LESSONS FROM THE GLOBAL FINANCIAL CRISIS The relevance of Adam Smith on morality and free markets R I C H A R D M O R G A N Taylor Trade Publishing A Connor Court Book Lanham (cid:129) Boulder (cid:129) New York (cid:129) Toronto (cid:129) Plymouth, UK Published by Taylor Trade Publishing An imprint of The Rowman & Littlefi eld Publishing Group, Inc. 4501 Forbes Boulevard, Suite 200, Lanham, Maryland 20706 http://www.rlpgtrade.com Estover Road, Plymouth PL6 7PY, United Kingdom Distributed by National Book Network Copyright © 2009 by Richard Morgan First printed by Connor Court Publishing Pty Ltd in 2009. First Taylor Trade edition published in 2010. All rights reserved. No part of this book may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without written permission from the publisher, except by a reviewer who may quote passages in a review. British Library Cataloguing in Publication Information Available Library of Congress Cataloging-in-Publication Data Available ISBN 978-1-58979-577-8 (pbk. : alk. paper) (cid:2) ™ The paper used in this publication meets the minimum requirements of American National Standard for Information Sciences—Permanence of Paper for Printed Library Materials, ANSI/NISO Z39.48-1992. Printed in the United States of America “Wherein consisted the happiness and perfection of a man, considered not only as an individual, but as the member of a family, of a state, and of the great society of mankind, was the object which the ancient moral philosophy proposed to investigate… In the ancient philosophy the perfection of virtue was represented as necessarily productive, to the person who possessed it, of the most perfect happiness in this life.” The Wealth of Nations 3 LESSONS FROM THE GLObAL FINANCIAL CRISIS Acknowledgements Although the views expressed are the responsibility of the writer, I am grateful for a number of friends and colleagues who have provided invaluable assistance in the preparation of this work. I particularly mention Jim Donaldson, Ian McFarling and Graham Sellars-Jones, who have helped on a more or less regular basis. Others who were generous with their time and contribution include John Kiely, Ian McDonald, Des Moore, Andrew Shearer and Tim Tyler. 2 THE REVELANCE OF ADAM SMITH ON MORALITY AND FREE MARKETS contents Preface by Ian M. McDonald...........................................1 Introduction .....................................................................5 Smith’s Life and Career....................................................9 The Philosopher Economist...........................................13 Smith and Social Cohesion.............................................17 Moral Judgments.............................................................19 How Living Standards Are Improved............................21 Smith and Self Interest...................................................25 The Importance of Benevolence...................................27 Self Interest Does Not Mean Selfish...............................31 Self Interest, Saving, Investment and Prosperity...........39 Self Interest and the Banking Sector..............................41 Smith, the Critic of Exploitation....................................45 The Proponent of a Well Governed Society..................47 The Threat of Government Intervention......................51 Conclusion......................................................................59 Addendum – Diagram of key factors identified by Adam Smith and supporting quotations.......................62 References.....................................................................103 About the Author..........................................................104 5 LESSONS FROM THE GLObAL FINANCIAL CRISIS 6 THE REVELANCE OF ADAM SMITH ON MORALITY AND FREE MARKETS Preface The global financial crisis has challenged the belief that free markets are the best way of organising economic activity. It has suggested to many that free markets lead to greed and that greed leads to indifference to the well-being of others. An unintended consequence of greed-driven markets is seen to be financial collapse, a collapse that harms all, not just the greedy. This might suggest that the ideas of Adam Smith, a founding thinker and extoller of the benefits of free markets, are no longer relevant. Richard Morgan, in this valuable book, counters this suggestion by presenting a nuanced account of Adam Smith’s ideas in which markets are seen as mitigating greed, and in which an important role is seen for limited government regulation of markets. Morgan emphasises Smith’s stress on the importance of virtue for individual behaviour and the idea from ancient philosophy that virtuous behaviour leads to “the most perfect happiness.” The incentive of happiness to encourage people to act virtuously is reinforced by the argument of Adam Smith that social interactions, including market interactions, reveal to people the importance of empathy with others and the danger to their self-interest of treating people unfairly. Thus, virtue and self-interest are encouraged by market activity. 1 LESSONS FROM THE GLObAL FINANCIAL CRISIS In recent years a new area in economics has risen, that is the area of behavioural economics. Morgan sees ideas and empirical findings from behavioural economics as supportive of Smith’s views. For example, Morgan points out that Smith’s view that benevolence is a part of human nature is supported by the results of controlled experiments in behavioural economics. Here the evidence from the ultimatum game and the dictator game are very compelling. Other ideas from behavioural economics, in particular present bias and self-serving bias, are also shown by Morgan to be supportive of Smith’s views. The global financial crisis would not appear to Smith as unprecedented. Smith was well-aware of financial crises and incorporated their threat into his economic views. Smith observed from financial crises such as the 1772 crisis in Scotland, which, Morgan reports, reduced 30 banks to three, that an unregulated banking system posed great risks for society. Smith’s argument for government regulation of banks, as quoted by Morgan, p.38, is based on a negative externality, in that the security offered by the banking system to all people can be endangered by the actions of a few individuals. Morgan’s exposition balances Smith’s argument that markets devoid of government regulation can defeat themselves with Smith’s scepticism about the wisdom of government decision-makers. In Morgan’s view, governments bear some of the responsibility for the GFC in failing to control the amount and type of credit. More generally, Morgan reminds us of Smith’s warning to beware of “the man of system”, that conceited individual enamoured with his ideal plan of government. The 20th century has chilling examples of catastrophes due to men of system. Less far reaching examples occur 2 THE REVELANCE OF ADAM SMITH ON MORALITY AND FREE MARKETS regularly in contemporary democracies. Perhaps a weakness of people to believe that a simple answer exists for economic and social problems makes them prey to “man of system” thinking. Richard Morgan has made a valuable contribution with this book, by bringing together succinctly Adam Smith’s work on markets and on morality, that is The Wealth of Nations and The Theory of Moral Sentiments. The importance of the latter is being increasingly recognized by economists at the current time, correcting an excessive focus on the Wealth of Nations in recent decades. Furthermore, bringing into his discussion ideas and evidence from the new field of behavioural economics, Morgan enhances the contemporary relevance of this book. And of course confronting the ideas of Adam Smith with the global financial crisis sets these ideas in the context of a most important practical issue. In my view, this book is both illuminating and stimulating. Ian M. McDonald. University of Melbourne. 3