Push to beat rivals overtakes need to replace bad economic theory

Going all-out for maximised growth is often pushed aside

We all have a competitive instinct. Humans? natural urge is to compete. Rather than do the best for ourselves that we possibly can, many of us instead aim just to do better than the other guy.

Few will find this much of an insight. But if it is really our nature to compete, rather than to maximise our welfare, then our understanding of economics will need to be radically changed.

That is the contention of the author George Cooper in a delightfully well-written new book called Money, Blood and Revolution.

He holds, convincingly, that economics is a science in crisis and, after a breakneck tour of scientific history, tries to resolve that crisis. Whether or not he succeeds, the discussion is invaluable, far beyond academic economics.

The basic notion that we are competitors above all can be illustrated from everyday life; people tend to want to keep up with the Joneses. We do not necessarily need a BMW, until next door has one. Then, for many, it becomes an imperative.

Or take sport. Cooper uses the example of the great Jamaican sprinter Usain Bolt. He famously does not maximise his performance (or finish in the fastest time possible). Rather, when the race is assured he tends to slow down and once, famously, beat his chest. In the office, people do not necessarily need to maximise their pay ? but grow furious if they find they are paid less than a colleague.

All of this could be relevant to economics. The concept of a scientific crisis comes from Thomas Kuhn, the American physicist, historian and philosopher. Famous examples include astronomy before Copernicus, anatomy before William Harvey or biology before Charles Darwin.

Symptoms of scientific crisis involve an acrimonious debate between incompatible versions of the science ? plainly true of economics at present ? and a tendency for people to keep using scientific models that have been decisively disproved, simply because nothing better has come along.

Five years ago, in the wake of the crisis, requiems were sung for such icons of financial economics as the efficient markets hypothesis, or the ?Value at Risk? model for assessing the daily downside risk being taken in a portfolio.

These ideas proved catastrophically inadequate during the crash. Yet they are still used, as nobody has conceived better models.

When a science is in such trouble, Kuhn found that it was necessary to fix one of its founding axioms, such as the old astronomical notion that the sun circled the earth, rather than the other way around. It is an axiom of classical economics that people maximise utility, rather than competing with others.

It is not new to question this assumption. Behavioural economists have for years been substituting the findings from experimental psychology for traditional economic assumptions of rationality. The theory of the firm includes a healthy literature on ?satisficing,? in which companies try to make sure that their outcomes are satisfactory, rather than going all out to maximise their gains.

But the relevance of these ideas to finance is obvious. Fund managers do not try to maximise their returns. They try to do better than their peers. And that is no surprise, as that is what they are paid to do. Fund flows, and management fees, go to those who have beaten their peers. As for big institutions such as pension funds, they tend to satisfice rather than going all-out for maximised growth.

Under these circumstances, funds tend to pour into the same things, bubbles grow and anomalies go unchecked. Contrary to the economic axiom, they do not tend towards equilibrium or fair value.

Cooper makes a stab at being economics? Copernicus with a gloriously ambitious model that starts from the axiom that people are competitive, and also attempts to take into account two key learnings from experience. First, government can and does play a role in economics, and needs to be part of economic models; and second, that economic breakthroughs and growth in history have overlapped with breakthroughs in democracy.

This yields a theory of ?circulatory growth?, in which economies function best when money flows to the wealthy and governments through taxes and profits, but also circulates back to the poor through transfer payments. There is plenty here to annoy socialists and libertarians alike, but the ideas are certainly plausible.

Could this really do for economics what Copernicus did for astronomy? The odds are that it will not. But the need for a new theory is clear, if only to stop the world?s investors from continuing to use models and assumptions that have already been proven hopelessly unfit for purpose. Anything that contributes to this search is welcome ? particularly when it is as readable as Mr Cooper?s book.

Money, Blood and Revolution by George Cooper, published by Harriman House