1848+: Last and First Men

NY Times Book Review, August 23, 2009
Crossroads
Theory and Morality in the New Economy
By DAVID LEONHARDT

The indispensable economist of the moment is clearly John Maynard
Keynes. Keynes’s prescription for financial crises — aggressive
government action and, by definition, big budget deficits — has been
Washington’s basic approach since Lehman Brothers collapsed last
September. Eleven months later, the economy remains deeply troubled, and
it probably will be for some time. But our Great Recession seems
unlikely to turn into another Great Depression.

It is impossible to know just how much credit the Keynesian approach
deserves, because we can’t rerun the past year with a Hooverite economic
strategy and see what would happen. Still, history seems to have
vindicated Keynes. Likewise, it has indicted the laissez-faire
philosophy that had been ascendant for most of the last three decades.

The indispensable economist of that philosophy, of course, is Adam
Smith. Smith’s invisible hand — which, in his description, guides an
individual to promote the interests of society more effectually than he
intends — has not looked so effectual lately. In Obama’s Washington,
understandably enough, Keynes seems to be in and Smith out.

Yet here is where the story becomes a little complicated. Six years ago,
Bantam Classic published a mass-market volume of Smith’s 1776
masterwork, “The Wealth of Nations,” with an introduction by Alan B.
Krueger, an economics professor at Princeton. Krueger argued that
Smith’s modern image had become unhinged from his actual writings.
“Smith was a nuanced thinker. He was not nearly as doctrinaire a
defender of unfettered free enterprise as many of his late-20th-century
followers have made him out to be,” Krueger wrote. “He recognized that
human judgment was not infallible.”

Smith was indeed a champion of individual liberty and worried about how
governments might muck up an economy. But he also wrote that the goal of
employers, “always and everywhere,” was to keep wages as low as
possible. “When the regulation, therefore, is in favor of the workmen,
it is always just and equitable; but it is sometimes otherwise when in
favor of the masters,” he concluded. He supported a tax on luxury
carriages and taxes on alcohol, sugar and tobacco. He said that
“negligence and profusion” inevitably occur when corporate managers
control shareholders’ money. And as the historian Emma Rothschild has
noted, “The Wealth of Nations” uses the phrase “invisible hand”
precisely once. In the 1,231-page Bantam edition, it appears on Page 572.

I stumbled on that edition earlier this year in my local bookstore and
was struck by Krueger’s name on the cover. These days, he is the chief
economist in the Obama Treasury Department, the lead agency in the
administration’s efforts to halt the economic crisis. The ideas of
Keynes, surely, are central to those efforts. But the ideas of Smith are
not anathema to the administration. In fact, Smith turns out to be a
useful guide to the ways Obama is and is not trying to reshape the
American economy. Smith also lurks, often unnamed, in some of the most
thoughtful early books to have been published on the Great Recession.

Beyond the immediate crisis, today’s overarching economic challenge is
figuring out how the country can reap the benefits of Smith’s
market-based system without experiencing the worst of its downsides. In
the decades after World War II, the Keynesians who descended on
Washington thought they had solved this problem. With the right mix of
spending, regulation and interest rates, they believed, the business
cycle could be tamed and unemployment largely eliminated. “This was
hubris,” Paul Krugman, the Nobel laureate and liberal Times Op-Ed
columnist, writes in “The Return of Depression Economics and the Crisis
of 2008.” Technocrats overestimated how many jobs they could create
without aggravating inflation, and aggravate inflation they did.

Their failures, combined with the greater failure of socialist
economies, set the stage for the ascendancy of laissez-faire economics.
Much of Asia moved to a market-based system and experienced stunning
improvements in living conditions. As Krugman writes, “capitalism could
with considerable justification claim the credit.” These successes,
however, created their own excesses. The principles of laissez-faire
capitalism were elevated to the status of religious scripture, with Alan
Greenspan as high priest. In “The Cost of Capitalism,” Robert J.
Barbera, a longtime Wall Street economist, notes that Greenspan and
others confused the fact that market capitalism was thebest economic
system with the misguided notion that it was the perfect system.

Barbera calls instead for “an enlightened synthesis.” Such a synthesis —
one that takes Smith at his word rather than his caricature — is at the
core of almost every serious vision of a postcrisis American economy.
For Barbera, it means the Federal Reserve should recognize that bubbles
are the norm and that preventing them is its job. For the conservative
appellate judge and law professor Richard A. Posner, it means seeing the
crisis as “A Failure of Capitalism,” as he titled his latest book. Among
other things, Posner suggests a modern-day version of Smith’s tax on
luxury carriages: “increasing the marginal income tax rate of persons
who have very high incomes, in order to reduce their appetite for
risk-taking.” And in “Animal Spirits,” George A. Akerlof (another Nobel
laureate) and Robert J. Shiller (who issued early warnings about the
dot-com and housing bubbles) say the synthesis must take into account
the many ways in which people are not the coldly rational,
utility-maximizing beings that laissez-faire economic models imagine.

Smith, as it happens, would have been quite comfortable with this
notion. At the University of Glasgow he held the chair of moral
philosophy, and his second most famous book was titled “The Theory of
Moral Sentiments.” In “The Wealth of Nations,” he wrote of the ways that
pride, envy, respect and other emotions influenced decisions.
Intriguingly, this is the version of Smith that Obama likes to recall.

Last summer, during an interview shortly before the Democratic National
Convention, I was asking Obama about the benefits and limits of a market
economy, when he brought up Smith. “Adam Smith, at the same time as he
was writing about the invisible hand, he was also writing about that
moral sense — that human ecology — that allows a market to work: the
sense that if I bring my goods into the market, someone is not going to
hit me over the head; the sense that because I am trading with this guy
often enough, that I know that the scales aren’t tampered with,” Obama
said. “That compact that we make is not just legalistic. It has to do
also with our politics and our culture, and when that starts eroding it
inhibits economic growth as well.”

You can make a good case that, for all the talk-show chatter about
whether Obama is a socialist, his agenda is in fact tinged with Smith.
The administration’s various attempts to reduce inequality are meant, at
their core, to make Americans feel as if the economic system is fair —
that the scales haven’t been tampered with. In responding to the
financial crisis, Obama eschewed the left’s calls for nationalizing the
banks and instead kept them in private hands, albeit with public
assistance. To reduce health care costs, he favors moving away from a
fee-for-service system, which has the same perverse incentives Smith
liked to denounce.

Economic historians could doubtless have a spirited debate about whether
Smith would have supported or disdained the White House’s agenda. But
it’s reasonable to think that, either way, he would have had something
trenchant to say about its chances of success. Among his more radical
observations was that legislators tended to defer to those “masters” of
industry, even when their aims would hurt the citizenry. To put it
another way, economic theory can do only so much for a president. The
rest falls to politics.

David Leonhardt writes a weekly economics column for The Times.