Adam Smith and the Wall Street Bonuses

In Smith's vision of capitalism, market failure and moral failure went hand-in-hand. Yet Smith realized that it was vanity, not prudence or restraint, that kept the wheels of capitalism turning.
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What would Adam Smith make of the Wall Street bonuses?

I was recently asked this by a student in my business ethics class. The author of The Wealth of Nations was a renowned moral philosopher long before he became interested corn laws and supply curves, and we spend considerable time looking at his non-economic arguments for capitalism. Yes, Smith believed that a dynamic economy could be established apart from extensive government control, but this was a theory premised on study and observation, not a moral argument on behalf of an economic system. The moral argument for a free-market was simple. "No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable," and no economic system provided for "the greater part" better than capitalism.

Of course, this was no guarantee that everyone would be provided for equally. We get a bracing reminder of this just after the holidays when reports of eye-popping bonuses start emanating from Wall Street. Goldman Sachs has set the high bar this year with its announcement that Lloyd Blankfein, its embattled CEO, would receive $13.2 million for 2010, considerably more than Morgan Stanley's chief executive, James P. Gorman, who was awarded $7.4 million in stock and options (with the cash portion to be disclosed later) and Bank of America's Brian Moynihan, who was awarded $10 million despite his bank's middling performance. All eyes, however, are on Jamie Dimon. He led JPMorgan to the most profitable year in its history, and when it is finally announced, his compensation is expected to exceed $17.5 million, the amount he received for 2009.

Executive compensation has a particular moral salience because it invites the kind of personal comparisons that human beings instinctively make, the very comparisons, for Smith, that shape our moral sentiments. We may not have much to say about the ethics of the derivatives market, but if we work long hours in a high pressure job, we almost certainly have an opinion about the morality of someone making 1,000 times what we do.

Smith knew that, as a moral matter, such differences are never going to seem entirely fair, though we may tolerate them if they provide a rising tide that lifts all boats or if we believe that the dangers of government interference outweigh the injustice of gross inequality. But tolerating some practice is very different from endorsing it. The two times Smith's uses his most enduring metaphor, the "invisible hand," to describe how resources may be evenly distributed apart from central planning, he observes that this happens not because of the beneficence of the "rich" but "in spite of their natural selfishness and rapacity."

This is Smith at his most cynical. He endorsed the economics of a free market, but he was wary of the moral consequences of capitalism. The heroes of his world were yesterday's small business owners -- the butcher, the brewer, and the baker -- the tradesmen and shopkeepers who exemplified the prudence, industry, and thrift Smith so valorized. By contrast, he was suspicious of the success of the more cosmopolitan merchants. Their "high rate of profit" betokened trade restrictions and royal monopolies and tended to "destroy that parsimony which in other circumstances is natural to the character of the merchant," fostering decadence and desuetude among the members of that class.

In Smith's vision of capitalism, market failure and moral failure went hand-in-hand. The forces of the free-market were supposed to narrow profit margins, not magnify them, creating an economic environment where no one was too big to fail because no one could afford to make a serious mistake.

Yet Smith realized that it was vanity, not prudence or restraint, that kept the wheels of capitalism turning. "[W]hat are the advantages which we propose by that great purpose of human life which we call bettering our condition?" he asked, "To be observed, to be attended to, to be taken notice of with sympathy, complacency, and approbation, are all the advantages which we can propose to derive from it."

The key word here is "all," for Smith is rather dismissive of the idea that the accumulation of creature comforts actually makes us any more comfortable. On the contrary, we are burdened with the upkeep of an ever-expanding empire of goods. That said, we gladly undertake such labors for the envy an empire brings.

For Smith, it was a sign that capitalism was working when these empires were small, scattered, and few. But when they ballooned in size and number and clustered around a specific trade, something was wrong. The free market was failing us.

I suspect that this is what Smith, the economist, would conclude about bonus season on Wall Street. Smith, the moral philosopher, would turn his eye to what happens when vanity goes unchecked by the braking effects of the free market. Whether rich or poor, the size of a man's stomach varies little, but the lining of the ego is the imagination, and its limits are boundless.

What this means in practice is that human vanity can never be completely satisfied, no matter how much money one makes. When Michael Lewis grouses about his bonus to a fellow trader in Liar's Poker, even though it is the largest given out to any member of his first year class, the trader tells him, "You don't get rich in this business. You only attain new levels of relative poverty." The corollary is that whatever level of financial success one attains becomes the minimum standard for future accomplishments. "The necessary of life is a vague and a relative term," observed Adam Ferguson, Smith's greatest student, "it is one thing in the opinion of the savage; another in that of the polished citizen."

This insight helps to explain the passion and indignation with which Wall Street has defended its bonuses, even after the financial crisis. The "necessary" is whatever we have become accustomed to, not what others deem. Market forces make this determination, both morally and economically, and to expect people to act differently is to expect them to violate their own self-interests -- at least as they have come to understand them.

But not all self-interests are created equal, and Adam Smith knew that gilded ones tarnish easily. They endure only if they justify themselves to "the greater part" as integral their interests, too. If bonus season for the few becomes a winter of discontent for the many, Smith would say that we can be sure of one thing: the seasons will change.

John Paul Rollert is a doctoral candidate at the Committee on Social Thought at the University of Chicago. He recently taught a January Term course in Business Ethics at the Harvard Extension School

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