Recently in Adam Smith Himself Category

I got back to New York this past Memorial Day Weekend after my extended European trip.

While the trip was even more professionally rewarding and successful than I had hoped--not to mention fascinating and deeply gratifying on a personal level--I owe you all, Dear Readers, an immediate and fervent apology for appearing to have gone into radio silence for essentially the entire duration. 

In mitigation all I can plead is that finding reliable and speedy online access in the various venues I visited was inexcusably difficult.  Before you think to yourself, "spoiled American!", let me hasten to add I had no expectation of being online whatsoever in the remote reaches of Scotland where the trip began, all of which were reachable only through that most economical and environmentally unintrusive means of access, the single-lane, two-way road.  Quaint and hair-raising in equal measure.  And yes, in those remote stretches my nonexistent expectations of online access were precisely fulfilled.

No, the surprising part was how sporadic and weak online access was even in first-class hotels in Edinburgh, London, Vienna, and Budapest.  Unless you're a fan of composing thoughtful and extended essays, requiring more than a modicum of genuine reflection, with your laptop on your knees and perched in the midst of bustling hotel lobby bars, getting online was more challenging than finding water in Death Valley.

That said, a brief recap of my recent travels.

Scotland

Where it all began, not just on this particular trip but figuratively and literally for Clan MacEwen.  In the 1100's (best guess estimate), Clan MacEwen staked out territory on the eastern bank of Loch Fyne, southwest of Glasgow, near what is now the tiny settlement of Kilfinan, just above Tighnabruich.  Over the centuries, home base to the Clan became the world-famous (sorry--lost my head) MacEwen Castle.

Calling the ancient structure, creatively embellished artists' renderings of which are all that remain, a "Castle" is of course one of those conceits to which any self-respecting Scottish Clan is manifestly entitled, but let's not kid ourselves:  It was probably more akin to a glorified fort, although in terms of fitness for purpose that might have been more realistically the ticket. 

In any event, the site itself--surrounding the location of which there is absolutely no doubt--is precisely the type of site you would pick several hundred years ago if defensibility were your primary criterion.  Situated atop a tall bluff dropping sheer on three sides to Loch Fyne and its beach, only the fourth side is remotely navigable, but even it requires scrambling up a steep and intimidating slope using tree limbs for aid and support.

Once you reach the top, all that remains of the Castle is a pile of rocks:  Literally, a cairn with a plaque commmemorating the site.  Those of us with highly active imaginations can pretend to discern the outlines of a large foundation, but speculating more than that is to go beyond what even the most self-indulgent clansman could condone. 

Aside from defensibility, the site has other fabulous attributes, from immediate access to Loch Fyne itself, whose salmon and oysters are still identified by name on menus of the finest restaurants throughout the UK, to woods stocked thick with deer and rabbits to fields in cultivated use today.  The day we got there, after a mile-and-a-half trek across fields, unbridged streams, rocks, a stony beach, and finally a marsh in full mucky bloom, was suitably foggy, drizzly, and exceedingly raw (we had sleet the nights before and after).

But the business reason for Scotland was to be the leader and rapporteur for the Annual Retreat of the Centre for Professional Legal Studies of the Law School of the University of Strathclyde. This honor I owe to Richard Susskind, whom I have long counted a friend. 

For those of you who may not be familiar with Strathclyde, the law school is pursing some seriously innovative initiatives in its curriculum and how law students go about learning to become practitioners. 

The "CPLS" retreat is held at Ross Priory on the banks of Loch Lomond.  Needless to say, this was a very special place to hold a retreat.

London

I was last in London this past January, and I found the atmosphere palpably, if subtly, less grim than it had been then.  (I'm speaking of law land, you understand:  London itself is anything but "grim"!)   Primarily, I visited with the Magic Circle and similar large firms, and there's an emerging sense that perhaps the worst is behind us. 

Let me immediately add that people aren't exactly dancing jigs, and the ratio of those saying they had their doubts about the alleged "green shoots" espied by members of the political classes outnumbered those who endorsed the green shoot theory by, oh, 20:1.  But when I say "the worst behind us" I think it's fair to report that the consensus seemed to be  that the most drastic of cuts are now in place and future cuts will be more by way of fine-tuning (and continuing, of course, to ratchet up performance reviews) than they will be by way of more massive culls.

That said, the challenge in this financial-services-driven meltdown is clearly more extreme in The City of London and here in New York than it is elsewhere in law land.  Indeed, I note that just this morning The American Lawyer published Citibank's Dan DiPietro's "First Quarter Update" which reports that "AmLaw 100 firms were hit harder than the broader sample [reflecting] heavy reliance on transactional work and clients who are more heavily weighted in financial services."

Yet another aspect of the New York/London axis that perhaps receives undue attention is the extent to which the UK-based firms are truly international and US-based firms are still, on that score, largely pikers. 

This is a topic worthy of a column or two in its own right, but suffice to say I did an analysis of the "Global 50" (courtesy of The Lawyer magazine) and well over half of all lawyers in Magic Circle firms are based outside the UK.  That makes them international firms by anyone's measure.

By contrast, here are the same statistics (graph is my work) for our home-town firms:

I know the mice type may be hard to read, but this is meant to chart major NYC-based firms by percentage of lawyers outside the US.  The somewhat arbitrary red line crossing the chart at the 20th percentile is mine.  I put it there on the theory that if 4 out of 5 of your lawyers are in your home country you cannot lay serious claim to being an "international" firm.  The percentage is arbitrary, as I said, and highly debatable, but I thought it worth drawing a line in the ether. 

This provokes two thoughts:

• If globalization is here to stay--which it is--how prepared are these firms for it?  Perhaps a better question is whether they still have work to do to spread their wings beyond the familiar and cozy US back yard.  You can, it is indeed true, serve clients internationally from a New York-centric base, but at some point there's no substitute for being there.  (Speaking parochially, the whole point of this extended trip I just returned from was working with non-US clients; sometimes the best and only thing to do is to get on an airplane.)
  
