Sunday, December 24, 2006

From Misunderstanding Comes Forth an Opportunity

It is inevitable that the excellent work of Muhammad Yunis and the Grameen bank would excite welcome comments around the world. It is also inevitable that misunderstanding of Smith's positive views on self-interest as an important driver of behaviour would be displayed in some of those comments.

The positive effect of exhibitions of Chicago's misunderstanding is that it creates the (unintended) opportunity for corrections to be made as part of your Christian, Mithras, or Pagan (strike to suit) holiday reading.

From the Jamaica Gleaner (est. 1834) (24 December) I read:

‘Touching the poorest of the poor’ by Cedric Wilson,

“In establishing the Grameen Bank, [Muhammad] Yunus was acting in contradiction to one of the fundamental principles of neo-classical economics: It is in the pursuit of self-interest that the whole society is better off and not through acts of altruism.

Adam Smith, the father of modern economics, in describing the virtues of the market had this to say: "Every individual endeavours to employ his capital so that its produce may be of the greatest value ... And is led by an invisible hand to promote an end which is not a part of his intention. By pursuing his own interest, he frequently promotes that of society more effectually than when he really intends to promote it."

Therefore, as an economist, Yunus would have known from the outset that Grameen Bank was a "bad idea". The objective of the Grameen Bank was not profit maximisation but something more elusive, more dubious: sustainability.
Beyond that, Yunus' banking operations were structured along lines that are seemingly counterintuitive - to put it mildly.

In a dominantly Moslem country, the bank accorded higher priority in lending hierarchy. Loans were given to people without collateral, and there was no provision for the use of legal means to recover loans in the event of a default.
On the surface, all of that seems like a recipe for disaster and perhaps conventional wisdom would suggest that he was simply just leaning against the wind. However, he saw good where others saw only ill; he believed that trust was more powerful than suspicion.

Today, the bank enjoys a 99 per cent repayment rate and currently has six million customers. Thousands of people's lives have been made better because they were able to access credit to start a chicken farm or purchase material to weave baskets, or some other endeavour that allows them to add value.”

Smith in the extract from the quoted passage was not ‘describing the virtues of the market’. He wasn’t discussing markets at all.

He was discussing the unintended consequences on individual motivation when faced with the differential risks of either exporting his scarce capital abroad to import foreign goods and to engage in the ‘carrying trade’ (shipping), or to invest it locally in home based activities where he could keep an eye on the venture and deal with people he knew, under laws with which he was familiar.

The consequence of his and fellow merchants’ risk aversion was that the national revenue was larger than it would be if merchants dispersed their investments across the world. In short, the national wealth (the production of ‘the necessaries, conveniences, and amusements’ of life) was the sum of its separate parts – if the parts are larger because of individual risk aversion, the sum would be larger.

Therefore, whatever neoclassical economics purports to assert, it does not follow that Adam Smith asserted in that passage that ‘it is in the pursuit of self-interest that the whole society is better off and not through acts of altruism.’ That latter argument is a different one and the distinction is important to understanding Smith’s political economy.

The unconstrained pursuit of self-interest, which in its wilder expressions, from the ‘anything goes’ school of corporate misbehaviours, it is reduced to ‘red in tooth and claw’ competition, which is about as far from Adam Smith’s moral philosophy and political economy as you can get, was not endorsed by Smith in this manner.

Self-interest promotes many different behaviours, including that of criminality (fraud, cheating, piracy, and theft), imposed externalities such as pollution, and legalised protectionism, monopolies, anti-competitive regulations, restrictive practices, slavery, forced selling, and ‘company towns’.

Self-interest can also promote the widespread mediation of competing interests through ‘truck, bartering and exchange’ propensities and the division of labour, where each party gains, not necessarily ‘equally’ from the outcomes. It was in this last form that mediated self-interest was ‘better’ (from being more reliable) than ‘benevolence’ (his famous allusion to the ‘butcher, the brewer and the baker’).

Muhammad Yunis and the Grameen bank did not ‘therefore’ act in defiance or contradiction of Adam Smith’s political economy (he may have acted in contradiction of the neoclassical economics, but then the whole of reality does that, if only its High Priests and true believers would look outside their cloistered windows and see how the world works).

‘Loans were given to people without collateral’; not quite true, if by collateral is meant secure physical assets usually preferred by bankers. The people borrowed as a group of individuals pledging to each other to repay what they borrow, and the power of those obligations made to people they know and live close to is regarded as sufficient to cover the small risk that any one of them will defect.

An acquaintance with the imperatives of ‘Prisoners Dilemma’ would assist in understanding how this minimises risks sufficient to calm the anxieties of the bank. Each person can choose to defect (‘do what is best for self’) or to co-operate (‘do what is best for all’). It comes down to trust and its necessary counterpart, risk (you can’t have one without the other). In PD, the prisoner defects because he can’t trust the other one not to do so – ‘I defect not because I want to, but because I must’. Some few defect because that is in their nature (‘I defect not because I must, but because I want to’).

Grameen found that the close social pressure of the women in each small group was sufficient, about ninety-nine times out of one hundred, for them not to defect. They borrowed the small sums and paid them back on time. They overcame the temptations of the negative aspects of the range of behaviours from self-interest, with the help of the trust exhibited by like minded neighbours.
This is exactly what Adam Smith would have expected – the impartial spectator (from whom they know what would eb wrong behaviour) and their unimpartial neighbours (who won't let them get away with defection without social costs)combine to lead to approved self-interested behaviours that benefited them and their neighbours, and, unintentionally, contribute to social harmony.

Cedric Wilson is on the right lines, but he may have done a small disservice to Smith’s legacy (though not Chicago’s version of it).



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