There is much to criticize in economics nowadays. For example, the profession focuses far too little on political issues and far too much on beating students to death with mathematics. But much current criticism of the profession is based on misunderstanding and ignorance.

Consider Adam Smith’s concept of the “invisible hand,” which implies that a market equilibrium is efficient if perfect competition prevails and well-defined property rights exist. Contrary to what many critics suppose, mainstream economists do not assume that these ideal conditions are always present. On the contrary, economists tend to use these conditions as a benchmark for analyzing market failures. Like sniffer dogs, they search the economy for such defects and ponder how they can be corrected through intelligent state intervention.

In this respect, economists are like doctors, who have to know what a healthy body looks like before they can diagnose disease and prescribe treatment. A good doctor does not intervene arbitrarily in the body’s processes, but only in cases where there is objective proof of a disease and an effective treatment can be prescribed.

Environmental regulation addresses a particularly striking example of market failure. Markets are generally efficient if companies’ revenues correctly reflect all the benefits that their output bestows on third parties, while their costs reflect all the harms. In this case, maximizing profit leads to maximizing social welfare.

But if production entails environmental damage for which companies do not pay, incentives are distorted; companies may turn a profit, but they function inefficiently in economic terms. So the state “corrects” firms’ incentives by levying fines or issuing bans.

Another malady that economists sometimes diagnose might be called “Keynes disease.” If demand is too weak, it can lead to a sharp drop in employment (because wages and prices are rigid in the short term). The disease can be cured with injections of public, debt-financed stimulus – like giving a cardiac patient doses of nitroglycerine to keep his heart going.

Contrary to what many think, there is no fundamental bias against this medicine in mainstream economics today. But stimulus cannot be seen as a universal remedy. Many ailments that may afflict an economy are chronic, not acute, and thus call for other types of treatment. Trying Keynesian therapy to resolve, say, the structural problems currently affecting the countries of southern Europe would be like trying to cure a broken leg with heart medicine.

Nitroglycerine addresses the risk of circulatory collapse. In economic terms, that is what was needed following the 2008 global financial crisis. But long-term use of such medication can be fatal.

Here and elsewhere, ideology causes conceptual confusion. For example, Smith viewed competition as a basic condition of the invisible hand’s operation, because monopolies and oligopolies exploit consumers and restrict production. But only competition among providers of similar products is beneficial. Competition among providers of complementary goods or services is harmful, and can be even worse than a monopoly. (That is why train drivers and pilots, for example, should be forced into monopoly unions that represent all of the other employees of their respective companies.)

The market failures that initially give rise to public-sector intervention tend to recur internationally, which means that competition between states is usually not efficient, either. Examples include competition between welfare states to deter economic migrants, the race to the bottom in taxation, and regulatory rivalry in the banking and insurance sectors. Competition, contrary to what many on the right believe, is not always good.

Of course, ideology often overwhelms terminology on the left as well. Consider “neoliberalism,” a term of derision for many because it has come to be viewed as a doctrine of deregulation and pure laissez-faire. But in Europe, at least, neoliberalism has a very different meaning. It was coined by Alexander Rüstow, who in 1932 proclaimed the end of old liberalism and called for a new liberalism featuring a strong state that lays down a solid legal framework within which firms operate.

Homo economicus, the rationally acting egoist who populates economists’ models, has recently attracted criticism as well, because all too often he does not represent the real behavior of individuals. Behavioral experiments have shown conclusively the limited predictive value of this artificial construct.

But homo economicus was never intended to be used for forecasting; its real purpose is to make it easier to distinguish between market failures and mental failures. Economists seek to detect collective irrationality, and economic models that assume individual rationality facilitate that. By ensuring that policies respond to flaws in the rules of the game, not to individuals’ fallibility or irrationality, this “methodological individualism” saves us from dictatorial paternalism.

Banks that grant risky loans on too little equity illustrate the analytical value of homo economicus particularly clearly. Their profits are privatized, but any losses exceeding their equity are dumped on their creditors, or, even better for them, on the taxpayers.

This asymmetry turns banking into a casino: The house always wins. Banks choose particularly risky investment projects, which may be profitable but are economically damaging.

The problem is not caused by human irrationality; on the contrary, it arises precisely because bankers are acting rationally. As we know from environmental regulation, preaching common sense or ethics to bankers will not help; but changing bankers’ incentives – by, say, requiring higher equity-asset ratios – would work wonders.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Hans-Werner Sinn, Professor of Economics and Public Finance at the University of Munich, is President of the Ifo Institute for Economic Research and serves on the German economy ministry’s Advisory Council. 

Image: A man walks past buildings at the central business district of Singapore February 14, 2007. REUTERS.