  More importantly, for all of those firms substantially below the 20% line, what is your international strategy going forward?  If you're a 55-year-old partner, that may not be a question of much moment and less urgency, but if you're a partner of 35 or 40, perhaps you're wondering.
  
  
• Recruitment issues:  About a quarter of the current Harvard Law School student body is not US native-born.  These students probably anticipate stints abroad during their careers as a matter of course.  What do you have to offer?

Are New York and London "existentially" threatened as centers of global finance?

Not during your career, or mine. 

Consider what they have going for them:

• A tremendous extant infrastructure not just of lawyers and investment bankers (remember them?--they'll be back), but also the latent infrastructure of everything from accountants, graphic designers, restaurants, hotels, and catering services, to black cars and messengers.
• Decent places to live:  Good housing stock.
• Wonderful shopping.
• Great culture:  Museums, theater, opera, performing arts, even sports.
• And quite tolerable climates, all things considered.  (No monsoons, no tornados, earthquakes, wildfires, or floods, and no need to live 11 months of the year in hermetically sealed airconditioned bubbles.)

In short, New York and London are here to stay for the foreseeable future. 

Although if you had to choose a timezone where you could most easily do business in the same day with Asia and North America, it would surely be London and not New York.  Can't have everything.

Vienna

What can you say about a City that has hosted so many profoundly important historical events, from the 1815 Congress of Vienna to some of the most recent UN negotiations over the fate of regions from Darfur to Bosnia?  Right after the Second World War, of course, it was divided into four zones, one each controlled by the US, the USSR, Great Britain, and France, making it the hotbed for endless spy dramas, factual and fictional.

More prosaically, this trip here 20 years after the Berlin Wall fell was courtesy of Hudson Legal, (as was the following destination, Budapest).  I thank them effusively for their hospitality and professionalism throughout my stay in Austria and Hungary.

The Central and Eastern European market for legal services is quite different than the US/UK/EU--"western Europe" model, although the strategic and economic challenges facing firms in the CEE region are fundamentally identical to those facing firms oriented more towards New York and London.  Just for the record, those challenges include recruitment and retention of talent, equitable and motivating partner compensation, winning the competition for premium client work, and managing geographic growth.

Speaking of geography, there is no substitute for a the wealth of information contained in a map.  So forthwith to just that:

I've drawn red boxes around the pertinent country capitals. 

After you've given yourself a moment to get oriented, here's the next most important thing you need to know about these markets:  They are each very small.  Populations (courtesy of the CIA):

• Austria:  8,205,000 (cf.New Jersey, 8,682,000)
• Hungary:  9,931,000 (cf. Georgia, 9,586,000)
• Romania:  22,247,000 (cf. Texas, 24,327,000)
• Poland:  38,501,000 (cf California, 36,757,000)
• Czech Republic:  10,221,000 (cf. Michigan, 10,003,000)

Also compare:

• UK:  60,944,000
• France:  61,538,000
• Germany:  82,370,000
• Italy:  58,146,000
• US:  304,075,000

This of course has tremendous implications for law firm strategy.  Indeed, according to the people I got to know in the region, many US and UK-based firms are pulling out of the CEE markets, leaving the premium work to locally-based firms such as Wolf Theiss.  Using that firm as an example, while they have 12 offices to cover the region (ranging from the Ukraine in the east to Albania in the south, and the Czech Republic in the north and west, with headquarters in Vienna), it's also the case that every office is reachable easily within a day.  And you can make a virtue of necessity, as Wolf Theiss does:  Over 80% of its work is cross-border.  Now that's an "international" law firm for you.

Vienna Staatsoper (State Opera)

Budapest

Hungary is perhaps most famous among former Warsaw Pact members for being restive under the yoke of Russia.  Not only was there the famous 1956 uprising, quickly put down by the Red Army at the cost of some 22,000 Hungarian lives, but starting in the 1960's and running through until 1989 and the fall of the Wall was "goulash Communism," a far more free-market oriented strain of government more attuned to civil rights and providing actual latitude for dissent (within bounds, to be sure).  It even permitted a limited number of small businesses to operate freely in the service sector and, mirabile dictu, unlike other Communist bloc countries in the 1960's and 1970's, groceries were sufficiently plentiful as to obviate lines.

Budapest itself is, historically, two cities:  Buda on the western side of the Danube and Pest on the eastern side.  The cities were not united by a bridge until 1849 when the famous Szechenyi Chain Bridge opened, designed by English engineer William Tierney Clark after his earlier Marlow Bridge crossing the Thames in Marlow, England.  On-site construction was supervised by the Scottish engineer Adam Clark (no relation to William) and in his honor the Buda terminus of the bridge now empties into Adam Clark Square. 

Before arriving, I was soundly skeptical that there would be any actual difference between the "two" cities, but there is indeed.  Geographically, Pest is as flat as Iowa, while Buda consists largely of the quite steep Castle Hill (with Buda Castle at the top).   Buda also tends to have a concentration of religious, historic, and ceremonial buildings, while Pest is where commerce and business actually get done.

As the capital of Hungary, Budapest features the national Parliament, which is the largest building in Hungary and, not unlike Westminster, is in Gothic Revival style.

Hungarian Parliament (Danube-facing side)

If you've never been to Edinburgh, I highly commend it to you.  And that's not just because of the Adam Smith connections, although that's what I'll very briefly mention here.

We're staying about 200 yards down the Royal Mile from Adam Smith's new statue, unveiled 4 July 2008, and about 400 yards up from his gravesite in the Canondale Kirk yard.  The statue is bronze, 10' tall, and prominently situated in front of St. Giles church, Behind him is a plough, said to symbolize the impact of his thinking on the eclipse of agrarian economies, and to his right is a beehive, symbolizing, of course, the invisible hand of unguided individual effort creating without a centralized authority something greater than the sum of the individuals alone.

From time to time, people ask me what I'm reading when trying to figure out what is going on in the economy these days. A glib response might be, "anything I can get my hands on," but the question deserves a more thoughtful response, so herewith a book review and a few pointers to online sites that are more helpful than most.

