Sunday, September 14, 2014

How Adam Smith Predicted the Financial Crisis of 2008

As a friend and follower of Ayn Rand and then Chairman of the Federal Reserve, first appointed by Ronald Reagan, Alan Greenspan was regarded as one of the leading proponents of free-market economic thinking.  But in October of 2008, as the global financial crisis created a deep recession, Greenspan admitted at a Congressional hearing that he was in "a state of shocked disbelief" that free markets had failed to steer the economy away from disaster. 

Matt Ridley (now Viscount Ridley, and a member of the House of Lords in Great Britain) has also, like Greenspan, been a proponent of free markets and libertarian thought.  In The Rational Optimist, he has even argued that the entire history of human evolution can be understood in the terms of Adam Smith as the progressive expansion of trade and the division of labor as spontaneous orders that foster wider and more productive cooperation.  Ridley's scorn of government verges on anarchism.  

And yet, he was quick to call for the help of government when he needed it.  He was the non-executive chairman of the Northern Rock bank from 2004 to 2007, having joined the board of the bank in 1994.  The bank fell into crisis in 2007 after making risky investments with money borrowed from other banks, and it became the first British bank since 1878 to face failure from a run of withdrawals by depositors.  The bank was forced to petition the Bank of England for a bailout.  Ridley was forced to resign.  In response to this scandal, some of Ridley's critics accused him of hypocrisy. 

In The Rational Optimist, Ridley writes one passage about this.  He expresses his regret, and explains: "The experience has left me mistrustful of markets in capital and assets, yet passionately in favour of markets in goods and services. . . . Speculation, herd exuberance, irrational optimism, rent-seeking and the temptation of fraud drive asset markets to overshoot and plunge--which is why they need regulation, something I always supported. (Markets in goods and services need less regulation.)" (9).  Previously, I have written a post on this.

Experiences like this have created a general belief that the financial crisis showed the failure of Adam Smith's optimistic vision of how the "invisible hand" could achieve prosperity and social stability through the spontaneous orders of free markets.

This belief is mistaken, however, because it ignores Smith's deep pessimism about whether his "system of natural liberty" was achievable, given the propensities of human nature to foolishness, fraud, and injustice that create economic crises.  When one looks at his reasons for pessimism, one can see that he foresaw all of the human mistakes that led to the financial crisis of 2008 and the Great Recession that it created. 

This also shows Smith's understanding of how markets depend on morals, so that markets fail without a healthy moral culture.  That explains why Smith saw political economy as part of moral philosophy, and thus his Wealth of Nations needs to be read together with his Theory of Moral Sentiments.

When one reads the whole of Smith's published writing with care, one of the main themes that emerges--perhaps surprisingly--is that Smith was pro-market but not pro-business.  As economist John Kay has noted, "both supporters and critics of the market economy have often confused policies that are pro-business with policies that are pro-market," and this has led to serious policy mistakes, while also weakening the moral and political legitimacy of market economies. 

Elaborating ideas that can be found in Smith, Kay sees three elements in the market economy: prices as signals for allocating resources, markets as a process of discovery that allows for adaptation to chaotic change, and diffusion of political and economic power.  The success of a market economy with all of these elements is manifest as what Kay calls "disciplined pluralism": "When prices act as signals, decentralized enterprises and decentralized information are brought together to create a coherent result.  Markets as a process of discovery are based on freedom to experiment, combined with discipline: unsuccessful experiment is acknowledged and terminated.  Markets as a means of decentralizing power are the determinant of the areas where politics and economics meet."

Smith makes it clear that rich and powerful businesspeople--merchants, manufacturers, and bankers--don't like this kind of market economy that diffuses and decentralizes power, because they want to use their concentrated power to engage in rent seeking by extracting wealth created by other people rather than creating it themselves.  Rent seeking can never be completely eliminated.  But the success of a market economy depends on limiting it.  The financial crisis was the product of too much rent seeking.

Kay observes:
"Rent seeking takes, and has taken, many forms--castles on the Rhine, the Wars of the Roses; ten per cent on arms sales, or seven per cent on new issues; awarding yourself control over former state assets, stealing the revenues from your country's resources deposits, seeking protection from foreign competition, blocking market access by new entrants; winning sinecures or overpaid positions by ingratiating oneself with public servants or corporate employees.  The mechanisms of rent seeking range from the application of armed force to victory in democratic election; the methods pursued range from lobbying on Capitol Hill and in the restaurants of Brussels, through access to the King or the Chief Executive."
I have been thinking about this while teaching my graduate seminar this semester on Smith.  Some papers by Maria Pia Paganelli have been helpful to me--particularly, "Is a Beautiful System Dying? A Possible Smithian Take on the Financial Crisis," The Adam Smith Review, 6 (2011): 269-282.  Much of what follows here draws from her article.

In Book IV of The Wealth of Nations, Smith refutes two false systems of political economy--the mercantile system that assumes that money or gold and silver is the sole or primary source of wealth and the agricultural system that assumes that land is the sole or primary source of wealth.  Both systems require that government enforces preferences and restraints on trade that favor some kinds of economic activity over others.  Such governmental intervention grants unfair privileges to those selfish interest groups that have influence over the government, and this violates the public interest, because it reduces the productivity of land and labor below what it would have been if economic activity had been free from such intervention.

