Every economic model is built on political assumptions
By Anat Admati – There is absolutely no way to understand events before, during, and since the financial crisis of 2007-2009 while ignoring the powerful political forces that have shaped them. Yet, remarkably, much of the economics and finance literature about financial crises focuses on studying unspecified “shocks” to a system that it largely accepts as inevitable while ignoring critical governance frictions and failures. Removing blind spots would offer economists and other academics rich opportunities to leverage their expertise to benefit society.
The history of financial economics is revealing in this regard. By the second half of the 20th century, when modern finance emerged as part of economics, the holistic approach of early thinkers such as Adam Smith—which combined economics, moral philosophy, and politics—was long gone. Narrow social-science disciplines replaced the holistic approach by the end of the 19th century. In the 20th century, economists sought to make economics formal, precise, and elegant, similar to Newton’s 17th-century physics.
The focus in much of economics, particularly in finance, is on markets. Even when economists postulate a “social planner” and discuss policy, they rarely consider how this social planner gets to know what is needed or the process by which policy decisions are made and implemented. Collective action and politics are messy. Neat and elegant models are more fun and easier to market to editors and colleagues.
Lobbyists, who engage in “marketing” ideas to policymakers and to the public, are actually influential. They know how to work the system and can dismiss, take out of context, misquote, misuse, or promote research as needed. If policymakers or the public are unable or unwilling to evaluate the claims people make, lobbyists and others can create confusion and promote misleading narratives if it benefits them. In the real political economy, good ideas and worthy research can fail to gain traction while bad ideas and flawed research can succeed and have an impact.
Having observed governance and policy failures in banking, I realized that the focus on shareholder-manager conflicts is far too narrow and often misses the most important problems. We must also worry about the governance of the institutions that create and enforce the rules for all. How power structures and information asymmetries play out within and between institutions in the private and public sectors is critical. more>