The online sites, first as they're easy to handle in a condensed fashion:

• David Warsh's Economic Principals is perhaps the single most studious, well-written, thoughtful, and occasionally (but not doctrinally) contrarian site I know of. David publishes on a faithful, if quaint, once-a-week schedule, just like the print journalist he was, with provocative pieces such as "More than two aspirin," and "What comes after a golden age?."
• Truth on the Market bills itself as 'academic commentary on law, business, economics, and more," and it's surely worth checking out for that promise alone. While uneven at times, at its best it can be great fun.
• Matrix (on interpreting the real estate economy, with a focus on New York City) is a remarkably wide-ranging and thoughtful site covering the industry that's arguably at the root of all our evil woes, written by Jonathan Miller, who is the gold standard of appraisers in the New York City market.
• Academic Earth bills itself as "thousands of video lectures from the world's top scholars."  And it is.  Origins of the Financial Mess (Alan Blinder, Princeton) is a good place to start.
• Marginal Revolution talks about a wide variety of topics in an often irreverent tone. A current post about the AIG bonus PR nightmare consists in its entirety of:
  

  Outrage, outrage, blah, blah, blah, etc. Often I feel that some topics are too obvious to blog.
  The real lesson is that this is another reason not to nationalize banks. It means politicizing every decision which ends up in the newspaper.
  Here is a good post on why the bonuses should be paid.
  Outrage, outrage, blah, blah, blah, etc.

But forthwith to the book review.

Animal Spirits, by George Akerloff (Nobel Prize Winner in Economics) and Robert Shiller, father of the famous Case-Shiller real estate index, was reviewed in the Financial Times:

[The authors] argue that the key is to recover Keynes's insight about 'animal spirits'--the attitudes and ideas that guide economic action. The orthodoxy needs to be rebuilt, and bringing these psychological factors into the core of economics is the way to do it. . . . The connections between their thinking on the limits to conventional economics and the issues thrown up by the breakdown are plain, even if they were unable to make every link explicit. Even more than Akerlof and Shiller could have hoped, therefore, it is a fine book at exactly the right time. . . . Animal Spirits carries its ambition lightly--but is ambitious nonetheless. Economists will see it as a kind of manifesto.

What are "animal spirits," again?  The most concise explanation was actually provided by a reviewer on Amazon:

In his epoch-making General Theory of Employment, Interest, and Money (1936), John Maynard Keynes noted that concerning investment decisions, "most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits--a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." Because of this propensity of investors to base decisions on variables other than "market fundamentals," the aggregate investment function of an economy will tend to be highly variable and erratic. Indeed, even today, it is virtually impossible to predict aggregate investment successfully, although the other sources of aggregate demand and supply are relatively well understood.

The book explores, in its Part I, five different dimensions of animal spirits and how they affect the economy: 

• Confidence
• Corruption
• The "money illusion" (basically, people's propensity to ignore modest levels of inflation and deflation and to believe in a constant value of money)
• "Stories" which can mislead (for example, "the Internet will revolutionize everything..."); and
• Lack of perceived fairness (for example, AIG bonuses).

Part II, in turn, looks at some consequences of animal spirits' role in economic decision-making, and how they can help explain the answers to such questions as:

• Why do economies suffer depressions?
• What's to be done about the current financial crisis?  (Caveat:  Events are moving so quickly on this front that the authors' discussion is already looking quite dated.)
• Why can some people not find a job?
• Why is saving for the future so arbitrary?
• Why are financial prices and corporate investments so volatile?

The most valuable aspect of the book is that the authors show how human decisionmaking—as it's really performed, animal spirits and all—violates the classic notion of purely rational homo economicus.  Consider this thought experiment they offer:

	Economic	Non-economic
Rational	Rational, economic decisions	Rational, non-economic decisions
Non-rational	Non-rational, economic decisions	Non-rational, non-economic decisions

Of course, neoclassical economic theory essentially addresses only the top left cell, whereas animal spirits help inform our understanding of the other three cells.  Actually, I would argue that we can ignore the entire right hand column for present purposes, since it's by hypothesis in the realm of the "non-economic," but even if you wipe that from the attention of your cortex, the bottom left quadrant is clearly where a lot of the fascinating debate today around "fairness" (AIG bonuses again), "moral hazard," "fragility," "systemic risk," and so forth revolves.

Indeed, our again-helpful Amazon reviewer, who has simulated the behavior of individuals in markets, reports:

There is nothing in economic theory that says that rational individuals interacting on markets will produce stable, efficient outcomes. The Walrasian general equilibrium model says that if there are no market externalities, there are market-clearing equilibria that are Pareto-efficient, but this model has absolutely NO attractive dynamical properties. When I subjected this model to an agent based simulation (Herbert Gintis, "The Dynamics of General Equilibrium", Economic Journal 117 2007:1289-1309), I found that there is a robust tendency towards market clearing equilibrium, but this is always offset by highly volatile stochastic movements in prices, wages, capital demand, and other macroeconomic variables. This stochasticity is due to the fact that the macroeconomy is a complex, nonlinear, dynamical system, not because of "animal spirits."

Jargon patrol:  A "Walrasian equilibrium" essentially means a competitive environment and not one populated by players with market power.  "Externalities" are costs imposed upon, or benefits enjoyed by, actors not participating in the market in question.  "Pareto-efficient" means that there is no possible change which would leave every player no worse off and at least one player better off.

The fascinating point here is that a core result is "always" "highly volatile stochastic [random] movements in [key] macroeconomic variables." 

And isn't that just what we've seen in the subprime meltdown and its aftermath?

The really stunning fact about the current macroeconomy is that disequilibrium in the home mortgage market could so seriously compromise the American financial system. Even those who foresaw the housing crisis did not predict so massive and credit collapse, leading to levels of government intervention that would have been inconceivable in the past.

Animal Spirits is without doubt an intriguing, thoughtful, and timely book (and a quick read as well at 264 pages including notes and index), but I fear that its very focus on the quirkiness of human decision-making might serve as a pleasant distraction from the core and unavoidable truth that under- or improperly regulated markets cannot be counted upon to produce economically or socially desirable results.

