Self-interest may be harmful to social health

Traditional economic theory is based around Adam Smith's assertion that individuals acting in their own self-interest can ultimately benefit society without consciously intending to do so. Producers motivated by profit develop and produce goods and services for the betterment of their fellow citizens.

Advocates of free market capitalism believe that this natural order suggests government interference should be minimised. Leave markets to determine the natural order and competitive pressures will ensure efficient outcomes.

Charles Darwin wrote The Origin of the Species, published in 1848. It is believed that his ideas were influenced by reading Adam Smith.

The concepts of natural selection and survival of the fittest interlock neatly with ideas about competition in markets ensuring efficient outcomes. But Darwin also pointed out a crucial aspect of the evolutionary process based on natural selection.

Traits that may favour individuals in the mating game may actually be harmful to the survival of the species. What is good for the individual may actually harm a society.

In the natural world there are many examples of this conflict.

The male elk grows large antlers, allowing him to do battle with his peers for mating rights. However, these antlers make him more vulnerable to predators. The male peacock grows a vividly colourful plume of feathers to attract mates. These feathers are otherwise of little practical use.

They make him a visible target for predators.

The conflict between the interest of an individual and that of society suggests Smith's belief in a natural economic order created by market competition may have a serious flaw.

Economist Robert Frank refers to this flaw as "Darwin's wedge".

An awareness of Darwin's wedge provides a lens on reality that throws up numerous examples of this conflict in human societies. The 2008 financial meltdown has been blamed on greedy bankers. But these bankers were acting in their own self-interest in a highly competitive lending market.

Any banker who refused to participate in the lending orgy that preceded the crash would likely have lost his job and certainly his bonuses. Self-interest in the marketplace may not automatically lead to social good.

Darwin's wedge plays out in various contexts in New Zealand.

Individuals can get rich by investing in housing, but nations cannot. Yet we continue to regard housing as the most attractive investment type. The reality is that no country has ever got rich by using borrowed money to bid up its own house prices.

The process is actually very distortionary for an economy.

In the 1930s, John Maynard Keynes pointed to another version of Darwin's wedge that was being played out to devastating effect during the Great Depression. He called it "the fallacy of composition".

What holds true for the part may not hold true for the whole.

Keynes pointed out that during the Depression, as consumers cut back their spending and increased their savings because of concerns about the future, this caused the overall economic situation to worsen. The fall in total demand in the economy led to more unemployment, creating a vicious downward spiral.

Keynes advocated massive government spending on infrastructure and other public projects in order to break this cycle.

After the 2008 financial crisis, most governments adopted Keynes' prescription to prevent a downward spiral.

Now, as governments around the world preach austerity in the face of mounting public debts, it is likely that countries will move back into recession. This has occurred in England under the Cameron Administration.

Darwin's wedge is also evident in the political arena. Last year's election in New Zealand offered several examples. Many voters are aware that there is an urgent need to address the retirement-age issue and to broaden the tax system. Our current tax system is distortionary for our economy.

Numerous commentators and tax-reform groups have highlighted this. Yet our political leaders are reluctant to address these crucial issues.

The reason is that individual voters will likely penalise any party that seeks to confront these issues, even though there is widespread awareness that these issues must be resolved. Individual self-interest prevents a socially desirable outcome. Darwin's wedge strikes again.

At a global level, Darwin's wedge is evident in the lack of meaningful consensus on how to address issues such as global warming, refugee flows, poverty, war and unfair trade practices.

Countries continue to act in their own self-interest, unwilling to take meaningful measures to resolve these issues.

Darwin's wedge is a seldom acknowledged feature of human societies. The only real solution lies in strong political leadership at both a national and international level.

Solutions to key economic and social issues cannot just be left to the impersonal forces of markets. Governments must set the parameters, particularly in resolving the conflicts between self-interest and the wellbeing of society.

It is important to recognise that the natural order that a capitalist economic system is supposed to deliver based on individual self-interest has some gaping flaws in it.

- Peter Lyons teaches economics at Saint Peter's College in Epsom and has written several economics texts.