We need to re-read his treatise on moral sentiments to appreciate the true causes of the financial crisis.
As the world economy recovers from the global financial crisis, questions related to causes of the crisis and the inability of economists to forecast it have gained significance. The recent report of the Financial Inquiry Commission set up by the US government provides an exhaustive narrative of the crisis and its proximate causes, but stops short of identifying the critical factor that led to the all-round crisis across economies.
This article argues that while the wealth and economies of nations have been built on Adam Smith’s free market approach, it is an inadequate understanding of the foundations on which Adam Smith intended the free markets to rest, that can perhaps be held responsible for periodic economic crises, including the most recent one.
The Financial Inquiry Commission found that just prior to the crisis, there was an explosion in risky subprime lending and securitisation, an unsustainable rise in housing prices, widespread reports of egregious lending practices, a dramatic increase in household mortgage debt and an exponential growth in unregulated derivatives, among many other red flags. The commission also identified widespread failures in financial regulation, corporate governance and risk management, lack of transparency, and a systematic breakdown in accountability and ethics as key causes of the crisis.
These factors are undoubtedly relevant, but the question that requires in-depth thought is, what is it that caused a breakdown or failure in each of the agencies and institutions, leading to not just systemic failure of those institutions, but systemic failure of economies as a whole? Identification of this underlying cause behind the causes is critical because remedial action at that level can prevent a recurrence of such crises.
The report mentions that there was a systemic failure across several agencies including, among others, financial institutions, governmentsponsored enterprises, regulatory bodies and credit rating agencies. Institutions pushed lending, risk taking and other activities beyond the dictates of normal prudence to maximise profits, at individual and institutional levels. There was an underlying psychology emphasising profit-making as the only relevant goal to be pursued relentlessly. Classical and neo-classical economic theory, justifying pursuit of self-interest as the socially optimal course of action, provided the licence to rationalise the pursuit of self-interest to ridiculous lengths.
Prior to the Industrial Revolution, which brought in its wake the concept of wage labour, the concept of “self” most often extended to interest of the tribe or community as a whole. However, the concept of “self” has progressively narrowed. The economic philosophy underlying faith in the invisible hand behind free markets has supported the practice of pursuing one’s limited self-interest as the rational course of action, even when the same has been in conflict with stability of the larger whole.
However, it appears that when Adam Smith referred to the advantages of an economic system based on self-interest of individuals, he had in mind individuals who had a moral fibre akin to that described in his Theory of Moral Sentiments, the opening words of which are: “Howsoever selfish a man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.”
The Theory of Moral Sentiments discussed concepts like propriety, the foundation of judgements concerning our sentiments and conduct, the sense of duty, character of virtue and systems of moral philosophy. Since this profound intellectual treatise was written prior to The Inquiry into the Nature and Causes of the Wealth of Nations, it is more than likely that Adam Smith’s concept of the individual self rested on foundations described in this earlier work, and should, therefore, have formed the building blocks of the real wealth of nations. Unfortunately, this did not happen, and these attributes did not find place in the economic framework as it has evolved thus far.
Why did The Wealth of Nations become a crucial part of the economic literature, while the Theory of Moral Sentiments, described by Nobel laureate Amartya Sen as an “outstanding book in the intellectual history of the world”, remain relatively obscure?
The Wealth of Nations acquired popularity as an economic text because it dealt at length with economic issues. In contrast, The Theory of Moral Sentiments was relegated to the field of philosophy as knowledge became compartmentalised.
Also, the Industrial Revolution and the accompanying material progress led to apreoccupation with the material aspects of life and a relative neglect of matters relating to moral sentiment and virtue, which were no less worthy contenders for the “mental space” available to human beings.
The last three decades, which reemphasised free market economics and the Washington Consensus as the basis of economic progress, reinforced the earlier trend and finally led to the recent financial crisis.
Fresh thinking on economic issues and integrating it more closely to the knowledge from philosophy, sociology, psychology and even neuro-science is needed to strengthen the foundations of economic theory. As aresult, public policy and practice will improve and society rescued from the present mess.
Daunting though the challenge may seem, it is not impossible, nevertheless. A beginning needs to be made, starting with the right thought emphasising the need to reverse the flow and stem the tide of blatant and uninhibited promotion of self-interest.
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