---

Given the general level of surprise and intellectual shock that have accompanied this global meltdown,, it has become increasingly common to hear calls for a "new capitalism" or for some inchoate reworking of the received canon of wisdom in economics to help us navigate these seemingly unprecedented times.

If you're tempted, as I admit I occasionally have been, to pursue this path, I commend to you Amartya Sen's Capitalism Beyond the Crisis in the March 26,2009 issue of The New York Review of Books.  Sen was the 1998 Nobelist in economics for his contributions to "welfare economics,"  ("Welfare economics," roughly speaking, is the branch that concerns allocative efficiency within a society, income distribution, and—you guessed it—achieving Pareto-optimal results.)

Sen's article is, by and large, an effective effort to debunk the mythologies that have been attributed, for motives base and innocent alike, to the Big Thinkers in economics including Adam Smith and John Maynard Keynes.  Perhaps we should not be surprised that the imprimatur of these legendary names would be appropriated for ideological or expedient means, but it's worth going back to what they actually said, as Sen does, to realize that we may have the blueprint for recovery in front of us if only we choose to see it. 

Here is Sen on the "public/private mix" that undergirds all of today's First World economics.  Forgive the somewhat lengthy excerpts, but Sen's argument is subtle and his prose pleasant:

What are the special characteristics that make a system indubitably capitalist--old or new? If the present capitalist economic system is to be reformed, what would make the end result a new capitalism, rather than something else? It seems to be generally assumed that relying on markets for economic transactions is a necessary condition for an economy to be identified as capitalist. In a similar way, dependence on the profit motive and on individual rewards based on private ownership are seen as archetypal features of capitalism. However, if these are necessary requirements, are the economic systems we currently have, for example, in Europe and America, genuinely capitalist?

All affluent countries in the world--those in Europe, as well as the US, Canada, Japan, Singapore, South Korea, Australia, and others--have, for quite some time now, depended partly on transactions and other payments that occur largely outside markets. These include unemployment benefits, public pensions, other features of social security, and the provision of education, health care, and a variety of other services distributed through nonmarket arrangements. The economic entitlements connected with such services are not based on private ownership and property rights.

[...]

[T]he pioneering works of Adam Smith in the eighteenth century showed the usefulness and dynamism of the market economy, and why--and particularly how--that dynamism worked. Smith's investigation provided an illuminating diagnosis of the workings of the market just when that dynamism was powerfully emerging. The contribution that The Wealth of Nations, published in 1776, made to the understanding of what came to be called capitalism was monumental. Smith showed how the freeing of trade can very often be extremely helpful in generating economic prosperity through specialization in production and division of labor and in making good use of economies of large scale.

Those lessons remain deeply relevant even today (it is interesting that the impressive and highly sophisticated analytical work on international trade for which Paul Krugman received the latest Nobel award in economics was closely linked to Smith's far-reaching insights of more than 230 years ago).

[...]

Even though people seek trade because of self-interest (nothing more than self-interest is needed, as Smith famously put it, in explaining why bakers, brewers, butchers, and consumers seek trade), nevertheless an economy can operate effectively only on the basis of trust among different parties. When business activities, including those of banks and other financial institutions, generate the confidence that they can and will do the things they pledge, then relations among lenders and borrowers can go smoothly in a mutually supportive way. As Adam Smith wrote:

When the people of any particular country have such confidence in the fortune, probity, and prudence of a particular banker, as to believe that he is always ready to pay upon demand such of his promissory notes as are likely to be at any time presented to him; those notes come to have the same currency as gold and silver money, from the confidence that such money can at any time be had for them.[1]

Smith explained why sometimes this did not happen, and he would not have found anything particularly puzzling, I would suggest, in the difficulties faced today by businesses and banks thanks to the widespread fear and mistrust that is keeping credit markets frozen and preventing a coordinated expansion of credit.

It is also worth mentioning in this context, especially since the "welfare state" emerged long after Smith's own time, that in his various writings, his overwhelming concern--and worry--about the fate of the poor and the disadvantaged are strikingly prominent. The most immediate failure of the market mechanism lies in the things that the market leaves undone.

And here, if you will, is the punch line:

Smith called the promoters of excessive risk in search of profits "prodigals and projectors"--which is quite a good description of issuers of subprime mortgages over the past few years. Discussing laws against usury, for example, Smith wanted state regulation to protect citizens from the "prodigals and projectors" who promoted unsound loans:

A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.[4]

The implicit faith in the ability of the market economy to correct itself, which is largely responsible for the removal of established regulations in the United States, tended to ignore the activities of prodigals and projectors in a way that would have shocked Adam Smith.

The present economic crisis is partly generated by a huge overestimation of the wisdom of market processes, and the crisis is now being exacerbated by anxiety and lack of trust in the financial market and in businesses in general.

Sen also writes that unappreciated in the current crisis is the relevance of Arthur Cecil Pigou (a contemporary of Keynes, also at Cambridge and also in fact at King's College).  Whereas Keynes viewed the economy primarily through a mechanistic and hydraulic lens (the value of the famous "multiplier" being a primary example), Pigou put his focus on psychology, where Sen (and yours truly) believe it belongs.  At the root of economic fluctuations, Pigou wrote, were "psychological causes," namely "variations in the tone of mind of persons whose action controls industry, emerging in errors of undue optimism or undue pessimism in their business forecasts.[5]"  Sen goes as far as to say that "the real crisis...has become many times magnified by a psychological collapse," and he scarcely overstates the case.

Perhaps we should conclude with the culminating irony of this short tour of the landscape of Fabled Economists:  It is that while Smith and Pigou are traditionally seen as "conservative," and Keynes as something of a rebel, the first pair were far more outspoken, insightful, and insistent upon the importance of non-market institutions and non-profit values.

