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The Credit Crunch

Don’t Blame Adam Smith

Toni Vogel Carey says Smith never wanted the free market to be freely corrupt.

Modern market economics was born in Scotland in 1776, with Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations. In 1876 the editor-in-chief of The Economist Walter Bagehot declared that “its teachings have settled down into the common-sense of the [British] nation, and have become irreversible.”

Smith’s political economics has had its detractors, of course. In Bagehot’s time it was tainted by Social Darwinism, the position – held neither by Darwin nor by Smith, but by Herbert Spencer – that biological survival of the fittest explains and justifies business competition red in tooth and claw. Strong challenges came from both Marxist and Soviet communism. And for fifty years, from Roosevelt’s presidency until Reagan’s, Smith’s theories were out, and John Maynard Keynes was in. After that, though, the stock of Smith’s market-based capitalism climbed to the sky, and its teachings began settling down even in communist China.

The question is whether Adam Smith will be blamed and discredited for the crash of 2008, as he was for that of 1929. Asked which economist is most influencing his thinking now, Larry Summers, director of President Obama’s National Economic Council, gave a one-word answer: Keynes. Is it that we need Keynes when the economic ship is sinking, and Smith when it rights itself? Does the pendulum inevitably swing back from too little regulation to too much, in an equal and opposite over-reaction? Experts endlessly debate these questions. I just want to make the simpler point that a) there are many people to blame for the crash of 2008, but b) Adam Smith is not one of them.

Bubble, Bubble

The primary cause of the crash of 2008 was rampant speculation in real estate, more particularly in exotic financial ‘derivatives’ known as ‘collateral debt obligation’ or ‘credit default options’ (CDOs). The market for these instruments eventually topped a mind-boggling $530 trillion. They were supposed to hedge (insure) against default on mortgages issued with no money down, and no test of the borrower’s ability to pay, on the pie-in-the-sky premise that housing prices only go up. Whether the problem was CDOs themselves, or just their misuse, in 2003 Warren Buffett accurately called them “financial weapons of mass destruction.”

After the Bernard Madoff scandal came to light, one pundit remarked that “discovering what the crooks have been up to is disillusioning, but not as disillusioning as coming to terms with what the so-called honest people did.” We still do not know the full extent of the carnage; but we can trace some of the major fault lines that caused Wall Street to implode. Culprits included thousands of otherwise normal people. Greed was as evident in Orange County and Tampa as on Wall Street, and even pizza delivery guys were selling sub-prime mortgages to satisfy it.

Of course, most people continued to earn money the old-fashioned way, including 99.7% of the workforce at AIG. This giant insurance firm was brought low by the 0.3% dealing in CDOs in an isolated London unit. Just so, we have all been brought low by relatively few, such as CEOs with broken moral compasses who ran their Wall Street firms into the ground and left with $160 million exit packages. It would be nice to see some expression of remorse, maybe an uncoerced offer or two to give back some ill-gotten – or more accurately, nil-gotten – gains; for while the bonuses were real, the profits on which they supposedly were based were not. This story is not just about Wall Street and Main Street, however. Where were those in Washington whose job is to ensure the safety and stability of our financial systems?

Item: In Congress, Senators from Republican Phil Gramm to Democrat Charles Schumer pushed aggressively for eliminating regulatory restrictions. The Depression-era Glass-Steagall Act, which prohibited banks from offering other financial services like brokerage and insurance, was overturned in 1999 by the Gramm-Leach-Bliley Act. That gave rise to Citigroup and the big five US invest ment banks, all of which, less than a decade later, have been seriously shaken. if not completely destroyed. The losses at now-defunct Merrill Lynch exceed all its profits for the previous twenty years.

Item: As Treasury Secretary in the Clinton administration, Robert Rubin also pushed hard for deregulation, as did Larry Summers, his assistant and successor. Rubin, who had formerly headed Goldman Sachs, moved on to Citigroup, and under his tutelage, this became the single largest holder of CDOs. When questioned by the Securities and Exchange Commission (SEC), Citigroup officials replied that the probability of default on these instruments was so low that it excluded them from its risk analysis.

