Adam Smith and Counter-Productive Markets, Is This the Case Today?

While re-reading a chapter from Amartya Sen's Development as Freedom, when Sen is about to explain that markets are important for development, not only for the productive economic outcomes they yield, but also because of the fact that markets give people the freedom to choose, to make transactions and to exchange freely (which are substantive freedoms that according to Sen must be taken into account in any measure of development), he mentions a case where Adam Smith in his Wealth of Nations actually supports market regulation. So, I turn to the original source to see what this was about.

In Book II, Chapter IV, Paragraphs 14-15 of The Wealth of Nations, Smith talks about the markets for loanable funds (though he uses other terms), and whether or not the usury rate for interest in this market must be controlled. The usury rate is a legal maximum interest that can be charged on these loans. Keep in mind that in this market different interest rates serve as equilibrium prices depending on the conditions and risk of the loan. He is very clear in stating that interest is the rightful payment that a person must receive for forgoing the use of his capital and lending it out to someone else, and, hence, it should be lawful to allow people to charge an interest for lending out their capital (in his time, some countries didn't allow charging interests; i.e. the usury rate was zero). The loans would be placed at the ongoing market interest rate for each loan; riskier loans entail a greater interest rate. Now, the usury rate here plays a role in determining the allocation of capital. Smith explains that if the usury rate is below the lowest market rate (that for the safest loans), no loans will be issued because people don't find it worthwhile to lend their capital, and thus, this capital is not allocated to a productive process as it would have been if it were loaned. If the usury rate is exactly at this lowest rate, potential borrowers who don't have enough collateral (thus making the loan risky), but who are honest and will pay won't receive loans, and once again, capital is not allocated efficiently. So, the usury rate must be higher that the lowest market rate, but how much?

Smith explains that if the usury rate is too high, loans will only be given out to "prodigals and projectors" (speculators in modern terms), since it is only they who are willing to pay high interest rates. A borrower wishing to undertake a productive enterprise will only be willing to pay a part of his profits back as interests. If the rate is too high, taking out the loan is not profitable. Lenders, on the other hand, will prefer to loan their capital to "prodigals and projectors" in order to benefit from the higher returns (I'm guessing eighteenth century Englishmen were not risk-averse...). If this happens, once again, capital is not put to productive uses, but is put instead in the hands of those most likely to waste or misuse it. In this case, the market outcome is counter-productive. Therefore, Smith concludes that the usury rate must be above the lowest market rate, but not very much so. This would cause loans and capital to be allocated to people with plans of starting productive processes, thus yielding a more efficient outcome.

"Prodigals and projectors" have the capacity of creating market bubbles. This is one of the reasons for the United States' current crisis; home prices rose a lot for several years, but it turned out to be s speculative bubble, where people bought homes not to live in but as an "investment", expecting a future return when prices rose. When prices started falling, many people saw the wealth diminish, and lost confidence in the system. Many people had their homes repossessed, a lot of whom had taken out a loan in order to pay for the house they were going to live in. So, speculation caused bad outcomes for those who Smith would deem "honest" borrowers. This was truly a non-efficient market outcome. Furthermore, Paul Krugman in his column in the New York Times yesterday (you might need to sign up to read it), states that one of the possible reasons for rising food prices is commodity speculation. People, expecting higher food prices, make deals on commodity futures, and, as a result of a self-fulfilling prophecy, food prices rise. Would Adam Smith, the father and foremost proponent of free markets say that this inefficient market outcome requires some sort of cap for commodity and property speculation? Maybe so...

Returning to Amartya Sen, I totally agree with both points of view about the importance of markets in development. Markets are the best tool for our disposal for the allocation of resources, as I have stated in a previous post, and they bring about the best opportunities for development in a traditional way. However, looking at development as freedom, the freedom to choose and exchange brought about by markets must be taken into account as part of development (the same market outcome under authoritarian rule would not be as good). However, sometimes markets allocate resources in a counter-productive way for society, and a little intervention or regulation is called for.