All right. You have laid out before you some of the machinery of prudence. To be prudent, or as some would put it, "prudent," you need to know what wealth you have (your balance sheet), what your cash flow is (your income/expenditure statement), extrapolated out into the future, because decisions, after all, are about the future. To put it another way you need to know what you can produce---your production possibilities curve, called for an individual a "budget line." The "budget line" tells you what you personally can do in the immediate future. Just as we moved from Paul's balance sheet up to Paciolo's and then the nation's, the "budget line" is just the individual's version of the nation's PPC. You have your prospects, what you can do separated out from wha you can't. The can-do includes a guitar vs. more pizza, or defense of food, or investment in new machines vs. expenditure on donuts for the office of Paciolo. Now choose.
But do people actually make choices this way? And should they? Most economists would answer "yes" on both counts. But many of our students and even some of our fellow economists have doubts.
Experimental objections to prudent/rational choice
Perhaps the most common argument against the idea of prudent choice is that we all behave imprudently from time to time, and even make "stupid" choices. Our students make the argument all the time. They are in the good company of the late Frank Knight, a distinguished economist and philosopher of the Good Old Chicago School, who shared this view---unlike many of his own students, such as Milton Friedman or George Stigler.
A body of research that tries to test the Perfect Prudence hypothesis directly, using data from laboratory experiments. The research combines cognitive psychology with economics, and is often called "behavioral" or "experimental" economics. Vernon Smith (whom you've already met) and a psychologist (of all things), Daniel Kahneman, received the 2002 Nobel Prize in Economics for their pioneering contributions to experimental economics.
Kahneman's work is an exploration of when and why people are "not prudent." For example, experimental economists have noted that if Maria loses an expensive ticket she just bought to a rock concert she will most likely go home, disappointed. The prudent thing to do is to buy another ticket, since after all she was willing to buy it before she lost it, and the loss is not so great that her yearly income statement or her balance sheet is much changed. But Maria did it. So would you, probably. Strangely, if she had lost the money, she most likely will go to get to the cash dispenser, or borrow from her friends so that she can buy a ticket anyway. Loosing the ticket with a certain value is different from loosing the amount of money with the same value. Intriguing, isn't it?
If Rodney is asked how much he will pay to prevent all air pollution in his neighborhood he might say as much as $300 a year: nice, clean, breathable air. But if he's asked how much it would take for him to keep on accepting the air pollution the neighborhood already has, he will often mention a smaller amount, $100, say. Test it on yourself. To an economist such behavior seems odd, since it assigns different values to the same commodity, breathable air. Kahneman showed the effect working in actual experiments with money and commodities. The experiments suggest that people do not choose consistently, at any rate from the point of view of purely prudent behavior, and do not always choose the best option.
Most economists would say that imprudent behavior---failing to choose the best available option---is relatively rare, and usually confined to minor matters such as lost rock concert tickets. Jeremy Bentham (1748-1832), the founder of the prudence-is-everything line in economics, declared in 1789 that "Men calculate, some with less exactness, indeed, some with more: but all men calculate."
The confidence of modern economists in the idea of calculating, prudent, rational choice is based on the simple logic of the so-called "$1 Bill Theorem." We all know that it's rare to find a $1 bill lying on the street. Why? People drop them pretty often and fail to notice that they have. The laws of physics say that a dropped $1 will stay where it's dropped. But of course the laws of economics say that anyone who noticed the bill would have stopped to pick it up. Only a tiny bit of prudence will drive him. The picker-up doesn't have to be super prudent or someone who never makes a mistake. Economics in this case beats physics for scientific predictions. Even modest profit opportunities and inexact calculation are enough to get people's attention and motivate prudent action. The economist does not have to assume that people are wildly greedy or omnisciently calculating. She need only assume that people are modestly calculating, enough to be prudent in buying a house, choosing a job, or picking money off the sidewalk.
