Where Jean Tirole goes wrong

The 2014 Nobel Prize winner’s models make some patently invalid assumptions about the real world: that governments don’t have self-interest, and that people are more rational when making collective decisions than when making individual decisions.

There was a very particular reason why, what we call ‘Economics’ today, was called ‘Political economy’ in the not so distant past. The transition of names was innocuous but it has led to such departures from reality that conclusions of ‘mainstream’ Economics must be approached with caution.

The basic assumptions

Economics, as it’s practiced these days, makes a simplifying assumption which is clearly invalid in the real world. What is that assumption?

Some will point out that this invalid assumption is that human beings are self-interested and rational! They are right and all schools of economic thought make this incorrect assumption. But the differences between different schools of thought show up in whether they use this assumption only for predictions or also for policy prescriptions. But let’s get to details on this later because this actually is not the most damning assumption made against ‘Economics’.

How would you react if I suggested that a better assumption to make while building the edifice of ‘Economics’, is that there exists a group of people who are rational and interested in the welfare of others? That this group chooses other people’s interests over their own? How would economics with this assumption look like? And then if I add another assumption that these people can be identified through democracy and should be given economic powers over the rest? How would Economics start looking now? Yes, it will start looking exactly like the ‘mainstream’ economics of regulation!

‘Mainstream’ regulation economics makes all these assumptions. A group of selfless people, with prowess in game theory, identified through democracy, by those same irrational people voting, who though incapable of managing their own money, will somehow identify what is in society’s best interest and choose these altruistic people to regulate the economy.

‘Political economy’ vs ‘Economics’

And this brings us to the semantic difference between ‘Political Economy’ and ‘Economics’.

‘Political economy’ assumes that the same patterns of self-interest apply to the political process as to the market process. Indeed, most economic events of the past several centuries can be explained beautifully with this assumption.

What we are these days taught as ‘Economics’, assumes that the political process is somehow less or un-affected by self-interest. And hence it is appropriate to subordinate the market process to the political process.

Yet, I would be doing a disservice to economics if I paint all schools of thought with the same brush. This baseless assumption is not shared by all schools. It is at the heart of the contemporary Marxo-Keynesian regulatory narrative. Without this assumption, regulatory economics cannot stand on its feet.

Austrian economics, which is much similar to Political Economy, rejects these assumptions about political players being more virtuous than economic players. Both are assumed to have similar self-interests, ready to use all means available to enrich themselves. Real world experience is our best guide and if you value it, this assumption looks more reasonable.

Human irrationality and free markets

On the question of assumptions, let’s also touch on the other common assumption attributed to economics—that human beings are self-interested and rational. The criticism is that free market ideas depend on an assumption that people are rational in the choices they make. And because this assumption is not always true, free markets fail.

What could be a worse travesty of logic! The fact is that regulatory ideas depend on the assumption that people are rational when they are choosing their politicians! Is this a valid assumption?

In the real world, no individual is perfectly rational or irrational. Every individual is affected by personal subjective emotions while making economic decisions. Even those who are more rational than others, can make mathematical mistakes when evaluating their options. So the real world question is this: Are individuals more rational when making personal economic decisions or when making collective political decisions like choosing politicians in elections? The answer to this question will determine whether free markets or government regulated markets are to be preferred.

Human irrationality is actually an argument against government control of markets. But then, why do most people consider human irrationality an argument against free markets? Because of an unstated, unverified assumption that humans are rational when choosing governments.

Generally, most people put in more effort while making decisions which affect them directly than when taking collective decisions. Collective decisions turn out to be even more irrational than individual decisions. Even Modi supporters will agree that many of their fellow supporters supported Modi for highly irrational reasons. Less said about Rahul Gandhi supporters, the better.

The fear of monopolies

The textbook case in favour of regulation is the monopoly argument, Jean Tirole earned his Nobel Prize this year for studying this phenomenon. Monopolies are the primal fear of mainstream economics. The solution given to us is government regulation. In other words, the solution to the problem of monopolies created by the free market is to create a bigger monopoly called the government, with which you cannot choose not to interact, and which has the power to take your money even if you are dissatisfied with its provided services! So, socialists, what was the original problem with monopolies, again?

‘But we choose the government through elections,‘ we are told! To see how uninformed this idea is, let’s consider monopolies again.

What is a monopoly? If a corporation has a 40% market share, is it a monopoly? Probably no. 60% customers in that market are choosing other companies. So nothing to worry about!

What if a company controls 80% market share? Now we are starting to get worried! Only 20% are choosing other companies. This is bad.

What if I propose a model which says that if 40% people choose a corporation and the rest 60% choose other corporations but no other corporation controls more than 40% market share, all 100% will be forced to pay and use the products of the company which has 40% market share. Now this is scary indeed for the socialist who has been studying the standard model of monopoly in textbooks.

What was the vote share of NDA in the 2014 elections? It was 40%. But 100% of the population has been forced to live their lives according to what 40%, rationally or irrationally wanted. The money owned by the 100% is spent the way 40% want it be spent.

Imagine, what would happen if 100% were forced to use the product of the corporation which satisfied only 40% of the market? Won’t that be horrible? But this is already happening in the political process. This tells us two things. First, the political process is more efficient at creating monopolies than the market mechanism. A 40% market share becomes a monopoly in the government mechanism but not in the market mechanism. Two, socialists are irrational. The last thing to do is leave government choices to socialists.

