Friday, September 3, 2010

One Thing Adam Smith Got Wrong (All Modern Economists Would Agree)

This past week in my Law & Economics course, I used the example of credit-rate ceilings to explain why it is important for legislators and other policy-makers to have a basic understanding of economic concepts. If they do not, they run the risk of enacting policies that have bad unintended consequences. Indeed, in the case of credit-rate ceilings, the effect is to hurt the very people such limits are intended to help.

Virtually all modern economists believe that government-imposed limitations on the interest rates charged by lenders are not only inefficient but actually harm high-risk debtors by reducing the availability of credit or driving (illicit) interest rates even higher. In the absence of red-lining or other forms of unlawful discrimination, which are much better dealt with through legal mechanisms other than credit-rate ceilings, the main effect of credit-rate ceilings is to drive creditors from the market, decreasing the supply of available credit. Loan sharks may fill some of the excess demand but because they operate, by definition, outside of the law, the interest rates they charge will be even higher than those previously charged by law-abiding creditors - reflecting the increased risk of violating the law - and the penalties for non-repayment will be greater. The graph below, taken from my Principles of Law & Economics book (with Peter Z. Grossman), describes the basic problem with credit-rate ceilings.

Given the virtually unanimous agreement of modern economists about the unwisdom of credit-rate ceilings, I was very surprised to learn from reading Amartya Sen's great book, Development as Freedom (Anchor 2000), that the father of economics, Adam Smith, supported credit-rate ceilings (though he opposed prohibitions on lending with credit) in The Wealth of Nations, Vol. I, Book II, Ch. 4 (1776).

It cannot be argued in Smith's defense that everyone in those days thought credit-rate ceilings were a good thing. Although that may have been the conventional wisdom, some were wise enough to understand the perverse effects. Among them was Jeremy Bentham, the father of utilitarianism. Bentham sent Smith a private letter rebuking him and arguing that that the market should be left alone. In the letter, which can be read here, Bentham recognizes the irony (or at least the presumptuousness) of teaching Smith an economics lesson. More ironic still is the fact that it was Bentham who was giving the lesson. As Sen notes, "the principle utilitarian interventionist" was "lecturing the pioneering guru of market economics on the virtues of market allocation." (Development as Freedom, p. 125). It was, as Sen concludes, "a rather remarkable episode in the history of economic thought."

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