Amid the global financial meltdown, the old debate about how much governments should regulate markets is back in the news. Is greed good because it creates value through competition, or should governments regulate markets in order to curtail greedy tendencies?
On the one side are unyielding defenders of market mechanisms. In spite of the problems created by over-leveraged banks, risky mortgages, and dissolving, unregulated funds that have decimated retirement accounts, some financial gurus and economists tell us that re-regulating the markets will only worsen the long-term success of the financial sector. Markets work their magic when the government leaves them alone. As Michael Douglas' infamous speech in Wall Street described it, shareholders, motivated by the "greed" of desiring profits, will keep managers on track to create legitimate value, which can then trickle down to everyone.
On the other side are those who believe that some regulatory intervention by the state is required in order to achieve justice and equity. Some economic actors have a tendency to go too far in promoting their self-interest, to the detriment of the social whole. Greedy bankers and money fund managers should be constrained by law, so they do not deceive or take unwarranted risks with peoples' savings in their scramble for profits. Such regulation aims to prevent bad behavior, not merely scrambling in response to public outrage after the damage has been set loose.
The free market deregulators like to endlessly cite Adam Smith as the modern father of the free market unhindered by bureaucratic control. Supposedly, Smith's legacy means essentially this: minimizing regulation maximizes freedom. Pursuing legitimate self-interest yields economic productivity: "Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men." If all economic actors are free to pursue their self-interest, their individual pursuits will coordinate -- through no intention of the actors -- to produce economic and social value.
This competitive market is self-constraining, we are told, since it will ensure that goods are produced and distributed efficiently, benefitting all, and prevent anyone from monopolizing the markets unfairly. Inefficiencies only arise when government is involved because regulation constrains economic freedom, thereby corrupting productive intentions and diminishing value. The government best serves this production of value if it stays away from micromanaging some choices, such as what people produce and what prices to charge. The market can sort this out better than bureaucrats.
Yet, Smith also tells us that this self-interest can become unhinged. In his "Wealth of Nations and Theory of Moral Sentiments," Smith describes human passions and desires in a way very familiar to moral and religious theorists. Our internal desires can overwhelm our reason and prudence as we embark on a quest for more and more profit, leading us to do things that harm others. If I want to maximize my profits, I may turn from legitimate business practices to the unscrupulous, like open deception, over-leveraging, and disregard for public harms.
Smith thought we will often act prudently and wise, since our long-term best interests are served if others trust us. We will, often, police ourselves, not wanting to look bad before others, or feel bad about ourselves. Yet, if our own internal checks fail, or we disregard them because we see an opportunity to make a huge amount of profit, we can act in ways that harm other people's private interests.
This is a big problem for Smith, who accepted classic, liberal political theory. If we act in ways that harm the public good and natural justice (most directly, if we harm another's freedom or property), then the government has a duty to block our harmful behavior. Indeed, the sovereign has "the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice." Laws and regulations must be in place to ensure that self-interest -- but not greed -- rules our economic practices.
In "The Wealth of Nations," for instance, he proposed a variety of regulations that would limit certain kinds of money trades and banking practices, in order to preserve public goods. While the regulations would certainly limit the liberty of the bankers to act in very profitable ways for themselves, "those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments." Not every action motivated by self-interest is permissible--if it leads to social instability, to destruction of value, or undermines justice, the government has a responsibility to intervene.
While Smith certainly does view government regulation of production and trade with suspicion and thinks that any regulations are a burden on a person's freedom, he also recognized--quite profoundly--that some constraints on freedom are required to maximize long term private and public benefits. Self-interest should be allowed its place, but that does not mean that greedy self-interest must be tolerated.
As we trudge forth to solve the current financial crises, both sides of the debate have something to learn from Smith. The deregulators would do well to read the rest of his work and not just cherry-pick quotes that support free markets with no attention to his other concerns. Fair recognition should be paid to his arguments for reasonable government regulations that protect society as a whole and increase overall economic value and justice.
Likewise, those calling for a return to zealous regulations at every level of the economy should not dismiss Smith simply as the caricature he has become. He makes powerful arguments about the ways that economic actors are incentivized, and the way that unreasonable regulations can interfere with economic value production.
Each side has something to learn from his cautionary tales.
