by Arsh Arora
March 24th, 2015
In 1759, Adam Smith eloquently described an ideal microeconomic agent—the prudent man—in his Theory of Moral Sentiments. The prudent man is rational and sincerely intelligent; he consciously enjoys being economical. Smith characterizes him carefully in his book, which underpins the philosophical ideas of his much later and more famous text, The Wealth of Nations (1776). Today, we recognize Adam Smith as the father of modern economics – the thinker who came up with groundbreaking theories on the division of labor, specialization, free market economies, trade, and the curiously famous metaphor of the Invisible Hand.
In an ideal Smithian world, prudence and individual self-interest (which is guided towards the public interest by that Invisible Hand) complement each other. For, if the self-interested consumers and producers who enter competitive markets were also prudent, then the scope for market failure would be minimal. Why? Because these microeconomic agents would be rational, requiring the competitive market to function just as it does on paper. It would maximize social welfare, cutting an equal piece of the cake for everyone. But to what extent do Smith’s 18th century assumptions of rationality and prudence hold today?
To answer this question, let’s take a closer look at Smith’s definition of the prudent man. In Moral Sentiments, Smith logically ranks the basic needs individuals commonly care for. Man, he says, first regards “the preservation and healthful state of the body.” He argues that the basic physiological needs, such as food, water, and shelter, are “recommended by nature” before all other needs. However, once these needs are met, what comes next, and what man perhaps has the “strongest of all desires” for, is to preserve his “rank and credit” amongst his equals. This preservation, which implies the need to attain some kind of security, is far more valuable than the “acquisition of still greater advantages.” After stating these objectives, Smith attributes several qualities to the prudent man, branding him assiduous, unostentatious, and thoroughly contented with his stable and steadily increasing standard of living. The last of these qualities, which is a certain satisfaction from a stable lifestyle, is especially important to Smith. The prudent man wants a controlled and secure way of life that is void of rigorous and sharp extremities. Achieving this well-balanced life in itself is perceived as desirable.
When we revisit these ideas today, it’s difficult to imagine that Smithian prudence is a common thing. The most immediate proof that comes to mind is today’s savings and spending industry, in which investors, businesses, and banks have all made some pretty rash decisions. Rash decisions in asset markets (such as the money market or the housing market) are the root cause of financial crises—highlighting immediately that several economic agents fail to meet Smith’s criteria for prudence.
In his History of Financial Crises, Charles Kindleberger (1910-2003), a contemporary economic historian who completed his PhD at Columbia University, neatly creates a timeline of modern financial crises. For those who aren’t quite familiar with how the finance sector functions (and malfunctions), Kindleberger’s easy-to-understand timeline, which historically traces the changes financial markets have experienced over the years, is a good place to start understanding these concepts. Basically, Kindleberger’s outline shows three key historic developments in asset markets (like the credit market) that have taken place since Adam Smith’s time:
In this first stage, which happened hundreds of years ago for the first time, the savings and spending industry experiences high levels of deregulation. The financial sector becomes more and more engrained in the market economy, as loans are given out more readily to investors. Pre-displacement financial markets didn’t really affect the entire economy severely, because there wasn’t a solid relationship between financial institutions and large industrial businesses. In the 1800s, things began to change, as giant industrial businesses relied on investments that were financed by the financial sector. Today, the financial industry continues to experience this growth and displacement; technology and policy together make financing loans faster and easier than ever before.
This is the stage when people really begin to realize that profiting (or seeking short-term capital gains) from certain industries that are booming is really, really fun. What’s dangerous about this development, however, is that credit works in a pro-cyclical manner. This basically means that banks give out loans more readily than usual during economic expansions (they are less risk-aversive), and less readily than usual during recessions (they are more risk-aversive). This tendency or flaw of the credit industry exaggerates how badly you might default on your loan, but also how well you might profit from an investment.
Despite the very dangerous-sounding nature of the Euphoria phase, it isn’t until the Mania stage that things really go out of control. The Mania stage marks a point of no return, making a future crisis almost inevitable. What happens here is twofold: first, optimism spreads to common people (rather than just experts on investment) and related industries (for instance, if tech is booming, them crude oil might experience a boom as well); second, speculation on behalf of common investors creates a self-fulfilling prophecy (that is, prices are driven upwards by an influx of hungry investors seeking capital gains).
This last stage, marked by widespread excitement, irrationality, and a collective unawareness of the large-scale dangers implied by individual actions, can cause market bubbles to implode. What makes things even worse is that banks work in a pro-cyclical way: if the economy were to overheat, buyers of credit would be “underwater” (that is, the amount you borrow to finance an investment on some asset is greater than the profit you’d make by selling that asset). These imprudent, irrational tendencies then cause distress and panic amongst investors, who immediately withdraw their money to cut their losses (almost like hundreds of people trying to escape a building on fire through a single door).
A common solution to this phenomenon is government intervention: the central bank, economists argue, should step in to bail out irresponsible private banks. This solution, however, has its own problem – the moral hazard that comes with the Fed promising to take the burden of bearing another party’s risk.
Revisiting Adam Smith’s portrayal of the prudent man certainly reveals a tension between many of the economic decisions made in today’s financial markets and the qualities associated with prudence. It’s hard to imagine that those in the mania phase of Kindleberger’s timeline would prefer securing wealth to “acquiring still greater advantages.”
However, to simply conclude that people today are more imprudent might be a simplistic treatment of what’s actually going on. The financialization and deregulation of our modern economies, together with increasing technology, say less about people’s moral tendencies than they do about sociocultural developments in general. Today, technology allows us to make investments easily. Today, knowledge of both economics in general and markets within economies is far more superior than in the past. All of these factors, together, afford us a higher degree of ostensibly irrational decisions – what one might be tempted to deem “imprudent”; however, it is merely the scale of the stakes involved that has increased, rather than human rashness. The latter, which is what Smith tries to delineate in his discussion of the prudent man, is a moral concept—it is something that’s a lot harder to change over generations than the economic institutions of a country.
Arsh Arora is an Editor at the Economics Review at NYU. He can be reached at firstname.lastname@example.org.