I might abhor NREGA myself, but I will defend to death the right of a socialist to use his tax money for funding NREGA-like programmes. The existing model denies this opportunity to the socialist. Tax money taken from socialists, is being used the way Sanghi Right wingers want! If this does not convince socialists of the inferiority of the government mechanism, nothing will!

If I don’t like a market monopoly, I have an option to not give my money to the monopoly. If I don’t like the political monopoly, it still has the right to take my money. So how about giving control to the political monopoly over the market! Monopoly fearers better start fearing the worse monopoly of the two!

The economics of monopolies

The problem with monopolies, we are told, is that a monopolist reduces production and increases prices. Compared to what? you may ask. Compared to the socialist defined ‘perfect competition’ model. Jean Tirole’s work is said to improve our understanding of this problem and provides regulatory solutions. While suffering from all the flaws of the wrong assumptions discussed earlier, its flaws are not limited to these wrong assumptions.

What does a monopolist do with the remaining capital after reducing production and increases prices? Does he keep this capital under his pillow? No, he invests them in sectors even more profitable than the original sector. Or, he does not even loan in that capital, leaving it available to be loaned out and invested by others in other more profitable sectors.

Let us say the government is able to do something to change this state of affairs. Break up the monopoly, or introduce more players into the sector. Either this increases the investment in this sector or it doesn’t. If it does not, it means we have broken up the economies of scale leading to less production with the same amount of investment. Is this good for customers? Or do we increase the total investment in the sector with an associated decrease in investment in some other sector? So you might think you have solved a problem, but the textbook does not tell you about the investment reduction in the other sectors you have caused. Now this is another new problem which is to be solved by more government regulation!

Am I arguing in favour of monopolies? Absolutely not! I am arguing that government regulation is not the solution to market monopolies.

The monopolies we should actually fear

In what cases are monopolies a problem, which require a change in governmental policy? These are the monopolies sustained due to governmental control over the economy. Monopolies we should fear are those where government has kept out competitors through regulation like Business Licensing with licensing handled by those who already have licenses! I would have loved to hear a game theoretic analysis from Jean Tirole on how licensing requirements create monopolies. But maybe he believes in the conventional wisdom of governments chosen by perfectly rational human beings!

We should fear when governments impose minimum wage laws and drive out the competition not having economies of scale, thereby sustaining monopolies.

We should fear when the government chooses to spend our money while using its own discretion to choose the private provider, thereby creating monopolies. This is where Jean Tirole has applied game theory to figure out that the best option is to give an option of various possible contracts to the private player to overcome informational asymmetry. But what happens when the government agency making the choice has its self-interest involved? As would now be obvious, the game theoretic problem chosen to be solved is wrong. The actual game theoretic problem is for the voter to choose between giving and not giving government the power to spend his money, while considering the self-interests of both the government and the private player involved. That is the difference between textbook economics and real world political economy.

Do you mean governments can do nothing right?

No.

The sensibility of the decisions of a government will depend on the level of rationality of the citizens who choose it. If the citizens are highly rational, the government will behave rationally. But if the citizens were highly rational, then even the free market will work. What benefit did the governmental regulation model give society?

If the citizens are irrational, they will choose a stupid government. How is the government regulation model helping here? Are there examples of a group which was not rational with their own private money, choosing a rational government?

The basic idea is that the level of rationality of the government will depend on the average level of rationality of the citizens. Government is not some magic entity which will automatically start making smart decisions for stupid people!

But deregulation caused the 2008 market crash!

The biggest Goebbelsian lie of the modern era is the theory that deregulation and free markets caused the 2008 market crash. Complicated financial instruments which were not regulated well enough by the government have been blamed for the crash. The solution proposed is more government regulation.

Let’s see. What will happen if the central bank buys a lot of government bonds from a bank and pays them in dollars? The bank now has more money to lend out at a lower interest rate .Who gets this money? The rich, because they are the debtors of choice for the bank. But is all the money used up? No. An increase in the money supply will inadvertently lead to reduction in lending standards. There is no escaping that.

Now continue doing this for multiple years and you create a bubble of spending. Add to the cocktail, government guarantees to banks against home loan defaults. You will get a housing price bubble. But the monetary expansion is also continuously moving purchasing power away from the poor to the rich. It will inevitably crash when the purchasing power of the poor depletes to such an extent that there are now no more customers for the bubble production. The crash precipitates. Loans are defaulted on by those who bet their lives savings on inflation going even higher. Long term investments by corporations become useless because customers have lost purchasing power.

Misallocation of capital caused due to monetary expansion leading to crashes has been so firmly established as a theory but governments and government-affiliated economists are not ready to let people know the real reasons for economic crashes. Governmental monopolistic control over money supply is the prime cause of the business cycle. But government’s self-interest miseducates the voters. This again is an example of how ignoring self-interest of the government leads to erroneous policy prescriptions.

So of what use is Jean Tirole’s research?

Jean Tirole’s research will help in designing new example problems in Game Theory textbooks. And new problems to be solved by students in their exams.

The people will serve themselves well by not applying these ideas to the real world and thereby giving governments more power over the market, precisely because these models make some patently invalid assumptions about the real world. The invalid assumptions that governments don’t have self-interest and that people are more rational when making collective decisions than when making individual decisions.