Thursday, December 26, 2013

Ethics, incentives and inequality

Joe Stiglitz digs out a quote from Adam Smith, the great classical liberal theorist of capitalism, and uses it in an op-ed piece, In No One We Trust New York Times Opinionator 12/21/2013:

The undervaluing of trust has its roots in our most popular economic traditions. Adam Smith argued forcefully that we would do better to trust in the pursuit of self-interest than in the good intentions of those who pursue the general interest. If everyone looked out for just himself, we would reach an equilibrium that was not just comfortable but also productive, in which the economy was fully efficient. To the morally uninspired, it’s an appealing idea: selfishness as the ultimate form of selflessness. (Elsewhere, in particular in his "Theory of Moral Sentiments," Smith took a much more balanced view, though most of his latter-day adherents have not followed suit.)
AS it happens, I just finished reading Smith's Theory of Moral Sentiments (1759). He took fellow Dutch philosopher Bernard de Mandeville (1670-1733), whose most famous work was The Fable of the Bees, to task for his philosophy that asserted a radical version of a sort of invisible hand that bring virtuous results out of selfish actions:

It is the great fallacy of Dr. Mandeville's book to represent every passion as wholly vicious, which is so in any degree and in any direction. It is thus that he treats every thing as vanity which has any reference, either to what are, or to what ought to be the sentiments of others: and it is by means of this sophistry, that he establishes his favourite conclusion, that private vices are public benefits. [my emphasis]
Smith was specifically rejecting this Ayn-Randian philosophy of Mandeville's. Contrasting the "love of glory" to "the love of virtue," he argues for the virtue on conforming to the moral standards of the community: "The man who acts solely from a regard to what is right and fit to be done, from a regard to what is the proper object of esteem and approbation, though these sentiments should never be bestowed upon him, acts from the most sublime and godlike motive which human nature is even capable of conceiving."

Stiglitz' op-ed emphasizes the need for a minimum level of trust in the functioning of a country's banking system, referring to the crisis that began in the US in 2007:

One of the reasons that the bubble’s bursting in 2007 led to such an enormous crisis was that no bank could trust another. Each bank knew the shenanigans it had been engaged in — the movement of liabilities off its balance sheets, the predatory and reckless lending — and so knew that it could not trust any other bank. Interbank lending froze, and the financial system came to the verge of collapse, saved only by the resolute action of the public, whose trust had been the most abused of all.

There had been earlier episodes when the financial sector showed how fragile trust was. Most notable was the crash of 1929, which prompted new laws to stop the worst abuses, from fraud to market manipulation. We trusted regulators to enforce the law, and we trusted the banks to obey the law: The government couldn’t be everywhere, but banks would at least be kept in line by fearing the consequences of bad behavior.

Decades later, however, bankers used their political influence to eviscerate regulations and install regulators who didn’t believe in them. Officials and academics assured lawmakers and the public that banks could self-regulate.

But it all turned out to be a scam. We had created a system of rewards that encouraged shortsighted behavior and excessive risk-taking. In fact, we had entered an era in which moral values were given short shrift and trust itself was discounted. [my emphasis]
He discusses a critically important issue, how supposedly performance-based incentives have in practice contributed to reckless behavior that can be rational for individual CEOs but destructive to the society at large and to their own corporations:

So C.E.O.’s must be given stock options to induce them to work hard. I find this puzzling: If a firm pays someone $10 million to run a company, he should give his all to ensure its success. He shouldn’t do so only if he is promised a big chunk of any increase in the company’s stock market value, even if the increase is only a result of a bubble created by the Fed’s low interest rates. ...

In practice, the right’s narrow focus on incentives has proved inimical to long-term thinking and so rife with opportunities for greed that it was bound to promote distrust, both in society and within companies. Bank managers and corporate executives search out creative accounting devices to make their enterprises look good in the short run, even if their long-run prospects are compromised.
And he explains how the staggering levels of inequality in American society corrode the basic levels of trust within society.

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