The Root Flaw in Economic Thinking

The idea of economic man, sometimes given a Latin nomenclature to increase its gravitas, is the real cause of economics’ more recent failures. Forty years ago it was referred to as a nineteenth century idea, as though the study of economics had moved on since that primitive Victorian era. But with Friedman’s shareholder primacy in the ascendancy with its supporting “theories” of agency, transaction costs and the market in corporate management, economic man resurged and is still dominant today, and wreaking its massive destruction.

It originated with Adam Smith’s ‘butcher, brewer and baker’, whose ‘self-love’, rather than ‘humanity’ was what produced ‘dinner’ for the population. But their self-interest lay in earning a living for themselves and their dependents over their life time. It was not concerned with maximising the benefit from the individual transaction, which was all calculus based economic theory was capable of modelling. Unfortunately, as discussed elsewhere on this site, the vital concomitant of maximising one thing, is the impoverishment of everything else. The result is necessarily short term rather than over a life time.

The sleight of hand, from self-interest to maximising/impoverishing was repeated with the Friedmanite deception of refocusing from profit to shareholder wealth. The underpinning idea was that the directors of a company were simply the agents of shareholders. This was the lie on which shareholder primacy is based. It leads to the so called ‘agency problem’ of directors being assumed, as examples of economic man, to be seeking to maximise their own utility rather than that of shareholders. To overcome the ‘problem’ required increases in bureaucracy to monitor and report on directors’ behaviour and to replace them if they were found not to be acting to maximise shareholder wealth.

The ‘agency problem’ may be real enough. As McGregor pointed out half a century ago, if you treat people as though they’re lazy, untrustworthy good-for-nothings, they may well feel inclined to behave that way. On the other hand, if people are treated according to Theory Y assumptions, there is a real probability they will respond accordingly. Agency theorists argue the only way to get company directors to focus on shareholder wealth is to make them shareholders themselves, through, for example, the now infamous share option schemes. Again, that may be successful. As David Ellerman, late of the World Bank, has pointed out, extrinsic motivation (eg monetary rewards) will inevitably ‘crowd out’ the more intrinsic motivations of real human beings.

The result, motivated and justified by bad economic theory, is the destruction of real economy firms, reorientation of company bosses from real strategic issues to quick profit deal making, explosive growth of the speculative financial sector feeding off the real economy, and the doomed attempt to recreate public sector organisations as pseudo-private sector firms, not to mention the deliberately seductive levels of remuneration for those bosses prepared to buy into and orchestrate the whole wretched fraud. And the root of that bad theory is the ‘economic man’ assumption.

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