How the Economists--and the Nobel Prize Committee--Are Still Failing Us

Who is more irrational: the tea party or the Nobel Prize committee? That's a pretty close call this week.

Tea party libertarians base much of their view of the world – and their current efforts to blow up Washington – on the simplistic idea that government is always bad and markets are always good. The more freedom, the better for all. The Nobel Prize committee effectively endorsed this concept on Monday by awarding the 2013 prize to the University of Chicago's Eugene Fama, whose "efficient markets hypothesis" was mocked even by the father of modern free-market economics, Milton Friedman, but which forms a fundamental justification of the world view that tea partiers, many of them unknowingly, live and breathe. That's the long-since debunked view that markets, especially financial markets, are always rational, so just let 'em rip. No regulation needed. No government needed.

So irrational was the Nobel decision that even the committee second-guessed itself; it simultaneously gave a piece of the 2013 award to Yale's Robert Shiller, whose life's work has sought to show that Fama's theory is "one of the most remarkable errors in the history of economic thought." (This is perhaps Stockholm's idea of what Wall Street calls a "hedge.")

Shiller has developed a field of "behavioral economics" fleshing out John Maynard Keynes's idea that irrational "animal spirits" drive markets more than policy-makers realize. If we needed any more proof of that, we got it in 2008, when we realized that virtually every Wall Street CEO and the biggest, most sophisticated banks in the world had no clue what they doing and would have destroyed themselves en masse had not the government (yes, the government) stepped in to save them at taxpayer expense.

Why does any of this matter now? Because in spite of the ample evidence before us, we in Washington still live in the free-market fantasy world that Ronald Reagan ushered in, that even President Obama has lamented he has not been able to alter, and which the work of economists such as Fama has propagated. Yes, we know that freer markets are better than "command" economies of the communist ilk. The end of the Cold War proved that as the United States essentially bankrupted the Soviet Union out of existence; even Beijing concedes this, as would the extinct dinosaurs of the Soviet era.

But it's long past time for the pendulum to swing back to the middle from the extreme conclusion that this means fully free markets always work well. They don't. The United States is, in truth, not a free-market economy but a "mixed" economy. As the great economist Paul Samuelson once wrote, the end of the Cold War meant only that "victory has been declared in favor of the market-pricing mechanism over the command mechanism of regulatory bureaucracy." The victor was plainly not pure laissez-faire capitalism but simply a more balanced economy—markets modified by government taxes and government-orchestrated transfers of wealth to limit inequality, and government monetary and fiscal policies to curb recessions and inflation.

The truth is not simple or rational, in other words, and in fact financial markets, most economists have long known, are the least rational of all,contra Fama. Even Milton Friedman didn't buy Fama's ideas, one of the late economist's students, Robert Auerbach, now a professor at the University of Texas at Austin, told me in a 2010 interview. Friedman asked his students: How could it be that all available information is instantly translated into price changes in a completely rational way, as Fama argued in his hugely influential theory, which opened the door to the kind of across-the-board deregulation that led Wall Street to almost destroy the global economy in the mid-2000s? Friedman pointed out that "traders couldn't make any money if that were true," Auerbach said.

Ironically, considering that it was tea-party antipathy to Obamacare – to "the government getting involved in health care"—that has put the United States on the precipice of default and economic disaster, some of the best economics work of recent decades has shown that the health care industry is one in which free markets don't work well. The Nobel-winning economist Joseph Stiglitz, among others, has demonstrated that this is because of the lack of good information shared between insurance companies and those they insure. The companies are habitually suspicious that their clients aren't forthright about their health and therefore always look for ways to deny coverage, like "preexisting conditions." Moreover, most health care is not a tradable "good"—everyone offers a different kind of service – and people rarely make "rational" decisions in health care. That's why many economists support universal coverage supplied or guaranteed by the government, or the idea of a public option. But you haven't heard much about that in the Obamacare debate, and of course as a sop to the free-marketers the public option was replaced by health care exchanges.

Obama himself has lamented the prevalence of a zeitgeist of free-market absolutism. Facing the debt-ceiling crisis in 2010, the president complained privately to a group of liberal economists how hard it was "to change the narrative after 30 years" of a small-government zealotry dating back to the Reagan presidency, according to one of the participants. In an interview last year, Maryland Gov. Martin O'Malley called it a "fairy tale gone wild." "Since Reagan, [the Republicans] have done a very good job of setting the frame and setting the story," O'Malley, a putative challenger for the 2016 Democratic presidential nomination, said. "The enemy is government. The enemy is taxes.… Taxes are things that must be eliminated. And the only good that comes from government is the elimination of taxes."

Economics, which flatters itself that it is a science (another myth perpetuated by the Nobel committee), should be helping us out of this confusion, but it is not. Should government be reined in? Of course. But the kinds of economic ideas that would allow a rational discussion of a mix of government and markets, spending cuts and revenue increases, no longer prevail in Washington, at least on the Republican side. And so we find ourselves in this perpetual non-debate, going from shutdown to shutdown and debt ceiling to debt ceiling, an endless state of brinksmanship fueled by misbegotten ideas. And the news from Stockholm isn't helping.