---

What else am I reading? Alpha by author:

• Geoff Colvin's Talent is Overrated:  What Really Separates World-Class Performers from Everybody Else.  This book, based soundly in empirical research, delivers the hard message that true excellence depends upon hours and hours (10,000 hours, to be precise) of "deliberate practice"—be it the young Mozart composing, the young Tiger Woods practicing, or any aspiring concert violinist.  The same, by extension, is true of surgeons, mathematicians, CFO's—and lawyers and writers.  As Colvin puts it, this is good news and bad news:
  
  "What would cause you to do the enormous work necessary to be a top-performing CEO, Wall Street trader, jazz, pianist, courtroom lawyer, or anything else? Would anything? The answer depends on your answers to two basic questions: What do you really want? And what do you really believe? What you want - really want - is fundamental because deliberate practice is a heavy investment."
  
  
• Jerry Coyne's Why Evolution Is True.  Demolishes creationism and "intelligent design"—and then intellectually carpet-bombs them again, to make sure "the rubble bounces," as Churchill described the goal of a particular bombing campaign in WWII—but does so with respect and patience.  I can do no better than to repeat the aphorism that "Nothing in biology makes sense except in the light of evolution."  Coyne explains why, and brings you up to date on recent developments in this endlessly fascinating science in the bargain.
  
  
• Niall Ferguson's The Ascent of Money: A Financial History of the World:  Ferguson recapitulates the history of money from the pre-Christian era through today's subprime meltdown and global credit freeze, noting that bubbles are as much a part of economic history as are booms and concluding with a warning that excessively precautionary regulation  cannot and should not remove the possibility of extinction for institutions which are weak.  That is to say, financial crises should and must result in casualties.  Or, as Joseph Schumpeter put it in The Theory of Economic Development (1934):  "This economic system cannot do without the ultima ratio of hte complete destruction of those existences which are irretrievably associated with the hopelessly unadapted."
  
  
• Dexter Filkins' The Forever War  A harrowing account of the "war on terror" from the rise of the Taliban in the 1990's through virtually today in Iraq and Afghanistan, by one of the New York Times' star reporters.
  
  
• Michael Lewis' Panic:  The Story of Modern Financial Insanity, a tour de horizon of recent financial embarrassments, using the tool of reproducing contemporaneous (and a few subsequent) accounts and analyses, and covering the collapse of Long Term Capital Management, the Asian financial crisis of the 1990's, the dotcom meltdown, and early warning signals of our present distress.  Plus c'est change.
  
  
• Jessica Livingston's Founders at Work:  Stories of Startups' Early Days.  The stories of mostly legendary (and a few relatively obscure) entrepreneurs, told in their own words through extensive interviews, about the early days at their would-be companies, including:  Max Levchin/PayPal, Steve Wozniak/Apple, Mike Lazaridis/Research in Motion, Mike Ramsay/Tivo, Charles Geschke/Adobe, and Ron Gruner/Alliant Computer.  Utterly charming.  And the moral?  (1)  Expect the unexpected.  (2) And meet it with persistence. 
  
  
• Daniel Pink's A Whole New Mind:  Why Right-Brainers Will Rule the Future.  Pink's thesis, fairly widely adopted today, is that human economic organization has moved from the agricultural to the industrial to the information and now to the conceptual age, where the value is on those individuals and firms capable of integrating empathy, meaning, design, and a narrative (a/k/a "story") to their products and services.  If you or your firm can't master those skills, beware of "Asia, Abundance, and Automation."
  
  
• Robert Samuelson's The Great Inflation and Its Aftermath:  The Past and Future of American Affluance.  An economic and political history of what is now a curiously forgotten period, the "great inflation" of the 1970's and early 1980's, famously cut off at the knees, along with much economic activity, by Paul Volcker and Ronald Reagan in the 1981-'82 recession.  Not, perhaps, a deep or subtle read, but a fascinating and thorough portrayal of, as I say, an oddly invisible era.
  

Enjoy.

Consider Detroit's Big Three.

Having made what  turned  out to be bad bets on  over-investing in now shunned product lines, they've been  conspicuously laying people off, downsizing, attempting to  renegotiate credit lines, and furiously trying to revamp their product offerings to align to and conform with the world's new reality. 

Sound familiar?

It should because the same description, with variants in emphasis, could apply to our industry.

So I have a modest proposal:  Let's put all our lawyer  brethren in Congress—surely we should at least get some good out of the vast over-representation our colleagues enjoy in poliitics—working on a bailout bill for BigLaw.

I owe the genesis of this insight to a faithful reader, Brent Jeffcoat, of McGuire Woods' Charlotte office.  He frames the key argument nicely:

When do law firms start seeking federal assistance?  After all, think of all the people we affect: our young associates marry and live in condominiums in urban centers.  We probably support Starbucks.  Allen Edmonds is toast.  Many high-end automobile dealerships will suffer mightily without the patronage of lawyers.  I mean, the list goes on.  Think of all those poor guys in Scotland who will not be able to sell their single malt whiskeys.  It would be a global crisis of unimaginable proportions if one or two of the AmLaw 100 were to fail.  The Federal government has got to step in and lend a hand.  Before year-end or else the distributions will be hit.  Heck, many people in the medical industry are dependent upon elective cosmetic procedures scheduled just after year-end distributions.  America needs us to survive.  Who will keep the kept women?

This is firmly in keeping with the evident economic philosophy of our times.  Who needs Microsoft, Intel, Starbucks, or, for that matter, Target?  Wouldn't we all be  better off in a world dominated by Wang, DEC, Howard Johnson's, and Nash Rambler?  And isn't your dream  for your kids that they can grow up and join the UAW?  Don't you wish you could, to paraphrase William F. Bucklkey, stand astride the tide of history and cry, "Stop!"?

Joseph Schumpeter (Mr. "Creative Destruction"), and Adam Smith himself, would be outraged and appalled.  And  rightly so. 

Permit  me  to remind our colleagues in Congress what happens when a company declares the dreaded "bankruptcy:"  Its workers are not taken out and shot, its factories and offices are not incinerated, and its customers' demand does  not evaporate.  Rather, all those assets  and market forces are  reallocated elsewhere.  If the Big Three have demonstrated anything  over the past 30 years, it is their unrivalled  managerial genius at misallocating productive  assets and falling ever further behind their rivals.  Time, one might  think, to give someone else a chance to deploy those assets.

