Your Money or Your Reputation: Adam Smith, the First Behavioral Economist?

Seventeen years before The Wealth of Nations (1776), Adam Smith published his Theory of Moral Sentiments (1759), nowadays a relatively neglected work which, to my mind, is nearly as astute, deserves far greater current recognition, and which not-incidentally puts pad once and for all to any charge that Adam Smith was unsympathetic to human nature or cavalier about the consequences of his theories for individuals.  Merely contemplate the book's very first sentence if you doubt me:

"How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it."

"To truly understand Adam Smith's economic masterpiece "The Wealth of Nations", one must understand its moral foundation. Without Smith's essential prequel, "The Theory of Moral Sentiments", the more famous "Wealth of Nations" can easily be misunderstood, twisted, or dismissed."

So, to today:  Harvard Business School's Working Knowledge has a piece positing that the Theory of Moral Sentiments was the original intellectual precursor to what we all know today as Behavioral Economics.  [The HBS WK article refers enticingly to the primary source, "Adam Smith, Behavioral Economist," published in the summer 2005 edition of The Journal of Economic Perspectives, but the troglodyte JEP keeps its online archives under severe lockdown—trust me, I tried.]

The premise of the HBS piece, "Adam Smith, Behavioral Economist" is that Moral Sentiments and Wealth of Nations, which Smith never sufficiently inter-connected during his own life, nevertheless together constitute the intellectual foundation of how human psychology (including incentives, preferences, risk-aversion, and the endless struggle between immediate and delayed gratification) affect how people behave in markets:  In other words, Behavioral Economics.

"Smith's two main works—The Wealth of Nations (WN) and The Theory of Moral Sentiments (TMS)—show him to be a brilliant economist and arguably a brilliant psychologist, but he was never fully able to bring the economics and psychology together."

One of the primary arguments of TMS is that human behavior is driven by passions—fear, desire, and greed among them—but that these passions are moderated by an "impartial spectator" looking out for the individual's long-term interests.  And there's apparently something to the theory:  Using it, the Harvard professors designed a "commitment savings product" for banks in the Phillipines that required customers to sign a contract prohibiting them from withdrawing funds until a certain amount of time had elapsed or a level of principal value had been achieved.   According to them, this "had a large and significant effect on clients' total savings," resulting in increased home purchases, educational investments, and small business-building.

But it's when we come to Smith's bedrock belief,  intimated in the opening sentence above, in the importance of trust, concern for fairness, and reciprocity, that the linkage of human psychology to market functioning becomes most clear.  Smith believed that those values become more, not less, important as markets evolve.  For example, with many of the professions, most assuredly including our own, clients cannot monitor "quality" in real time—and the same goes for doctors, auditors, and financial advisors.  So trust and reputation stand in where cold economic calculus fails.

Likewise with corporations:  Shareholders must at a fundamental level trust management to operate in the shareholders' interest since the range of variables over which management has control or influence is far too vast to specify contractually (and such a hypothetical specification would also be obsolete the moment it was completed).

Finally, Smith recognized, and placed great value upon, "the aerial coin of praise," and social and professional status, as critical motivational ingredients.  Reputation ("the aerial coin") is the flip-side of trust; one trusts those who have earned their blue-chip reputations.  And Smith would have insisted on the most scrupulous care and feeding of reputation, if for no other reason than the dire consequences attendant upon its destruction.

More currently, consider this (emphasis supplied, hat tip to Larry Ribstein): 

"The market is capable of levying harsh penalities [for financial malfeasance] on its own. Recent evidence comes from Karpoff, Lee and Martin, The Cost to Firms of Cooking the Books (July 25, 2005). Here’s the abstract:

"We examine the penalties imposed on all 585 firms that were targeted by SEC enforcement actions for financial misrepresentation from 1978-2002. Consistent with the view that penalties are small, monetary fines were imposed on only 7% of the firms. A larger fraction, 36%, faced class action lawsuits from investors. Overall, however, the penalties imposed on firms through the legal system appear to be small, as the unconditional mean total of all legal penalties is only $14.3 million per firm.

"The penalties imposed by the market, in contrast, are huge. Our point estimate of the reputational penalty - which we define as the expected loss in the present value of future cash flows due to higher contracting and financing costs - is over twelve times the sum of all penalties imposed through the legal and regulatory system.

"For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $2.47. Of this additional loss, $0.18 is due to expected legal penalties and $2.29 is due to lost reputation. This evidence belies a widespread view that financial misrepresentation is disciplined lightly. To the contrary, reputational losses impose substantial penalties for cooking the books."

So next time you're cynically thinking that money is the only motivator, try putting a price on your reputation; Smith would have.