Seventeen years before The Wealth of Nations (1776), Adam
Smith published his Theory
of Moral Sentiments (1759),
nowadays a relatively neglected work which, to my mind, is
nearly as astute, deserves far greater current recognition,
and which not-incidentally puts pad once and for all to any
charge that Adam Smith was unsympathetic to human nature or cavalier
about the consequences of his theories for individuals. Merely
contemplate the book’s very first sentence if you doubt me:
"How selfish soever 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."
One reviewer nicely summarized its relationship to Wealth of
Nations as follows:
"To truly understand Adam Smith’s
economic masterpiece “The Wealth of Nations”, one must understand
its moral foundation. Without Smith’s essential prequel, “The Theory
of Moral Sentiments”, the more famous “Wealth of Nations” can easily
be misunderstood, twisted, or dismissed."
So, to today: Harvard Business School’s Working Knowledge has
a
piece positing that the Theory of Moral Sentiments was
the original intellectual precursor to what we all know today
as Behavioral Economics. [The HBS WK article refers enticingly
to the primary source, "Adam Smith, Behavioral Economist," published
in the summer 2005 edition of The Journal of Economic Perspectives, but
the troglodyte JEP keeps its online archives under severe
lockdown—trust me, I tried.]
The premise of the HBS piece, "Adam Smith, Behavioral Economist"
is that Moral Sentiments and Wealth of Nations, which
Smith never sufficiently inter-connected during his own life,
nevertheless together constitute the intellectual foundation
of how human psychology (including incentives, preferences,
risk-aversion, and the endless struggle between immediate
and delayed gratification) affect how people behave in markets: In
other words, Behavioral Economics.
"Smith’s two main works—The Wealth of Nations
(WN) and The Theory of Moral Sentiments (TMS)—show him to
be a brilliant economist and arguably a brilliant psychologist,
but he was never fully able to bring the economics and psychology
together."
One of the primary arguments of TMS is that human behavior is
driven by passions—fear, desire, and greed among them—but that
these passions are moderated by an "impartial spectator"
looking out for the individual’s long-term interests. And there’s
apparently something to the theory: Using it, the Harvard professors
designed a "commitment savings product" for banks in the
Phillipines that required customers to sign a contract prohibiting
them from withdrawing funds until a certain amount of time
had elapsed or a level of principal value had been
achieved. According to them, this "had a large and
significant effect on clients’ total savings," resulting in
increased home purchases, educational investments, and small
business-building.
But it’s when we come to Smith’s bedrock belief, intimated
in the opening sentence above, in the importance of trust,
concern for fairness, and reciprocity, that the linkage
of human psychology to market functioning becomes most
clear. Smith believed that those values become more,
not less, important as markets evolve. For example, with
many of the professions, most assuredly including our
own, clients cannot monitor "quality" in real time—and
the same goes for doctors, auditors, and financial advisors. So
trust and reputation stand in where cold economic calculus
fails.
Likewise with corporations: Shareholders must at a fundamental
level trust management to operate in the shareholders’
interest since the range of variables over which management
has control or influence is far too vast to specify contractually
(and such a hypothetical specification would also be obsolete
the moment it was completed).
Finally, Smith recognized, and placed great value upon, "the aerial
coin of praise," and social and professional
status, as critical motivational ingredients. Reputation
("the aerial coin") is the flip-side of trust; one trusts
those who have earned their blue-chip reputations. And Smith
would have insisted on the most scrupulous care and feeding
of reputation, if for no other reason than the dire consequences
attendant upon its destruction.
More currently, consider this (emphasis supplied, hat tip to Larry
Ribstein):
"The market is capable of levying harsh penalities
[for financial malfeasance] on its own.
Recent evidence comes from Karpoff, Lee and Martin, The
Cost to Firms of Cooking the Books (July 25, 2005). Here’s the
abstract:"We examine the penalties imposed on all 585 firms that were targeted
by SEC enforcement actions for financial misrepresentation
from 1978-2002. Consistent with the view that penalties
are small, monetary fines were imposed on only 7% of the
firms. A larger fraction, 36%, faced class action lawsuits
from investors. Overall, however, the penalties imposed
on firms through the legal system appear to be small,
as the unconditional mean total of all legal penalties
is only $14.3 million per firm."The penalties imposed
by the market, in contrast, are huge. Our point estimate
of the reputational penalty – which we define as the expected
loss in the present value of future cash flows due to
higher contracting and financing costs – is over twelve
times the sum of all penalties imposed through the legal
and regulatory system."For each dollar that a firm misleadingly
inflates its market value, on average, it loses this dollar
when its misconduct is revealed, plus an additional $2.47.
Of this additional loss, $0.18 is due to expected
legal penalties and $2.29 is due to lost reputation. This
evidence belies a widespread view that financial misrepresentation
is disciplined lightly. To the contrary, reputational
losses impose substantial penalties for cooking the books."
So next time you’re cynically thinking that money is the only
motivator, try putting a price on your reputation; Smith would
have.
