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Best Business Books 2004: Behavioral Economics

The Company of Strangers argues that self-reinforcing institutions sustain prosperous societies; these institutions originated during the transition from a hunter-gatherer existence to settled agriculture. Economic specialization rests on trust, as it is rare to exchange goods and services simultaneously, like the exchange of hostages in an old-fashioned spy thriller. Usually there's a gap in time, and the transaction is mediated by symbols such as paper currency or electronic records.

The trust among billions of people that makes our global economy function can be sustained only thanks to the institutions that make it worth everybody's while to participate. "Modern political institutions temper their appeals to the deep emotions, to family and clan loyalty, with just enough abstract reasoning to help Homo sapiens, the shy murderous ape, emerge from his family bands in the savanna woodland in order to live and work in a world largely populated by strangers," Seabright writes. Money is a good example of such an institution.

Seabright argues that this mutual consent to trust one another is based partly on rational calculation that we'll be better off by being trusting, and partly on our psychological inclination toward reciprocity. "Tit for tat" has a firm foundation in evolutionary psychology.

The book ends by asking whether the logic of economic organization could undermine the social institutions that underpin it. Can the openness and flexibility needed by a modern industrial society coexist with the need to trust strangers on an ever-greater scale? The answer -- "who knows?" -- is not exactly comforting. Our safety and prosperity depend on how fast we can evolve our social and political institutions. This is a book every concerned citizen should read, along with anybody in business who ever has to tangle with government regulations or the law, and who wants to understand why those relationships are so complex.

The Intangible Hand
Seabright's emphasis on the importance of institutions for economic success is becoming a common theme in economics. This is a revival of the subject's early tradition found in the work of pioneers such as Adam Smith and David Hume. Smith's The Theory of Moral Sentiments is far less well known than his later The Wealth of Nations, but he regarded it as providing the philosophical scaffolding for his analysis of the economy, and his conclusions about how the benign results of the market rest on virtuous behavior. Smith's "moral sentiments" are the subject of The Economy of Esteem, by Geoffrey Brennan, an economist at the Australian National University, and Philip Pettit, a political philosopher at Princeton University. They argue (in a book slightly more technical than the other two) that there are three fundamental human drives: drives for property, for power, and for esteem, defined as the good opinion of others.

Social scientists have long studied property (the invisible hand) and power (the iron fist), but the desire for esteem as a motive in human society has been overlooked. The authors apply the methods of economic analysis to this missing driving force and consider the part it plays in the institutions of the economy. Mobilizing the "intangible hand" of esteem, they say, can help support desirable social norms and institutions.

Why? Because esteem is mutually reinforcing. As David Hume put it in his Treatise of Human Nature: "Tho' fame in general be agreeable, yet we receive a much greater satisfaction from the approbation of those whom we ourselves esteem and approve of, than of those whom we hate and despise. In like manner, we are principally mortified with the contempt of persons upon whose judgment we set some value, and are, in great measure, indifferent about the opinions of the rest of mankind." Esteem is a compliance mechanism. For example, the recycling of household waste started out as an unusual activity, an ostentatious signal of virtuous concern for the environment. This warm glow of virtue attracted others to recycle their trash as well. This trend steadily reduced the special kudos of being ultra-green, and in the end recycling has become normal. Now only those who want to make a strong statement of their anti-environmentalism will never use recycling centers.

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