Item: Before Henry Paulson became US Treasury Secretary in 2006, he too headed Goldman Sachs, where in 2004 he led the big five in pushing the SEC to relax its rule on how much debt their brokerage departments could carry. At a sparsely attended meeting not covered by the major media, the SEC complied, after which the risk ratio at Bear Stearns, the first of the five to collapse, went from 12:1 to 33:1.

Item: In 1997 Brooksley Born, who headed the Commodity and Futures Trading Commission, began worrying about financial derivatives and exploring ways to regulate them. That met with vehement opposition from Federal Reserve chairman Alan Greenspan, seconded by Rubin, who objected that it would cause a financial crisis. In 1999 they recommended that Congress permanently strip the CFTC of regulatory authority over derivatives. When House members asked about the wisdom of this, Greenspan assured them that there is “an underlying structure of markets in which many of the larger risks are dramatically – I should say, fully – hedged.” He stopped short of saying “all” risks, but his meaning was clear enough for the bill to pass overwhelmingly. Phil Gramm then attached it as a rider to a Senate appropriations bill passed late at night before the Christmas recess, signed by President Clinton.

Item: The role played by Moody’s and other credit-ratings agencies was pivotal, because not only were CDOs poorly understood – even Greenspan, by his own admission, found them mystifying – but credit-worthy mortgages and sub-primes were pooled together to be sold to investors. Everyone therefore relied on these agencies for a stamp of approval indicating that the pool was credit-worthy, preferably triple-A. Fees for rating these newfangled instruments were much higher than for the plain-vanilla kind, and competition among credit-ratings agencies was intense. So if a big mortgage issuer like Countrywide Financial complained about a low rating, the rating agency might simply raise it. Thus ratings became as untrustworthy as the pools themselves. This was not helped when they had to reverse course, sothat a Goldman Sachs mortgage pool rated triple-A in August 2006 was demoted in August 2007 to Baa, the lowest investment grade, and in December to ‘junk’ status.

Item: Between 2005 and 2008, worried about losing market share to private lenders, the government-sponsored mortgage institution Fannie Mae purchased triple the number of high-risk loans as in all its earlier years combined. President Bush made an attempt to get Congress to toughen regulations on Fannie Mae and its competitor Freddie Mac, but he would not compromise to reach an agreement; and his chosen overseer assured him that Fannie and Freddie were sound, even as they veered toward free-fall. As many have said, the irony is that President Bush, so averse to meddling with market forces, brought us government intervention on a scale not seen since the 1930s.

Item: President Truman declared that the buck stops at the Oval Office. But in the financial world, experts like Nobel laureate Joseph Stiglitz would say the buck really stopped with Alan Greenspan, who chaired the Federal Reserve for an entire generation (1987-2006), and was more powerful than presidents and kings. In 1996 his two word utterance “irrational exuberance” was enough to rock the markets. So had he expressed a modicum of caution about CDOs at almost any point from 1997 to 2003 – by his own account, the bubble did not even begin to form until the fall of 2001, and took until 2005 to be full-blown – the meltdown might have been avoided. But Greenspan consistently supported deregulation; and to judge from his 2007 memoir The Age of Turbulence, he would do much the same today (the 2008 Penguin paperback edition contains an epilogue that addresses the meltdown).

Ben Bernanke became Federal Reserve chairman in 2006, pledging as his first priority to continue Greenspan’s laissez-faire approach; and for more than a year he kept his word. But as John Cassidy dryly concluded in The New Yorker in December 2008, “It is now evident that self-regulation failed.”