At the end of Book IV, he concludes:
"All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord.  Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, an to bring his industry and capital into competition with those of any other man, or order of men.  The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of society" (Liberty Fund edition, 687).
According to the system of natural liberty, the government has three duties: the military defense of society against other societies,  securing the administration of justice to protect each individual against the injustice and oppression of other individuals, and erecting and maintaining certain public works and public institutions necessary for the public good that would never be erected or maintained by private individuals.  Book V lays out how government might fulfill these three duties.

The careful reader of The Wealth of Nations will notice, however, that this "natural system of liberty" does not really arise naturally.  In fact, Smith admits that "perfect liberty and perfect justice" is unattainable (674), that expecting to establish complete freedom of trade is utopian because it's opposed by public prejudices and private interests (471), that rich merchants and manufacturers "naturally" seek monopolistic privileges to satisfy their natural concern for their own self interest (462), that restrictions on the freedom of global trade satisfy some natural passions (467), and that in some circumstances, it is advantageous to restrict free trade to favor domestic industry (463).

 Smith also admits that the public interest requires governmental restraints on banking transactions, although these restraints are "in some respect a violation of natural liberty."  He explains: "these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical.  The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed" (324).

Smith suggests that what one sees in banking and financial systems generally are the impediments to a natural system of liberty that come from the distorting effects of three propensities of human nature.  What he says about these three propensities goes a long way towards explaining the recent financial crisis.

The first troublesome propensity is the tendency of many human beings to irrational risk-taking, because they overestimate their chances of success and underestimate their chances of failure.  Smith observes that "the chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued" (WN, 124-25).  This creates problems in lending markets.  Borrowers are too optimistic about their prospects for paying back their loans, and lenders who are rewarded for each loan they issue ignore the risks incurred in their loans.  This was a big part of the mortgage crisis.  Too many borrowers were asking for mortgages they could not repay, and too many lenders were giving out loans that were too risky.  Both groups assumed that housing prices would go up perpetually without the bubble ever bursting.  For this reason, Smith proposed regulations on lending by banks, even though this was a violation of natural liberty.

Smith thought that the foolish optimism of human beings about their luck was illustrated by their gambling on lotteries (WN, 125).  Similarly, as I indicated in my post on John Kay's lecture at the MPS conference in the Galapagos Islands on evolution and liberty, he has observed that many of the casino gamblers in London are successful entrepreneurs who play games of pure chance (like roulette and black jack) as if they know they're going to win.  They're irrational risk-takers who exaggerate their control over things.

The problem irrational risk-taking in banks and other financial institutions extending too much credit is exacerbated by excessive concentration of financial power.  When firms become "too big to fail," they are not punished for their imprudent decisions by going into bankruptcy, because they will be saved by governmental intervention.  For the free market economy to work in financial markets, there must be many small banks and financial institutions, which is what Smith recommends (WN, 329).  Allowing a bank to fail teaches bankers a lesson.  This needs to be done, Smith observes, because banks often do not understand their own interests, and they need to be taught to be prudent (WN, 300-21).  The failure of a small bank is not a great shock to the economy.  But if banks grow too large, their failure is too great a shock for the public good.

The second troublesome propensity is the tendency for our moral sentiments to be corrupted by our disposition to admire the rich and the great (TMS, 61-66, 226, 252-53).  The massive financial frauds of recent years can be explained by this tendency.  When deceptive financial practices yield billions of dollars of wealth, and when "the great mob of mankind are the admirers and worshippers, and, what may seem more extraordinary, most frequently the disinterested admirers and worshippers, of wealth and greatness" (TMS, 62), then it should not be surprising that great financial frauds are committed.

The success of financial transactions depends upon a moral culture of trust, because it depends on promise-keeping.  Daniel Friedman has written:  "Financial markets are where promises are traded: borrowers sell new promises to the highest bidder in the primary market, and investors buy and sell old promises in the secondary market" (Morals and Markets: An Evolutionary Account of the Modern World, 2008, p. 100).  When moral norms of trust decay, the financial system collapses.

The third troublesome propensity is the tendency for human beings to form factions to advance their special interests at the expense of the public interest.  (Here is where James Madison picked up much of his thinking about the "problem of faction.")  "Sometimes the interest of particular orders of men who tyrannize the government," Smith warns, "warp the positive law of the country from what natural justice would prescribe" (TMS, 341).  "To hurt in any degree the interest of any one order of citizens, for no other purpose but to promote that of some other, is evidently contrary to that justice and equality of treatment which the sovereign owes to all the different orders of his subjects" (WN, 654).

Rich merchants, manufacturers, and bankers show this behavior.  "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices" (WN, 145). 
"The interest of the dealers . . . in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public.  To widen the market and to narrow the competition, is always the interest of the dealers.  To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they would naturally world be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.  The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution. . . . It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it" (WN, 267).
Thus, Smith foresaw that big business would always be lobbying government to advance the special interests of big business at the expense of the public interest by engaging in rent seeking (WN, 434, 468, 493-94, 496, 647-48).

For this reason, the greatest enemies of a free market economy are big businesspeople.  This was manifest in the financial crisis of 2008.

Some of my other posts on Adam Smith can be found here, here, here, here, here, here, here, here, here, here, here, here, here, here, here, and here,.

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