|A Valuable Tip, Compliments of Prudence-Only Economics|
|The $1 Bill Theorem, actually, can save you a ton of money. Suppose late-night TV show host tells you that he has a plan to make you rich. At home. In your spare time. By investing in real estate. Using credit cards. The $1 Bill Theorem makes you wonder why he's telling you about the plan. If it's a good plan, as easy as he claims it is, it would be like finding $1 lying on the sidewalk. Do people normally go around telling other people about $1 bills lying on the sidewalk? Of course not. They pick them up themselves. If the late-night counselor is really capable of dreaming up investment plans that amount to picking up $1 bills, why hasn't he taken advantage of it for himself? Why is he sweating making an info-mercial? If he's so smart, why isn't he rich?
|Stockbroker: If You're So Smart, Why Aren't You Rich?|
|If we can persuade you to stay away from get-rich-quick salespeople, we guarantee you---money back!---that you will save over your lifetime the cost of this book and the tuition for the course many times over. If on the other hand you don't pay attention to your wise professors of economics, and don't believe the $1 Bill Theorem, you are doomed to believing con men, stock tipsters, and so-called "economists" who claim to predict what's going to happen to the interest rate. Believe us, we implore you: if you don't pay attention here, it'll cost you!|
Ethical objections to prudent/rational choice
Klamer: Abrahamic religions such as Judaism and Islam and especially Christianity disapprove of rich, calculating people. They say that you can't serve both God and Mammon. Or, as Jesus of Nazareth said, "It is easier for a camel to go through the eye of a needle than for a rich man to enter into the kingdom of God." Buddha made a similar point. These are ethical arguments against the self-centeredness of prudent choice.
Ziliak: Adam Smith said it too: "To feel much for others, and little for ourselves, to restrain our selfish, and to indulge our benevolent, affections, constitutes the perfection of human nature."
McCloskey: I'm sympathetic. But the criticisms are based on a misunderstanding of prudent choice. Prudent behavior is not necessarily selfish or cold-hearted. As we noted earlier, rationality or prudence simply means that people make reasoned, consistent choices in pursuit of their goals, whatever the goals may be. Some people will have the goal of loving their families. Others will follow Jesus' invitation to "go and sell what thou hast, and give to the poor." Others will seek only a comfortable bachelor pad, ignoring the beggar on his stoop. But prudence does not exclude ethics. It just makes it a choice.
Klamer: But economists often say that they do not care about people's intentions. They think ethics has no place in economics, believing that what they do is "positive," not "normative." And ethics, they say, is "just" taste. Adam Smith certainly didn't treat what he called "moral sentiments" as mere matters of taste on a par with our preference for chocolate versus vanilla ice cream.
McCloskey: I agree, and wrote a long book saying so, The Bourgeois Virtues: Ethics for an Age of Commerce (2006). But economists are mostly interested in the consequences (especially the unintended consequences) of prudent action. This was Smith's main point in the Wealth of Nations. When self-interested behavior is harnessed by market competition---what Smith called "the simple and obvious system of natural liberty"---the unintended consequences are big and good.
Rodney: But what about people's intentions? Do economists just condone the profit motive, say, or greed, no matter what, on the assumption that it leads to good things for other people in the long run?
McCloskey: Not "no matter what." There are ethical limits. As Milton Friedman (b. 1903) put it, the goal of a corporate manager should be to raise the value of the corporations stock by trying to "make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom."
Klamer: Hmm, interesting. I had forgotten that last clause in Friedman's paper.
McCloskey: And remember that the intentions behind the so-called profit motive are not necessarily greedy or indifferent to the welfare of others. In fact, some would say that capitalist entrepreneurs are the most ethical economic actors of all---because their whole purpose is to discover what people want and then provide it! There are worse things one could do to another person than try to sell him something at a profit. As Samuel Johnson, the 18th-century English writer, said, "There are few ways in which a man can be more innocently employed than in getting money."
Ziliak: How so?
McCloskey: Consider the alternatives to market exchange, "getting [and using] money." One alternative is murder and mayhem in defense of an aristocratic honor. As Johnson said in another connection, "A man who places honor only in successful violence is a very troublesome and pernicious animal in time of peace." Another alternative to market exchange is the insolence of office from non-market bureaucrats. Another is having the "right" skin color or religion or membership in the ruling political party. The prudent person in a market environment is not usually vicious or snobbish, merely a bit calculating.
