For a long time, many financial sector actors believed in a truncated interpretation of Adam Smith’s insight that the pursuit of personal gain promotes the common good. However, after the global financial crisis (GFC), this mindset is no longer tenable. If it ever was.
The World of Adam Smith
“It is not the charity of the butcher, brewer or baker that makes us expect our dinner, but that they seek their own advantage,” Smith observes in The Prosperity of Nations.
Although the book is a classic of liberal economics, the author wrote it as a work of moral philosophy. Smith sought to show that the common good is better served when each member of society pursues their own goals rather than common ones set by a planning body.
Smith lived in a fairly manageable world compared to ours. First, it was easier to assess the goods produced under the division of labor and traded on the market. Their quality could be checked at the time of purchase: The buyer could see, smell, and feel whether bread and meat were fresh or old and rotten. And second, Smith was guided by the conviction that our inherent sympathy for one another would set the standard for morally correct actions.
Of course, there was lying and cheating in Smith’s world, but the liar and cheat were understood to know that what they were doing was wrong. Smith therefore assumed that people were limited in the pursuit of their own goals not only by state laws and regulations, but also by moral standards and the social influence they exerted. The honorable merchant not only observed the laws, but also did not take advantage of their trading partners even when a skillful interpretation of the laws, without direct transgression, made it possible.
As a moral philosopher in a Christian social environment, Smith assumed the existence of honorable merchants.
The World of Today
In contrast, our current era is both more complex and more complicated than Smith’s. It is more complex because our goods are more diverse. Economists distinguish between three types: search, experience, and credence goods. With search goods, you know what you are getting before you buy them. For example, you try on clothes before purchasing them. Experience goods can be judged soon after purchase. You will know whether you like the wine you bought by the third sip.
But credence goods are much more difficult to judge. Whether the doctor provided the correct diagnosis and prescribed the proper therapy to deliver a cure is unknown. You must trust the doctor. Financial investments present a similar conundrum. For laypeople, financial markets are often a mystery, and whether they can trust a financial adviser is up to the stars.
And our world is more complicated, because as religious morality and close community ties fade, the empathy Smith expected can no longer be assumed. For where morality is politically defined, empathy reaches its limits.
While Smith justified the pursuit of self-interest based on a morality determined by mutual sympathy, today self-interest is mostly understood as the individual maximization of benefit without higher meaning and as an end unto itself. Where societal rules that originated through a commonly accepted moral doctrine are no longer binding, the possibility of individual utility maximization can become practically boundless.
After all, what prevents me from taking advantage of my business partner if it’s legally permissible? This question is particularly important with credence goods, because the buyer can only judge whether the seller has taken advantage some time after the transaction, sometimes long after, if ever. This makes taking legal action against fraud in the trade with credence goods very difficult.