- The Washington Times - Tuesday, April 28, 2009

OPINION/ANALYSIS:

As Wall Street staggers and the federal government takes an ever-increasing stake in the economy, there is an active campaign under way to repudiate the market system underlying modern economics.

Most eloquently described in the 18th-century works of Adam Smith and most recently embraced by former President Ronald Reagan and former British Prime Minister Margaret Thatcher, the market was viewed as the engine of economic growth essential for improving the well-being of a nation’s population.

The current economic downturn has provided skeptics an opportunity to ridicule this economic tradition, claiming it starts from a basic misunderstanding of the frailty of human nature and requires a fatal reliance on self-interest.

Indeed, a former prime minister of Denmark recently proclaimed, “the simple dictum of more markets and less government - championed by Mr. Reagan, Mrs. Thatcher and their ideological heirs - has failed on a momentous scale.”

The reality is much different - Adam Smith did not fail us; we failed him.

The dramatic market collapse of course requires an analysis of what went wrong. That is a matter of great debate, as commentators struggle over who lost Fannie Mae and Freddie Mac, and which party was guilty of the most irresponsible deregulation. Almost always, however, there is an assumption that market-based economics is complicit in the economic meltdown.

Critics claim existing economic models are mechanistically ignorant of the role played by faith and trust and that we must develop a better understanding of human nature in order to better contain the self-destructiveness that flows from unbridled self-interest. But for Smith, this is nothing new; it is precisely these aspects of human nature that initially inspired his work.

Smith’s first important work, “The Theory of Moral Sentiments,” was a direct challenge to one of the most provocative publications of the early 18th century - Dutch moralist Bernard Mandeville’s “The Fable of the Bees,” which held that self-interest alone would provide both the engine for economic growth and the check on the excesses of greed. Ordinary morality and justice were unnecessary.

Smith disagreed, and, to greatly oversimplify, he posited an ethic beyond simple self-interest. Man was innately interested in understanding how others would react to his own behavior, and, all other things being equal, people would tend to behave according to the Golden Rule - treating others as they would expect to be treated.

For Smith, a “tribunal within the breast” guides behavior, weighing actions according to how they would be viewed by an “impartial spectator.” These insights into human nature are critical, and Smith’s more famous work, “The Wealth of Nations,” cannot be appreciated fully in the absence of Smith’s earlier insights on conscience and moral philosophy.

Smith would have found much to question in the recent economic collapse, with a keen eye toward the government’s role in subverting important checks on self-interest. Local mortgage bankers would not intentionally market mortgages that neighborhood customers could not afford unless they were enticed to resell them to government-supported housing monopolies such as Fannie and Freddie, which had no ties to the community and few worries about repayment. Similarly, he would have criticized the Securities and Exchange Commission-supported exclusivity of the rating agencies, who risked no competitive check on inflating ratings for captive customers.

Smith also would have insisted on a stable monetary regime and would have vigorously opposed the Federal Reserve’s monetary expansions that he would have said unnecessarily favored the housing industry. Put simply, Smith hated monopolies and all other forms of government regulatory preference sought by businessmen to the detriment of competitors and consumers.

In fact, Smith did not much like businessmen at all, saying once that no two of them could get together in private without engaging in a “conspiracy against the public or in some contrivance to raise prices.”

Smith also would have worried about the misalignment of shareholder and management interests because, given such misalignment, self-interest alone would not lead bankers to protect their shareholders or their customers. Finally, given his reliance on the human need for “feedback,” it is also very unlikely that he would have countenanced the development of derivatives and securitization without an accompanying transparent market to support that need and the price signals necessary for the “invisible hand.”

It is thus inaccurate to claim that Smith did not pay any heed to temptation or human frailty when envisioning a marketplace motivated by self-interest. To the contrary, one of his principal concerns was the impact of special interests successfully seeking government preferences for self-serving policies that crowd out the normal operation of private morality.

Smith would not support as an answer to today’s difficulties the creation of a mixed economy with an expanding public sector, or even “big government conservatism” with all of the attendant opportunities for special-interest capture. Smith preferred the market precisely because of human frailty; he preferred the dispersed power of the market to the centralized nature of government as the best defense against unchecked self-interest.

C. Boyden Gray served as President George W. Bush’s ambassador to the European Union from 2006 to 2008.

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