Auditing Self-Interest: How the Great Recession provoked an economic examination of conscience

For 30 years, the economic theories of Milton Friedman and others associated with the University of Chicago have shaped American policies. Their theories assume a world of rational people who make optimal choices about spending and saving. In pursuing self-interest, the theory goes, people seek to maximize their wealth and other material goals; they generally do not care about other social goals when those goals conflict with their economic self-interest. When “self-interest and ethical values with wide verbal allegiance are in conflict,” said the Chicago School economist George Stigler, “much of the time, most of the time in fact, self-interest theory…will win.”

Self-interest, says the Chicago School, drives markets toward more efficient outcomes. The government need not intervene in the economy, since rational individuals pursuing their self-interest prevent or quickly cure most market failures. Until the recent financial crisis, competition was assumed to be a self-initiating, self-correcting process that, when largely left alone, will allocate resources efficiently toward users who value them the most. The economic theories, wrote Cardinal Joseph Ratzinger in “Church and Economy” (Communio, fall 1986), assume that the “natural laws of the market are in essence good...and necessarily work for the good, whatever may be true of the morality of individuals.”

These Chicago School theories are now under attack. The “orthodox and unvarnished Chicago School of economic theory is on life support, if it is not dead,” remarked Commissioner J. Thomas Rosch of the U.S. Federal Trade Commission recently. “In the real world—as opposed to the worlds of political and economic theory—markets are not perfect…imperfect markets do not always correct themselves; and…business people do not always behave rationally.” Prompted by the financial crisis, the Obama administration is re-examining fundamental issues like the efficiency of markets and the role of legal, social and ethical norms in a market economy.

This re-examination raises three central issues. First, do people actually behave like the Chicago School’s self-interested profit-maximizers? Second, if the answer is no, should self-interested behavior be the desired norm? Third, what are the risks if social policies promote self-interested behavior as the norm?

In addressing these three issues, policymakers are looking at “behavioral economics,” which the Nobel laureate Daniel Kahneman and the cognitive scientist Amos Tversky pioneered. A key assumption of the Chicago School’s economic theories is that humans are rational, self-interested and wield perfect willpower. Behavioral economics, in contrast, uses facts and methods from other social sciences—like psychology, neuroscience and sociology—to understand the limits of the assumptions of the Chicago School.

Testing these assumptions in experiments, behavioral economists find that in certain scenarios people do not behave as neoclassical economic theory predicts. Human behavior is more nuanced, diverse and complex. Many people, for example, are not predisposed to pursue their self-interest. They sacrifice wealth to punish what is considered to be unjust behavior and generally care about treating others, and being treated, fairly. We see this daily. Many donate blood, take time to help strangers or tip waiters in places they are unlikely to revisit.

The Ultimatum Game

There is a common behavioral experiment called the ultimatum game, in which the subject is given money (say $100) with two conditions: First, the subject must offer another person some portion of the $100. Second, the other person can either accept or reject the offer. If the other person accepts, both parties keep their portions of the $100. If the other person rejects the offered amount, then neither person keeps any money. The question: How much to offer.

A Chicago School economist would predict that the subject would offer one penny. If people pursue their self-interest, then the subject would want selfishly to keep as much money as possible, and the other person would recognize that a penny is better than nothing. But actual experiments using this game in over 20 countries have found that most people offer significantly more than the nominal amount (ordinarily 40 percent to 50 percent of the total amount). Recipients typically (about half the time) reject nominal amounts (less than 20 percent of the total amount available). Similar results occur even when the participants’ identities are secret and the game is not repeated.

Sometimes an appeal to social or ethical norms is more effective than an appeal to self-interest. In many behavioral experiments, financial rewards or penalties, when these displace social or ethical norms, actually decrease human motivation. Dan Ariely, a professor of behavioral economics at M.I.T., in his book Predictably Irrational describes experiments in which the participants—divided into three groups—all performed the same mundane task. One group (the social-norm group) was not compensated but was asked to undertake the task as a favor. In the first experiment, the social-norm group outperformed the group whose members received $5 as compensation for the task, who in turn outperformed the group whose members received 50 cents. In the second experiment, the two groups did not receive cash but a gift of comparable value (a Snickers bar for the 50-cents group and a box of Godiva chocolate for the $5 group). These two groups performed as diligently as the social-norm group. In the third experiment, after the gifts were assigned a monetary value—a “50-cent Snickers bar” or a “$5-box of Godiva chocolates”—they again devoted less effort than the social-norm group.

Some people, of course, behave selfishly. So the outcome in behavioral experiments can depend on other factors, including whether the participants are reminded about money. Recent behavioral experiments show that even nonconscious reminders of money can cause us to be more independent in our work but also less likely to seek help from others, less willing to spend time helping others and stingier when asked to donate to a worthy cause. Consequently, many people do not predictably pursue their self-interest.

Which Way to Happiness?

Because social perceptions and other factors can influence human behavior, the second issue is whether self-interested behavior, as classical economics teaches, should be the desired norm. Is greed good? Will self-interested behavior improve overall well-being? The answer is, not always. Another branch of economic research confirms the age-old wisdom that once our basic needs are met, money has a weak relationship to happiness. Once a country’s gross domestic product per capita exceeds a moderate level of income, societies do not become happier as they get richer.