Sympathetic as I am to law firms struggling with yesterday'spractice areas, and to lawyers rudely discovering the urgency of reinventing themselves, the dynamism of the  market will not abate. 

That is something devoutly to be celebrated.

Not every day do we get a new Nobel Prize winner in Economics, not to mention one whose name, Paul Krugman, might actually be familiar to more Americans than the few of us who are poor closet economists. Krugman is of course not only a Princeton professor (we pause to take pride here in the home team), but a regular op-ed columnist in The New York Times where he is known for wielding a hatchet against all things touching or concerning the Bush Administration.

As for his Times op-ed columns, we are, as you know, resolutely apolitical here at "Adam Smith, Esq." Perhaps the best that can be said of those is that we come not to praise but to bury them in the context of his winning the Prize. Or, as was said more pungently in Australia's National Post, "You don't get the Nobel Prize in Economics for writing newspaper columns (as I've been trying to explain to my mother the last couple of days). So the prize awarded Monday to Paul Krugman should not be read as an endorsement of Krugman's uber-Democratic newspapering."

Actually, I'll give the last word on his Times op-eds to his fellow columnist Maureen Dowd:

"I'm not sending Paul Krugman Champagne.

He won the Nobel prize in economics this week, and while I'm sure that's delightful for him, it has raised the bar to an impossible height for his fellow columnists at The Times. We used to strive for Pulitzers, or simply regional awards, or even just try to top each other on the paper's most e-mailed list.

Now we're supposed to compete for Nobels?"

We're here to take a brief interlude, a detour, if you will, into economic theory and into what Krugman's Nobel is all about.

Classic models of trade between countries, stemming from David Ricardo's shockingly brilliant concept of "comparative advantage," predicted, in theory, that trade flows would depend on such things as ratios of capital to labor, with capital-rich countries exporting capital-intensive goods and importing labor-intensive goods from labor-rich countries.

But that's not what the data showed. In reality, most international trade takes place between countries with very similar capital:labor ratios.

Krugman sought to, and succeeded in, explaining this. His explanation was based on economies of scale and on transaction costs across distances. What does this mean?

Economies of scale mean that producer incentives are to concentrate production in a limited number of locations. Too abstract? Let's make it concrete: There's a reason Silicon Valley is a self-reinforcing hub of high technology and innovation in general. An engineering and entrepreneurial culture combined with venture capitalists combined with a world-class research university (Stanford) combined with a very start-up friendly business ecosystem has made it a hotbed for new companies.

Similarly, New York and London are likely to remain global financial centers as far as the eye can see. They both have the infrastructure that sophisticated financial professionals depend on. Permit me to state the obvious ones:

• English
• Entrepreneurial cultures
• The Anglo-Saxon common law tradition, and the rule of law
• An indigenous infrastructure of banks, law firms, marketing professionals, and all the multifarious support professions.

And the less obvious:

• Workable, if not Asian-clean-slate, physical infrastructures
• Terrific international air connections
• Fabulous stores, restaurants, museums, parks, and schools
• Great, and highly diverse, residential and commercial real estate

But back to Krugman.

He described his basic findings in the 1992 "Geography & Trade:"

"Because of economies of scale, producers have an incentive to concentrate production of each good or service in a limited number of locations. Because of the cost of transacting across distance, the preferred locations for each individual producer are those where demand is large or supply of inputs is particularly convenient -- which in general are the locations chosen by other producers. Thus [geographical] concentrations of industry, once established, tend to be self-sustaining."

An example he used was that the auto industry in capital-intensive Sweden exports cars to capital-intensive America while also importing cars from America.  The logic is that both Volvo and GM can reduce costs by producing a relatively large output (sufficient to satisfy worldwide demand) in particular geographic niches where the requisite inputs are concentrated. 

Krugman, of course, was building on the theory of comparative advantage, which he explained perhaps most famously in "Ricardo's Difficult Idea." Comparative advantage is a theory at once powerful and notoriously elusive, which--although beloved by economists, including yours truly--seems to inspire incomprehension even by those who loudly retort that while they subscribe to it, they only happen to see certain exceptions applying, which are only visible to those with a particularly subtle intellect.

At that point you know you're in the company of someone whose fellow intellectual travelers include those who proclaim their belief in evolution while demanding equal time in the schools for "intelligent design." They say they believe, but they don't believe.

Here's where Krugman's brilliant "Ricardo's Difficult Idea" comes into play. Permit me to quote at some length (my own Cliff's Notes version is here at the bottom):

My objective in this essay is to try to explain why intellectuals who are interested in economic issues so consistently balk at the concept of comparative advantage. Why do journalists who have a reputation as deep thinkers about world affairs begin squirming in their seats if you try to explain how trade can lead to mutually beneficial specialization? Why is it virtually impossible to get a discussion of comparative advantage, not only onto newspaper op-ed pages, but even into magazines that cheerfully publish long discussions of the work of Jacques Derrida? Why do policy wonks who will happily watch hundreds of hours of talking heads droning on about the global economy refuse to sit still for the ten minutes or so it takes to explain Ricardo?

[...]

At a deeper level, comparative advantage is a harder concept than it seems, because like any scientific concept it is actually part of a dense web of linked ideas. A trained economist looks at the simple Ricardian model and sees a story that can be told in a few minutes; but in fact to tell that story so quickly one must presume that one's audience understands a number of other stories involving how competitive markets work, what determines wages, how the balance of payments adds up, and so on.

[...]

I believe that much of the ineffectiveness of economists in public debate comes from their false supposition that intelligent people who read and even write about world trade must grasp the idea of comparative advantage. With very few exceptions, they don't -- and they don't even want to hear about it. Why?

[...}

[I]f one tries to explain the basic model to a non-economist, it soon becomes clear that it really isn't that simple after all.