Liberty and Justice for All

The idea of laissez faire did not originate in eighteenth-century economics. It goes back to the Stoicism of ancient Greece and Rome, and beyond that, to Daoism in the sixth century BC. The Dao does nothing, said Laozi; yet it is the Way by which all things are done. “Demand not that events should happen as you wish,” counseled the Roman Stoic Epictetus, but “wish them to happen as they do happen, and you will go on well.” Smith’s famous ‘invisible hand’ principle in Wealth of Nationsis in the same paradoxical vein: while acting solely in their own interest, individuals are often “led by an invisible hand” to promote that of society, sometimes more effectively than when they consciously try to promote it.

Latter-day economists often assume the invisible hand is conditional on people acting out of purely rational self-interest. But Smith’s principle rests less on reason than on the Stoic idea of the ‘wisdom of nature’, which in the ‘political body’ can remedy many “bad effects of the folly and injustice of man, in the same manner as it has done in the natural body, for remedying those of his sloth and intemperance.” Smith rejected the cynical Hobbesian view that a state of nature is a “war of all against all,” and held, with Locke, that people are by nature cooperative as well as competitive. He was aware that there can be, as one scholar puts it, invisible ‘backhands’ as well as ‘forehands,’ but he was optimistic that the forehands would on the whole outweigh the backhands.

A second Stoic idea underlying his invisible hand principle is that self-preservation comes first, and to this purpose “every animal was by nature recommended to its own care, and was endowed with the principle of self-love.” Individuals are better equipped than anyone else to know their own needs – certainly better, in Smith’s view, than government officials. It is only natural that everyone is “more deeply interested in whatever immediately concerns himself” than in what concerns other people. After the self, in decreasing intensity, come a concern for family, friends, neighborhood, nation, and finally the world at large.

Business dealings take place largely between strangers, so they are driven overwhelmingly by self-interest. “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner,” Smith famously said, “but from their regard to their own interest.” For Smith, self-interest is “the uniform, constant, and uninterrupted effort of every man to better his condition.” This is “the principle from which publick and national, as well as private opulence is originally derived.” It is this effort, “protected by law and allowed by liberty to exert itself in the manner that is most advantageous, which has maintained the progress of England towards opulence and improvement.”

Those who have most advanced this progress are merchants and manufacturers. In his Lectures on Jurisprudence Smith posited a four-stage socio-economic development from the most primitive to the most up-to-date society – hunting, shepherding, agriculture and commerce. It is the last stage which “gradually introduced order and good government, and with them, the liberty and security of individuals.” Indeed “this, though it has been the least observed, is by far the most important of all” the effects of commerce and manufacturing.

At the same time, Smith was keenly aware that the “interest of any one order of citizens” can be subverted “for no other purpose but to promote that of some other.” Merchants in particular have “an interest to deceive and even to oppress the publick” and in fact “have, upon many occasions, both deceived and oppressed it.” Consequently, Smith did not rely exclusively on the workings of an invisible hand to ensure a good outcome. He specifically stipulates in the passage quoted above about the constant effort to better one’s condition that it be “protected by law,” as well as “allowed by liberty.”

My freedom to pursue my interest my own way means little unless it entails a like freedom for everyone else. Thus an element of justice is inherent in the concept of freedom; and Smith declares at one point that justice is “the main pillar that upholds the whole edifice.” I have been quoting not only from Wealth of Nations, but also from Smith’s other major work, The Theory of Moral Sentiments. There, justice is a moral notion; in Wealth of Nations the ‘pillar’ is a legal justice system.

What is really surprising, though, even to many Smith scholars, is the extent to which he was willing to allow laws to encroach on liberty. It is well-known that he accepted the need for public education and public works, the latter because highways and bridges which do not make sense as private investments, can be easily paid for by public tolls. Strict libertarians will not be happy to hear, however, that Smith even countenanced graduated tolls; for thus the “vanity of the rich is made to contribute in a very easy manner to the relief of the poor.” More importantly, safety and security consistently take priority for Smith over profits. He was prepared to restrict the freedom of bankers to issue promissory notes to willing customers where that “might endanger the security of the whole society.” He acknowledged that this is a “violation of natural liberty,” but compared it to a building-code requirement to erect fire walls.

