the philosophy of utilitarianism—this is why ‘good’ things in economics, literally referred to as ‘goods,’ are said to create utility. Utilitarianism is the idea that we should maximize good things, commonly defined as those things that cause happiness. It is not a radical philosophy by any means, and it doesn’t really take a stance on values either; at least not in the way economists use it, which is what I am concerned with (as opposed to the original argument by Bentham and Mill).

Utilitarianism, however, has some serious faults. For example, consider the civil rights act—or even the end of slavery—where the government created a policy to protect people’s rights. This policy destroyed utility in its most basic form. That is to say, the government stopped people maximizing their utility to protect the rights of black people. They decided the value of protecting civil rights was important to our society and as a result it preceded the crude act of utility maximization. Another way of looking at it is that some ‘utility points’ are intrinsically worth more than other ‘utility points.’ Although this argument presupposes that there is an objective way of deciding what points would be worth more than others, and quickly falls to pieces. We can all agree that slavery is a bad thing but it is not easily argued against by pure utilitarianism. Another common argument that utilitarianism cannot answer is the question of the sadist, or a person who gains utility (happiness) from inflicting pain upon others. Hurting others increases the utility of the sadist but decreases the utility of the victim. How, then, can utilitarianism help us decide if the sadist should be allowed to hurt the victim? It is a simple calculus, weighing the sadist’s utility against the victim’s (assuming one could even measure such things)? Or are there some basic human values that utilitarianism just cannot capture, such as equality or fairness?

So far we have considered the basic philosophy behind economics and how it meshes with a populous that holds values (such as ‘slavery is wrong’). So how does this affect economists? Well, as I said before, economists like to attempt to operate in a value-free realm that only measures utility. And utility is defined as things that people like, whether it’s feeding the poor or shooting animals for sport. Economists are generally concerned with showing the incentives involved in a situation, the reasons people act they do given these incentives, and the way to maximize or minimize certain events with what is known about utility-maximizing and rational individuals. These duties are based upon generally agreed upon values that the sample they are working with all must hold. Inevitably no group of people will hold the same values, so while an economist maximizes value for the whole group, some people will win more than others. Utility can be maximized even if one person gets the entire possible surplus in an economy, leaving the rest with nothing. This can become a problem if the losers tend to be part of a certain group that society would like to protect, such as minorities or those living under the poverty line. The argument might then be made that while the current system maximizes efficiency in the short-run, it doesn’t maximize efficiency in the long run given our society’s values.

Consider two scenarios: In the first scenario person A and person B each receive 50 utility points. In the second scenario person A receives 70 points and person B receives 35 points. The second scenario is more efficient (70+35 is more points than 50+50), but it might be less efficient in the long run if by distorting the distribution of utility points, person B eventually becomes depressed and stops working as hard, leading to less output in the economy, leading to less utility points to go around, and so on. Many people might argue the second scenario is worse because it is less equal. But desire for equality is a subjective value held by society and is not part of the utility equaiton. Instead of looking at values, I would like to focus on short vs. long term efficiency.

I believe that Economics can build itself absent of values. It can help maximize the utility of a sample of people regardless of their values. Economists work within the constraints of government value-based policies. Whether or not a population agrees abortions are right or wrong, economists can help create policies to maximize abortions or minimize abortions given different incentive structures. We often see those against abortions creating legislation to pull money away from abortion services while those in support of abortion adding more funding.

In our complex reality where there are more than just a couple variables, the differentiation between efficiency and values is instantly obscured. Economists are often consulted and put in positions to create labor laws, for example. Consider the example I presented earlier with person A and person B in the two scenarios. Which scenario would be more efficient? Some economists might think that maximizing efficiency is the most important regardless of distribution, therefore preferring the second scenario with more points but distributed ‘unfairly’ (this does not include any considerations of the relative merit of person A and person B – in some situations it does seem fair that one person will deserve more compensation for doing more or better work). Others might think that it is important to consider equality and keep people who value equality satisfied so as to prevent them from becoming discouraged and quitting. In these situations economists are considering the values of others in creating their policies. But when these two economists debate they are each recommending a different policy based on their understanding of human values.