Ziliak: Fine, so far as it goes. But a social science will keep the societal perspective in mind. Sure, an "individual" may be innocently employed in getting money. But entire social groups, such people of color, or women, or gays and lesbians, may be the victims of a not-so-innocent institutional racism or sexism that obstructs equal access to or denies fair outcomes to Johnson's innocent game.
McCloskey: But as I just said, Steve, racism and sexism are more characteristic of non-market transactions than of market transactions. When did you last see the greeters at Wal-Mart turning away Jews or women or African Americans? By contrast, non-market realms like government or private country clubs are notorious for doing just that.
Ziliak: Not Wal-Mart, so far as I know, but Denny's does: they turn away African-Americans and even obese people. The law suits are there for all to see; I've witnessed it in person. I understand your point and I agree that markets do not by themselves create racism and sexism. But Wal-Mart and low prices did not create the Civil Rights Act of 1964, which banned discriminatory behavior; the blood, sweat, and tears of purposive, voluntary, and group action, and the eventual cooperation of the federal government, did.
McCloskey: Yes, that's true and important. "We shall overcome" is a folksong I'll never tire of singing.
A killer argument for the prudence/rationality assumption in economics is that if it were not so there would be $1 bills lying around all over the place. In particular, if markets such as the New York Stock Exchange were imprudent in the simple ways that psychologists have found experimental subjects to be, then the professors of psychology could become millionaires---maybe even the owners of multi-national corporations! Anyone who says that the housing market, say, is irrational, or that the stock market is a "bubble," is claiming to be smarter than the markets. Try it if you think so. Or, better, save your money.
But an even better killer argument is that a hypothesis of prudence does after all explain a great deal of what actually happens in the world, from business behavior to politics and beyond. Or so at least we will attempt to show you.
Ziliak: But we economists need to take seriously Amartya Sen's (b. 1933; Nobel prize, 1998) criticism of prudence-only choice-"Rational Fools" (1977, Philosophy and Public Affairs). Sen points out that after the 1880s the mainstream economic theory of prudence or rationality lacks any notion of "sympathy" or "commitment"-two central characteristics of human life you yourself are sympathetic with.
McCloskey: Of course, and not just on Sundays. My book The Bourgeois Virtues I just mentioned is all about that. Love, sympathy, and commitment, I say in the book, are not "inside of" the prudence calculation. They stand distinct from and outside of prudence, and give it spiritual meaning. Tastes are nothing without values available to reason about them. A high price in the underground sex market, for example, does not mean that the now-"richer" parents will put their children (their "assets") on the market. Human commitment to the sanctity of life does not allow such brutality. Not much, anyway.
Rodney: Quick question. . . .
McCloskey: Oh, Rodney, wait a minute. Never ask a question, in this classroom or in business, by saying, "A quick question"! Just ask it! Anyway, I'm paid to answer your questions: the Answer Lady!
Rodney: You're the boss, Answer Lady: What about the evil multi-national corporate machine? Aren't they unethical?
McCloskey: No. They don't exist. Perfect competition rules.
Ziliak: [Laughs.] Of course they exist. The multi-national corporations may or may not be evil, but the remoteness of economic decision making in big markets exists.
McCloskey: "Exists" is not the same thing as "matters seriously to outcomes."
Ziliak: You know I agree with that. It's an empirical question and to you and me the matter is still being settled by the work of Arnold Harberger, George Stigler, and others. But Rodney's got a point, one that the American philosopher John Dewey made in his neglected book, The Public and its Problems (1927). It's the point today of aboriginal peoples of Canada and Australia challenging the taking of their land. And, come to think if it, of the rock band Rage Against the Machine. How you or I do in the economy is changed by corporate and governmental decisions far outside the control of you and me, even in a democracy. It's what late John Kenneth Galbraith's said again and again. And our Marxist friends.