Pursuit of Truthiness

my gut tells me I know economics

Were the Roots of the Global Financial Crisis in our Business Schools?

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No. Well, maybe, the proposition does sound like there is something to it, but after reading “The Roots of the Global Financial Crisis are in our Business Schools” I am actually much less convinced of this thesis than I was when I read the title. This is because the article throws a bunch of shit on the wall hoping some will stick, without even considering that some of the shit might be contradictory. But I think it is a good example of how populism that sounds reasonable at first will end up providing its own contradictions.

Two of the main arguments are that people in finance are too self-interested and care too much about profit maximization (and that they learned each of these in business school), and so don’t consider morality or what is good for society generally. Attributing the financial crisis to individual selfishness or to profit maximization might each sound good individually, but can’t work together, which is the whole point of principal-agent theory. Are people acting in their own best interest (work as little as possible, make as much money for yourself as possible, be neutral about what all this means for the firm), or are they acting in the firm’s shareholders’ best interest and trying to maximize profits? Given the actual history of the financial crisis, it seems more realistic to blame selfishness, since many of the firms involved spectacularly failed to maximize their profits, while the compensation structures based on short-term performance allowed many individuals to make a killing in the process of sinking their firms.

Another main bogeyman of the piece is Milton Friedman and the Chicago school of economics, who are claimed to have taken over business education (I wish!). They are blamed for teaching that individuals are rational and selfish utility maximizers, something which was actually in the textbooks of Alfred Marshall and Paul Samuelson well before the ascent of Chicago. More importantly, the very existence of many departments in business schools and financial companies demonstrate that the people involved do not believe in the standard economic model. How much marketing and advertising is based on the premise that the audience is rational? How many investment companies could justify their existence and huge salaries and fees if they really believed in the Efficient Markets Hypothesis, and believed that their clients were also rational and believed the EMH? Basically just index funds, which don’t have the huge salaries and fees anyway. As an economist, it is very hard for me to believe that my kind has had a huge influence over business schools or business practice. Though I may be a bit biased as a member of a department which just left the business school, and to its credit this argument is more empirically wrong than actually contradictory.

The article also blames Milton Friedman specifically for arguing that a corporation’s sole goal should be to maximize profits and shareholder value, rather than also caring about “corporate social responsibility”. What corporate goals should be is up for debate, but I think it is hard to say that the problem was firms being too profit focused. Again, the problem was that many of these firms turned spectacular losses and failed, or would have failed without bailouts. There are many possible reasons for this, which have been discussed to death: compensation structures, previous bailouts and moral hazard, lack of regulation or poorly structured financial regulation, a giant pool of investment-seeking money caused partly by overly loose monetary policy in 2003-4, misregulation and massive subsidies for the housing sector- all these could have encouraged excessive risk-taking that led to giant losses. But it is hard to argue that firms lost money because they were focused on making money. Furthermore, some of the firms which exploded worst were actually known for “corporate social responsibility”.

But suppose the financial crisis was caused by the standard economics model and the business schools- what do we do about it? This article provides further evidence that an argument jumps the shark when its proposed solution is “more Holistic approaches”. This is the epitome of something which sounds vaguely nice but is actually meaningless. Even better, the article calls for “the rejection of the ideology of rational knowledge in favor of one that gives greater weight to experience, or to spirituality”. I couldn’t make this stuff up.

So, the people actually making this argument made themselves into strawmen. What would a better version look like? Is it possible to “steelman” the argument? I would start with the observation that students who have taken economics classes are more likely to defect in the repeated prisoners dilemma, and their selfishness in this case leads them to worse outcomes than those who haven’t taken economics. Then discuss the importance of cooperation in business, especially as work is done by larger teams. Finally and most importantly, look for empirical evidence that firms act differently based on the college major of their management, and see if firms with more business majors and MBA’s actually take more risks and act less socially responsible.

One major advantage blaming business schools is that it can give new life to an old argument. After any financial crisis or other economic problem people tend to blame “greed”. Economists will often reject this argument by asking, “why was there suddenly more greed now? The crisis started suddenly but human nature changes slowly if at all”. But one possibility is that business schools have in fact been teaching people to be greedier. I’m sure one could make a reasonable case for this; but as we have seen, the worst fate for a position is not to be adeptly attacked, but to be ineptly defended.

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Written by James Bailey

November 25, 2012 at 2:03 pm

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