Paul Krugman is a left-leaning New York Times op-ed writer and author of Conscience of a Liberal. He believes our values should reflect compassion. In his book and writing he strongly believes that compassion, in the long run, will promote a more efficient and robust economy. The late Milton Friedman, a more right-leaning economist, believed that economists and governments should not consider compassionate values and let people make those decisions themselves with their own money, an argument most famously laid out in his book Free to Choose. They each had different personal beliefs on the values and nature of humans, specifically Americans. Of course, these two economists are on the most opposite ends of the spectrums as well as some of the most vocal. But their differing opinions illustrates how people trained in the same discipline and attempting to maximize the same thing, namely utility, can still have different views about the best way to maximize utility and what doing so means in a value-based society.

At this point I have established that

1.)   An economist’s job is to maximize utility and efficiency.

2.)   This job can exist no matter the values of the public.

3.)   The line distinguishing utility maximization and values becomes easily blurred in reality

4.)   As a result economists, in trying to maximize efficiency, often find themselves being forced to consider and develop their own values.

Through this process, policies are created. The goal of these policies is to implement efficiency in a way that is consistent with our values into a certain facet of society, market, government and so forth. I would now like to consider how we discuss the players affected these policies. A good way to study how people respond to various policies and incentives is through game theory. Let’s consider my favorite event to study, the financial crisis of 2007-2009. There was a lot of animosity towards bankers and the financial sector at this time. I wrote about this and the explicit reasons in previous posts (part one and part two). In my experience economists are often less likely to join in on the anger towards the financial sector. They would probably blame the rules of the game, or the incentive structure, instead. For example, imagine that there were only four banks in an economy. One of the banks develops an accounting loophole to hold high-risk mortgages in an “off balance sheet” conduit. They take a risk, but feel comfortable easing their foot into it, along with their team of lawyers on retainer. Eventually they quickly realize the loophole works! The legislators didn’t want this to happen. But legislation is slow, and there was billions of dollars to be made through this loophole before the legislators and regulators caught up. Suddenly this bank is doing far better than its three competitors. Now two of the other banks realize if they want to compete they need to develop an off-balance sheet conduit as well. At this point there are three banks making billions by exploiting an accounting loophole. Let’s pretend that bank four has a CEO and board with strong personal morals. They have always been against exploiting loopholes and engaging in quasi-legal activity. They saw their competitors making billions and the government and SEC doing nothing to stop them. Eventually bank four realized if they didn’t exploit this off-balance sheet loophole as well they couldn’t stay competitive and might even go bankrupt.

All these firms are players in a game. And the government sets the rules of the game. Should we be mad at firms who take advantage of loopholes? Or is it the legislator’s faults for not better setting up the rules? I’m not concerned with writing on morality or values, but I think that when the rule makers put firms and ultimately real people in positions where they need to decide to either stay competitive or stay moral, we haven’t given the people a fair chance. Their goal as an executive of a bank are to maximize utility (profit), within the constraints of a society’s values, which can really only be effectively imposed through regulation.

Not everyone will agree with me, and I think here my bias as an economist is very much revealed. It is a strong claim to say that it is okay for firms to do morally questionable activities because if they don’t do it they can’t stay competitive. But here is where economists can strongly deviate from those who want to debate morality. Whether or not it is morally permissible, it will happen. No matter how many centuries of anger at bankers and masses of people finding their actions ethically dubious, bankers will continue to exploit loopholes until they are prevented from doing so with strong regulation (where the punishment for doing so outweighs any potential benefit). An argument about how human nature ought to be will never be as useful in fixing an issue as creating a policy that accounts for people acting in their self-interest. Protesting specific firms might be a good idea in some cases. For example, if a firm tried to cover up a death due to a poor product, protesting can bring attention to the event and justly cause the firm to suffer. But protesting a general industry because the rules are set up to promote cheating will not convince people to be ‘nicer.’ Instead people need to protest those who wrote the rules of the game in the first place. So maybe economists aren’t actually saying that it’s okay that those who exploit loopholes and perform legally acceptable but morally dubious acts are acting immoral—just that we have no right to be surprised, and in a way we might have enabled them through inept regulation and perverse incentives.

Lastly, I would like to consider the other side of the argument. I think too often economists take ‘right’ and ‘wrong’ as constants that just reflect the general values of a population. Economists themselves are often in situations where they work to create policies. I don’t just mean members of the Federal Reserve members, but also those who think like economists (or who have been hired as economists) working at firms like Washington Mutual. Those executives were accused but never convicted of fraud. They exploited the lack of regulation in the mortgage backed securities (MBS) market to the core (see my post on the subject). They knew it was not illegal and made hundreds of millions before the firm crashed. While they may not have acted maliciously, they took an immoral (but legal) amount of risk. They might have just been products of a faulty regulatory system. But based on the values of our society, they should still know that they are rotten when they go to sleep at night.

