Quote of the Day

“Many economists – including Viner in the essay I have already quoted – have regarded Smith’s analysis of self-interest in The Wealth of Nations as inconsistent with his discussion of “sympathy” in his Theory of Moral Sentiments. In one of the best-known sentences from The Wealth of Nations, Smith points out “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest”. Smith, so the critics argue, failed to integrate the thinking in his two great works. It would not, to coin a phrase, be a sensible division of labour for me to enter the debate about whether his two great works form a consistent whole or represent two different and inconsistent viewpoints. Smith was a cautious and often obscure author. What we know of his theory of law and government is through the notes of two students who attended his lectures on jurisprudence. His failure to produce the projected third great work means that we do not know what institutions he thought would best support a market economy. But irrespective of what Smith thought, two things are clear. History is littered with failed attempts to order society without reference to individual incentives. And we understand the need for social institutions to constrain our actions.

Since Smith, economists have underplayed the importance of institutions, although there have been notable exceptions such as Douglas North and Ronald Coase. Over the centuries, theories of a competitive market economy have been refined. From these theories flows the remarkable result that, under certain conditions, the pursuit by each person of their individual self interest leads to a more efficient outcome for society as a whole. That work reached its apogee in the post-war work by Kenneth Arrow and Gerard Debreu. Those economic models are, however, silent about many of the institutions that are fundamental to the results.12 But without the appropriate institutions we tend to anarchy not prosperity. The challenge facing us is to design and maintain the right set of institutions or laws, and to abolish the unhelpful ones. And it is that challenge of institutional design to which I now want to turn….

As such, institutions must have, and be likely always to have, widespread support. Their design must meet three principles. First, in order to maximise the breadth and permanency of support, the objective should be as clear as possible. Second, the institution must have the appropriate tools and competence to meet those objectives and be held accountable for doing so. Third, for the institution to command widespread support, the design must reflect history and experience.”

- Trusting in Money: From Kirkcaldy to the MPC , The Adam Smith Lecture 2006 by Bank of England Governor Mervyn King