There are, I believe, at least three implicit assumptions that underlie the most basic Ricardian model, assumptions that are justified by the whole fabric of economic understanding but are not at all obvious to non-economists. Here they are:

- Wages are determined in a national labor market: The basic Ricardian model envisages a single factor, labor, which can move freely between industries. When one tries to talk about trade with laymen, however, one at least sometimes realizes that they do not think about things that way at all. They think about steelworkers, textile workers, and so on; there is no such thing as a national labor market. It does not occur to them that the wages earned in one industry are largely determined by the wages similar workers are earning in other industries. This has several consequences. First, unless it is carefully explained, the standard demonstration of the gains from trade in a Ricardian model -- workers can earn more by moving into the industries in which you have a comparative advantage -- simply fails to register with lay intellectuals. Their picture is of aircraft workers gaining and textile workers losing, and the idea that it is useful even for the sake of argument to imagine that workers can move from one industry to the other is foreign to them.

Not is it obvious to non-economists that wages are endogenous. Someone looks at Vietnam and asks, "what would happen if people who work for such low wages manage to achieve Western productivity?" The economist's answer is, "if they achieve Western productivity, they will be paid Western wages" -- as has in fact happened in Japan. But to the non-economist this conclusion is neither natural nor plausible.

- Constant employment is a reasonable approximation: The standard textbook version of the Ricardian model assumes full employment in both countries. But in reality unemployment is constantly a concern of economic policy -- so why is this the usual assumption? There are two answers. One -- the answer that Ricardo would have given -- is that international trade is a long-run issue, and that in the long run the economy has a natural self-correcting tendency to return to full employment. The other, more modern answer is that countries have central banks, which try to stabilize employment around the NAIRU ["Non-Accelerating Inflation Rate of Unemployment"--Bruce]; so that it makes sense to think of the Federal Reserve and its counterparts acting in the background to hold employment constant. This is not at all the way that non-economists think about the issue.

- The balance of payments is not a problem: The standard textbook presentation of the Ricardian model assumes balanced trade -- indeed, it is usually a one-period model in which trade must be balanced. Yet the news is full of stories about the balance of payments, of complaints about trade surpluses and deficits. Why are these absent from the story?

Again, economists have good reasons for thinking that it is a good approximation to separate balance of payments from real international trade issues. In Ricardo's case, the essential ingredient was the argument by David Hume that trade imbalances are self-correcting: a surplus country will acquire specie, leading to rising prices that price its goods out of world markets, while a deficit country will correspondingly find its goods increasingly competitively priced. In the modern world, again, the channels involve less Invisible Hand and more government intervention: when monetary policies target the unemployment rate, exchange rates do the adjusting. Economists are also aware that even persistent trade imbalances are not necessarily a problem, and certainly that surpluses are not a sure sign of health or deficits one of weakness.

Permit me to try to summarize the virtues of comparative advantage.

The benefits of trade do not depend on countries' having absolute advantages over other countries, but only on having comparative advantages. This means that a country that is absolutely disadvantaged in producing all relevant goods and services can still benefit from trade. The secret is opportunity costs, not absolute costs.

Consider two hypothetical countries, North and South, which produce only two goods, food and clothes. If each country devoted its entire economy to producing food, North would produce 100 tons and South 200 tons. Similarly, if each devoted everything to clothes production, each would produce 100 tons of clothes. South appears absolutely advantaged, so where's the benefit from trade?

First, let's pretend that each country is equally predisposed to consumption of food and of clothes, so that each devotes 50% of their productive capacity to each. This produces:

	Food	Clothes
North	50	50
South	100	50
Total	150	100

Now let's assume trade barriers are lifted and each concentrates entirely on its preferred output in anticipation of being able to trade. This yields:

	Food	Clothes
North	0	100
South	200	0
Total	200	100

Of course, this "production" leaves North starving and South naked.

So if we introduce actual trade and imagine some arbitrary preference "price" of one ton of Food for 2/3 ton of Clothes, we get:

	Food	Clothes
North	75	50
South	125	50
Total	200	100

Everyone is better off.

---

Now, if you still don't believe me, consider the famous "attorney/typist" example.

Suppose you're the best lawyer in town and also the fastest typist in town; you have an absolute advantage in both.

Q1: Are you going to go to work as a secretary? Obviously not. You put your absolute advantage as a lawyer to its highest use.

Q2: Are you going to type your own documents? Obviously not. You put your comparative advantage as a lawyer to its highest use.

You are now a subscriber to the doctrine of free trade.

At long last, Adam Smith has been honored in his native Edinburgh, with a prominent statue outside St. Giles' Cathedral on the Royal Mile.

As reported by the FT, the unveiling was yesterday:

Vernon Smith, the George Mason law and economics professor and winner of the 2002 Nobel Prize in economics, and a lifelong Adam Smith admirer, performed the unveiling.  His 2002 Prize was shared 50/50 with Daniel Kahneman of Princeton for their work in "having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty" and ""for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms."  (We call this behavioral economics.)

The statue cost nearly half a million dollars (£250,000), entirely paid for by private subscriptions organized by the Adam Smith Institute.  The Paisley sculptor Sandy Stoddard designed and produced the monument, which shows Smith in academic robes.

High time for a return visit to Edinburgh.

Today, June 5th, is Adam Smith's birthday, in the year 1723.  He would be 285 today. 

As I noted a year ago today, he was born in Kirkcaldy, Scotland, a dozen miles north of Edinburgh across the Firth of Forth:

Although his birth home has since been demolished (all that remains is a plaque commemorating its location), we do know where he's buried, in Canongate Churchyard on the Royal Mile in Edinburgh:

The inscription reads:

"Here are deposited the remains of ADAM SMITH
Author of the Theory of Moral Sentiments and Wealth of Nations:
He was born 5th June, 1725 [sic: 1723] and died 17th July, 1790."

Today is Adam Smith's Birthday: June 5, 1723. He would be 284 today.

He was born in Kirkcaldy, Scotland, about 12 miles north of Edinburgh across the Firth of Forth, and is buried just off the Royal Mile in Edinburgh itself. Although there is no memorial to Adam Smith in Edinburgh, aside from his gravestone, one has been proposed, which would look roughly like this:

My birthday was just two days—and a few centuries—later. I expect no monuments in Edinburgh.

At the intersection of the original Adam Smith and the 'net is, well, irresistible territory.  And now we have it in the current Forbes, courtesy of P.J. O'Rourke's "Adam Smith:  Web Junkie."