7 thoughts on “Economics in a Value-Based Society

  1. Excellent. Morality aside, if we spent a fraction of the energy we do getting angry at people and “throwing the bums out” on changing existing harmful incentive structures in electoral politics, finance, health care, immigration, etc., we’d be in a very different position.

    I have no argument with anything written here, and just wanted to say I love what I’ve seen so far. Keep up the great work Simon and Alison!

    • While I agree that altering incentive structures is the ultimate goal, I don’t believe “getting angry” (i.e. protesting) is an insignificant act–as your comment and this piece seem to imply . Indeed, such acts are almost always the first steps towards achieving that ultimate goal. Energy spent getting angry can motivate politicians to change policies and, thereby, incentive structures. Maybe your comment was directed more towards people who just sit at home, brooding over bankers and crony politicians. And that’s the extent of their action (or inaction). If so, I get what you’re saying. But if it is more of a reflection on OWS or related movements, well…

      Nevertheless, this was a fun and interesting read!

      • To clarify, I am not at all complaining about protest movements; on the contrary, like you stated, protests are often the needed catalyst for action. I am happy to have movements like OWS, as they direct attention to clear problems and provide much needed space and platforms for debate…even though I must admit I am consistently frustrated with the lack of understanding of basic economics/politics on the part of many of the protesters. It is enough for me, though, that their heart is in the right place. We have had many conversations in the media and in private over the past several months that we would not have had without OWS.

        That said, I do find it incredibly disheartening that so many people (sometimes justifiably angry, sometimes wildly misinformed) do NOT view changing incentive structures as the ultimate goal, but rather think that long-term, meaningful, systematic change will occur simply by trading out one set of politicians for another. I like that anger leads to action, but if the action is just voting people out or appealing to morality, then we are treating the symptom (at best) and not the disease.

      • Thanks for your comment Max. I don’t have much time to respond so I will put it very succinctly. I would like to see protesters at a legislative building rather than a bank. But I do believe change is strongly necessary and the financial system as is, is poor.

  2. I’m not sure I buy your argument here. You should remember your Marx. You argue:

    > All these firms are players in a game. And the government
    > sets the rules of the game. Should we be mad at firms who
    > take advantage of loopholes? Or is it the legislator’s faults
    > for not better setting up the rules?

    You argue as if the economy were neatly separated from political discourse. Those firms are players in more than one game. They do not simply accord to the rules under which they buy and sell; they shape them. At times they buy them outright. Marx argued that state was nothing more than the executive committee of the bourgeoisie. You know I am not nearly so extreme in my views of democracy. Nonetheless, rebuking people who whine about greedy corporations for their lack of sophistication strikes me as a waste of your talents, brother. Teach them the arguments they SHOULD make, the arguments they COULD make had they been taught to see and understand what you have.

    If you want to be a philosopher and a writer, make economics sing. Make it weep. I believe that you can do it.

  3. If I may suggest, in terms of this is/ought problem, when you propose, “An argument about how human nature ought to be will never be as useful in fixing an issue as creating a policy that accounts for people acting in their self-interest,” you are basically saying: “arguments about how people ought to be aren’t as useful as descriptions of how people are.” Now, at first this is persuasive, except it seems to me that this is itself a statement about what people ought to do—ie, make more useful statements about how people are, not how they ought to be. So aren’t you arguing against your own premise there? You’re essentially telling us that it is less useful to make judgement statements—which is itself a judgement statement. So why should I believe you?

    You are clearly interested in how people choose to think about and apply economic theory—so you’re making a case of how people ought to be. Just like the people who are mad at firms who take advantage of loopholes, you have a sense of how those mad people ought to think: that they should look at the entire system, the rule-makers, the government, not just the banks.

    So, w/r/t your statement: “…it is okay for firms to do morally questionable activities because if they don’t do it they can’t stay competitive … Whether or not it is morally permissible, it will happen,” you are making a judgement about what people ought to do—not just describing. (Plus, via induction, we can only suppose “what will happen.”) So, given that you are interested in helping your audience make choices about economics—if not how to apply economics, how to think about economics—it would be more persuasive to say: “whatever might happen, this is what you should do.”

    (I hope this was useful and clear.)

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