Adam Smith and Alan Greenspan

Our economy now seems to have been driven beyond the point where it can remedy its own intemperance, thanks to the shenanigans of bankers et al, and their enablers in Washington, who eliminated many fire-wall laws and allowed others to go unenforced.

On October 23, 2008, testifying before the House Oversight Committee Greenspan said that he was in “a state of shocked disbelief.” Almost per impossibile, there was a flaw in the economic model that “defines how the world works”, namely “the self-interest of lending institutions to protect shareholders’ equity.”

Smith too believed in self-interest based on “private frugality and good conduct,” and in the strength of such behavior to counteract the misconduct of a few, as well as the “extravagance of government” and the “greatest errors of administration.” But to ensure safety and stability, he yoked natural liberty with an adequate system of justice.

Greenspan shows a fine understanding and appreciation of Wealth of Nations in his 2007 memoir, except for giving extremely short shrift to “an appropriate – but circumscribed – role for government, and the rule of law.” He has little use for regulators, or the rigid and clumsy regulations they impose, and except for supporting law-enforcement against fraud, makes no bones about remaining “an avid defender …of letting markets function unencumbered.”

To his credit, on becoming Fed chairman he decided that such personal views on regulation “would have to be set aside.” To his debit, the record does not show that he did so. Greenspan is also short on accountability, and does not seem to think the fatal ‘flaw’ had much to do with him. According to Greenspan:

• The ‘villains’ were the bankers, who “gambled that they could keep adding to their risky positions and still sell them out before the deluge.” Not a word about his credulity in trusting these villains, or his failure – the Fed is, after all, a regulatory body – to keep a wary eye on them.

• He did not know. “In 2004 there was just no credible information” on a boom in the sub-prime mortgage market; the “first inklings” of that did not come until “well into 2005,” by which time 20% of all US mortgages were sub-prime.

• He did know, and said so. The suddenness of the crisis came as a shock, but “the fact of it was no surprise.” He predicted trouble back in August 2005, remarking that “history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

• He was powerless. “The world economy has become so awesomely complex that no individual or group of individuals can fully understand how it works:” And besides, “governments and central banks are powerless to diffuse periodic surges of euphoria and fear,” which are part of human nature.

• Besides, why worry unduly? Markets “are already repairing themselves,” and the most toxic derivatives have already been selected out, probably for good. To be sure, “our country has long since abandoned the notion that we should leave crises to be resolved solely by the marketplace.” But “even in crisis, economies seem inevitably to right themselves (though the process sometimes takes considerable time).”

In short, Greenspan leaves a lot to be explained. One thing I want to know is why he glossed over the importance of justice for protecting freedom. Certainly it was not due to any lack of respect for Adam Smith’s work, or a lack of attention to detail, or, obviously, any lack of brilliance as a thinker; not for nothing was he known as ‘the Oracle’. Was he merely wrapped up in complex mathematical models and, unlike Smith, forgot to factor in human fallibility? Or was this perhaps an error of the heart? Greenspan was an early and avid devotee of Ayn Rand, a novelist and philosopher of a strict form of laissez faire. When he was sworn in as chairman of the Council of Economic Advisors, she was at his side. Could it be, then, that he relied more on the story-book laissez faire of Atlas Shrugged than on Adam Smith’s fact-filled locus classicus of market capitalism? If so, the man in charge of our financial universe was not only astonishingly credulous – which is to say, lacking in Street smarts – but what he might consider worse, sophomoric.

Toni Vogel Carey, a philosophy professor in a former life, is on the US board of advisors for Philosophy Now, and writes about the history of ideas.

Sources: The New York Times 9/28/08; 10/2/08; 10/3/08; 10/9/08; 11/23/08; 12/7/08; 12/18/08; The New Yorker 12/1/08; 1/12/09; 2/2/09; 2/9&16/09; CNBC special with David Faber, 2/12/09; The Wall Street Journal 7/25/08; Huffington Post 2/19/09