One behavioral experiment published in the March 21, 2008, issue of Science magazine reaffirmed the adage that there is more happiness in giving than receiving. The authors of the study found that while spending on oneself was unrelated to happiness, spending more of one’s income on others (like gifts for others and donations to charity) was a predictor of greater happiness. How people spent their bonus (on themselves or others) was a more important predictor of their happiness than the amount of the bonus. In another experiment, participants, after rating their happiness in the morning, were given envelopes with money and divided into two groups. Members of the first group were told to spend the money in the envelope on themselves by 5 p.m. The second group was told to give the money to someone else or a charity. After 5 p.m., the participants were asked about their happiness. Although the amount of money received ($5 or $20) did not significantly affect the participants’ happiness, those who gave the money away reported greater post-windfall happiness than did the personal-spending group.

So if giving leads to greater happiness, the study’s authors ask, why don’t we spend less on ourselves and donate a little more? Because people predict poorly. The authors found that 63 percent of the university students predicted personal spending would make them happier than more altruistic spending and that $20 would make them happier than $5.

This also explains why so many of us whose basic needs are met still desire more money. We are on a hedonic treadmill. We adapt to our improved lifestyle (such as a bigger home and second car) and desire more. We perceive absolute wealth (say, possessing a million dollars) as less important than relative wealth (how much we possess compared with our peers, neighbors, friends or, as H. L. Mencken observed, one’s wife’s sister’s husband). As the Roman stoic Seneca commented, “However much you possess, there is someone else who has more, and you will be fancying yourself to be short of things you need to the exact extent by which you lag behind him.” Envy keeps the hedonic treadmill humming. Every time someone else acquires more, I have less. So I need to acquire more. Status competition has no ultimate winner and, besides death, no finish line or satisfactory resting spot.

So if self-interested behavior does not promote happiness, what does? The results are unsurprising. On an individual level, as Richard Layard recounts in Happiness: Lessons From a New Science, the primary sources of happiness are: family relationships, employment, community and friends, health, self-control or autonomy, personal ethical and moral values, and the quality of the environment. People who look beyond their self-interest and practice religion, belong to community organizations, do volunteer work and have rich social connections are generally healthier and happier than those who do not. Not surprisingly, in a recent survey clergy members, physical therapists and firefighters reported the greatest satisfaction from their jobs.

Promoting Self-Interest

The Chicago School’s assumption of self-interest describes neither how we actually act nor how we ought to act. This leads to the third and final issue: What are the risks of a social policy that promotes self-interested behavior? One risk is that an ethical life of charity and community interest becomes anachronistic. Religious norms are among the few counterbalances today against the pursuit of self-interest. A you’re-on-your-own society may view the clergy and environmentalists as eccentric but harmless, but its attitude toward the poor hardens. A society’s wisdom lies not in its ingenious ways of creating wealth but in its attitudes toward poverty and wealth and its actions regarding both. In the Athens of Pericles, for example, wealth was “more for use than for show,” recounted Thucydides, and ancient Athens placed “the real disgrace of poverty not in owning to the fact but in declining the struggle against it.”

Pope John XXIII struck the same theme in 1961 in the encyclical Mater et Magistra: “The economic prosperity of any people is to be assessed not so much from the sum total of goods and wealth possessed as from the distribution of goods according to norms of justice, so that everyone in the community can develop and perfect himself. For this, after all, is the end toward which all economic activity of a community is by nature ordered” (No. 74).

Self-interested behavior can sometimes undermine rather than support a market economy. An economy, as Amartya Sen, a Nobel laureate, recently wrote, “needs other values and commitments such as mutual trust and confidence to work efficiently.” Suppose, for example, a prospective employer offers you a contract that meticulously details every requirement and penalty for every conceivable transgression or deficient work performance. Would you want to work there? Behavioral experiments show that communicating such penalties to employees may backfire; the penalties signal distrust and engender a lower level of productivity from the employee.

A social policy that promotes the perception of widespread self-interested behavior may be self-defeating. Individuals are not inherently selfish. But if we believe that many others are behaving selfishly (cheating on their taxes), then we may be more inclined to behave selfishly as well. One study of over 5,000 business and nonbusiness graduate students at U.S. and Canadian universities found that graduate business students cheat more than their nonbusiness-student peers. The largest influence in the business students’ behavior, the study’s authors found, was the students’ perception that their peers were also cheating.

Ultimately, our survival depends upon our ability to look beyond self-interest. As the Internet and global commerce over the past 20 years have broadened social relationships and increased the interdependence of citizens throughout the world, this has become even more important. To evolve, economies must rely on complex, large-scale cooperation. As the financial crisis shows, economic risks are not isolated to particular regions. But the crisis has provided the needed impetus for policymakers to re-examine many assumptions underlying our current economic policies. Such re-examination, the economist John Maynard Keynes wrote, may enable us to:

return to some of the most sure and certain principles of religion and traditional virtue—that avarice is a vice, that the exaction of usury is a misdemeanor, and the love of money is detestable, that those walk most truly in the paths of virtue and sane wisdom who take least thought for the morrow. We shall once more value ends above means and prefer the good to the useful. We shall honor those who can teach us how to pluck the hour and the day virtuously and well, the delightful people who are capable of taking direct enjoyments in things, the lilies of the field who toil not, neither do they spin.