The Baseline Scenario

Jeb Hensarling and the Allure of Economism

By James Kwak

The Wall Street Journal has a profile up on Mike Crapo and Jeb Hensarling, the key committee chairs (likely in Crapo’s case) who will repeal or rewrite the Dodd-Frank Wall Street Reform and Consumer Protection Act. It’s clear that both are planning to roll back or dilute many of the provisions of Dodd-Frank, particularly those that protect consumers from toxic financial products and those that impose restrictions on banks (which, together, make up most of the act).

Hensarling is about as clear a proponent of economism—the belief that the world operates exactly as described in Economics 101 models—as you’re likely to find. He majored in economics at Texas A&M, where one of his professors was none other than Phil Gramm. Hensarling described his college exposure to economics this way:

“Even though I had grown up as a Republican, I didn’t know why I was a Republican until I studied economics. I suddenly saw how free-market economics provided the maximum good to the maximum number, and I became convinced that if I had an opportunity, I’d like to serve in public office and further the cause of the free market.”

This is not a unique story. Robert Bork, who took economics at the University of Chicago Law School, recalled the experience as a “religious conversion” that “changed our view of the whole world” (quoted in Sidney Blumenthal, The Rise of the Counter-establishment, p. 303).

Introductory economics, and particularly the competitive market model, can be seductive that way. The models are so simple, logical, and compelling that they seem to unlock a whole new way of seeing the world. And, arguably, they do: there are real insights you can gain from a working understanding of supply and demand curves.

The problem, however, is that the people who are most captivated by the first theorem of welfare economics (the one that says that competitive markets produce optimal outcomes) are often the least good at remembering the assumptions that don’t apply and the caveats that do apply in the real world. They forget that the power of a theory in the abstract bears no relationship to its accuracy in practice.* As Paul Samuelson said in one of my two favorite passages of the original edition of his textbook (p. 36):

“Even [Adam Smith] was so thrilled by the recognition of an order in the economic system that he proclaimed the mystical principle of the ‘invisible hand’: that each individual in pursuing only his own selfish good was led, as if by an invisible hand, to achieve the best good of all, so that any interference with free competition by government was almost certain to be injurious. This unguarded conclusion has done almost as much harm as good in the past century and a half, especially since too often it is all that some of our leading citizens remember, 30 years later, of their college course in economics.”

Hensarling, who likes to quote market principles in the abstract, doesn’t appear to have moved on much from Economics 101. The Dodd-Frank Act, he has said, “is gradually turning America’s largest financial institutions into functional utilities and taking the power to allocate capital—the lifeblood of the U.S. economy—away from the free market and delivering it to political actors in Washington.” The alternative he proposes is to “restore market discipline, end taxpayer bailouts and protect consumers with innovative, competitive markets policed for fraud and deception.” This ritual invocation of markets ignores the fact that there is no way to design a contemporary financial system that even remotely resembles the textbook competitive market: perfect information, no barriers to entry, a large number of suppliers such that no supplier can affect the market price, etc.

As Samuelson continued, our economy “is neither black nor white, but gray and polka-dotted.” Regulatory policy that presumes well-functioning markets that don’t exist is unlikely to work well in the real world. Actually, Bill Clinton and George W. Bush tried that already, and we got the financial crisis. But to people who believe in economism, theory can never be disproved by experience. Hensarling is “always willing to compromise policies to advance principles,” he actually said to the Journal. That’s a useful trait in an ideologue. It’s frightening in the man who will write the rules for our financial system.

* Actually, one could argue that, because of competition among theories, those that are more powerful in the abstract are less likely to be accurate in practice.