Here's the thesis, which is indisputably correct:

"I wonder if the know-it-alls at Wikipedia realize that the Internet was fully described and completely understood more than 200 years ago by Adam Smith, founder of free market economics. [...]

"In The Wealth of Nations , published in 1776, Adam Smith explained the three factors that constitute the free market: pursuit of self-interest, division of labor and freedom of trade. There you have the Internet without so much as a mouse click. [...]

"The Internet is not a wonderful new world. The Internet just is a natural extension of the free market."

But it's deeper than that, at least to my way of thinking.

Every time I see or read another hyper-ventilating media expose of that old devil the Internet, with its fraud, its cons, its porn, its deviants, and its identity thieves, I can't help but think of the marvelous, uplifting, inspirational, fascinating, and deeply challenging experiences that constitute my own personal history of exposure to the 'net.

And in trying to reconcile these views, the answer is really staring us in the face: Humans created the 'net, and the 'net reflects us.  So lots of traffic (read: attention) goes to news, sports, money, food, family, travel, sex (of course), health, shopping, commerce—you get the idea.  I'd wager that the proportion of off-line, "real world" assets and dollars devoted to each of those categories is almost precisely mirrored online.

But back to Adam Smith.

"In The Wealth of Nations Adam Smith said that an individual "stands at all times in need of the co-operation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons."

"Smith saw that the free market answered liberty's need for a larger network of voluntary association. The pursuit of self-interest means that the free market has built-in incentives for network maintenance and expansion."

The 'net promotes, above all, connections.   And this brings us to P.J. O'Rourke's key, and deadly serious, insight:

"Since networks are self-organizing they are, like all do-it-yourself projects, a mess. This makes networks too hard for any one person to understand, let alone dominate.

" Most of our lives are spent in channels or chains of command or circuits.  Networks release us from this. We are presented with numerous alternative connections. On the Internet these connections are, without intending a pun, virtually unlimited. We can take our business elsewhere or be that elsewhere by starting a business of our own.

"Networks aren't egalitarian. Michael Dell always will be a bigger node than we are. But networks aren't hierarchal, either. There's no top and bottom to them, no magnetic north of authority. It's all side-to-side and back and forth. Detours, shortcuts and work-around's make a network."

In other words, the 'net permits us to create new connections, to launch new conversations, and to form new micro-communities neither foreseen nor exhorted by any person or group directing our actions or our attention. Sounds like a free market to me. If, as O'Rourke says, "the Internet is an advance for voluntary association," then Adam Smith would surely approve.

And of course he'd be publishing working drafts of Wealth of Nations online for critical commentary as they were done.

.

At "Adam Smith, Esq.," we don't talk about Adam Smith himself very much, but at year-end it seems appropriate to pay a moment's homage to this site's intellectual godfather and, I hope, provide those of you who may not have studied him closely a slightly more nuanced perspective of his views.

To start, there could be no better introduction than this discussion of the interplay between his most famous work, obviously, The Wealth of Nations, and its predecessor by 17 years, the relatively unsung Theory of Moral Sentiments.   The piece takes off from Adam's Fallacy: A Guide to Economic Theology, written by Duncan Foley of New School University in New York, which is described as "a beautiful little book. It contains some of the most lucid exposition of the core ideas of economics that I have ever read."  (The reviewer is David Warsh, author of Knowledge and the Wealth of Nations, which I will soon be reviewing here; Warsh is a former Boston Globe columnist.)

The "fallacy" of "Adam [Smith]" is this:

"So what exactly is Adam's fallacy? According to Foley, it's "the idea that it is possible to separate an economic sphere of life, in which the pursuit of self-interest is guided by objective laws to a socially beneficent outcome, from the rest of social life, in which the pursuit of self interest is morally problematic and has to be weighed against other ends." This abstraction of an economic sphere from the messy complexity of real life is indeed the kernel of present-day economics.

But this entirely overlooks Moral Sentiments (for the 18th-Century phrase "moral sentiments," substitute today's more apt "conscience," and your understanding will increase), which opens thus:

"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.... The greatest ruffian, the most hardened violator of the laws of society, is not altogether without it."

And Adam Smith is astutely attuned to the inability to cabin human beings into the rigor of the model of homo economicus, without attending to

the social and psychological realities of free will, choice, and impulse:

And here he describes "the man of system," who "seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces on a chess-board; he does not consider that the pieces on a chess-board have no principle of motion besides that which the hand impresses on them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own altogether different from that which the legislature might choose to impress upon it."

Indeed, these extra-homo economicus considerations are not just competitive with rational, gimlet-eyed, calculating analytics, at times they overwhelm "reason" altogether:

"What is it that prompts the generous, on all occasions, and the mean, upon many, to sacrifice their own interests to the greater interests of others? Is it not the soft power of humanity, is it not that feeble spark of benevolence which Nature has lighted up in the human heart, that is capable of counteracting the strongest impulses of self-love?"

Now, for some reason, the received wisdom handed down over 200 years later about Adam Smith is that he abandoned these views with publication of The Wealth of Nations.  Well, I'll spare you the academic arguments, but suffice to say there's not a scintilla of evidence that was the case.  Indeed, the better reasoned side of the debate, able to marshal far more evidence in support of its view, is that Smith intended a third and possibly even a fourth volume (cut short by his death, and his mandated destruction of all his unpublished manuscripts) reconciling and extending Moral Sentiments and Wealth of Nations by adding to the mix a treatise on the theory and impact of law and another on science and the arts.

So where are we left here in the 21st Century? 

Economics, a somewhat feckless discipline for the last few decades (there you have, in a nutshell, why I never entertained the notion of pursuing a Ph.D. in economics), has opted to "model what it can at the expense of ignoring what it cannot," and "moral sentiments" are famously unsusceptible to modeling.

One of my fonder, if milder, hopes is that my beloved discipline of economics will come to grasp more strongly the world as it really is with all its human complexity and contradiction, and return from its exile in the arid, mathematically intricate "blackboard economics" domain of homo rationalis economicus.

Happy New Year.