'We Don't Face Any Good Options'

Nobel Prize-winning economist Vernon Smith on the financial crisis, Adam Smith's underrated insights, and his journey from socialist to libertarian

"I remember the '30s like it was yesterday," says economist Vernon Smith. And he's not kidding. In 1935, when the future Nobel Prize winner was 7 years old, his family decamped to their Kansas farm to wait out the hard times. "On the farms," Smith explains, "you can eat." His parents only made it to eighth grade, but "they were people who read," and they expected their son to go to college. They got their wish'"and then some. 

Smith's higher education began with remedial work at a local Quaker college ("I was not a good student in high school," he says) but eventually took him from a Caltech electrical engineering degree to an economics Ph.D. at Harvard. Beginning at Purdue University, and then at the University of Arizona and George Mason University, Smith founded and developed the pioneering field of experimental economics, which studies actual human behavior'"a major breakthrough in a discipline obsessed with abstract models. This work culminated in 2002, when Smith was awarded the Nobel Memorial Prize in Economic Sciences "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms."

Over that time span, Smith's political views evolved in tandem with his economic insights. He left behind the socialism he learned at his mother's knee for a more libertarian outlook. He says "experimental economics destroyed whatever was left in me of the notion that somehow you could do better than to find institutions that organized this decentralized information and create." Now continuing his lab work at Chapman University, Smith is riding out the second most serious economic crisis of his 84 years in sunny California. 

In July, Smith sat down with reason.tv Editor in Chief Nick Gillespie to discuss his ideological journey, how FDR (and perhaps George W. Bush) saved capitalism, why some of Adam Smith's most important intellectual contributions are overlooked, and what experimental economics has to say about the collapse of the housing market. 

reason: We're sitting in your office at Chapman University, a beautiful campus in Orange County, California. Tell us about your setup here, what kind of experiments you're running, and what you're hoping to find with them.

Vernon Smith: We're asking some questions that came out of the economic crisis. We started doing asset-trading experiments in the '80s and discovered bubbles, quite unintentionally.

reason: In your experiments, you were able to create bubbles, or did they just pop up?

Smith: They popped up. We thought we would create bubbles, but we never had to.

reason: How does a bubble take place? 

Smith: Right now, we don't understand why people get caught up in self-reinforcing expectations of rising prices. The first time you're in this experiment, you may have bought early and you may have sold before the break. Bring those same people back in another two or three days, put them in the same environment, and we get a lower-volume bubble. Typically, it booms earlier and crashes earlier; they are expecting a bubble. Bring them back a third time, and they tend to trade fairly close to fundamental value.

reason: How does this type of experiment map onto, say, the last five years in America?

Smith: If you think about the housing bubble, buyers, sellers, borrowers, lenders, real estate agents, government regulators'"everybody believed that prices would rise and continue to rise. And that is the essence of a bubble. Suppose a regulator in 2003 or 2004 said, "Hey, this thing is not sustainable. We've got to do something to stop it." I think he'd have been fired. If the bubble had been stopped in 2003 or 2004, it probably would have been a lot less damaging. But who's going to know that?

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reason: Why has it taken so long for economics to become more seriously empirical in its operations? It really seems like it's taken forever for economists to want to observe actual human beings trading either in an experimental setting or in the real world.

Smith: Economics enjoyed a major breakthrough in the 1870s: the marginal revolution.

reason: Give us the short definition of the marginal revolution.

Smith: If you go back to Adam Smith, he was puzzled as to why diamonds command a higher price than water, whereas water is more useful. The key idea he didn't have is the notion of marginal utility or marginal value. Unfortunately, I think we lost a lot of the other insights of Adam Smith because we'd solved this intellectual problem of understanding better the determination of prices. Equilibrium economics really [took] the driver's seat.

reason: Which holds…

Smith: The idea is an economy consists of preferences and technology for producing goods. This gives you a conjunction of supply and demand where demand depends not on the price of this particular good but the price of the alternatives, because the concept of opportunity cost comes in on both the demand side and the supply side. So it's a complex problem mathematically and intellectually, but this problem got solved and it helped them to understand the operation of a static, equilibrium world. 

Of course the great insight of [economist F.A.] Hayek and his criticism of equilibrium theory was that it began with a bunch of givens that are not, in fact, given to any one mind in the economy. The essential thing about a real economy is that all this information is dispersed. So the name of the game is how people discover this equilibrium. And that's where I think the experimental work has importantly dramatized the essence of Hayek's critique. Given the institutions of trading, people are very good in the laboratory at finding these equilibria that they don't have any understanding of'"and they get there by repetition.

reason: You say you're a libertarian with a lot of reservations. The experiments you have run and the research you've done over the years really argue that institutions create good and bad behavior.

Smith: As a libertarian, I'd like to emphasize the property rights aspect of it. People say what we need is more regulation. All markets are regulated in terms of property rights, the dos and don'ts. The important thing is that those property rights provide people with the right incentives. What was so devastating in the mortgage market is this separation of mortgage originations from the lender without properly incentivizing the mortgage originator. What's your incentive to do due diligence if you get your fee up front and then it goes out the back door and down the line?

reason: You say we got away from understanding that everyone needs to have skin in the game. What was driving that loss of knowledge? Was it federal policy? Was it collective amnesia?

Smith: The way I would describe it is: We created new mortgage and financial institutions too fast. No one had an incentive to think it through. Not only were there bad incentives up front with mortgage origination, but those mortgages then would be packaged, mortgage-backed securities issued, and then they were rated and "insured." But they weren't collateralized. They were exempt, you see. And exempt meant that they were exempt from the property rights rules that would have applied if derivatives had been classified as securities.

reason: This has been a very long recession, and whether it has ended or not, we're facing slow economic growth and high unemployment. What are the forces extending this crisis?

Smith: The main thing is the negative equity problem in households. Or near negative equity. You have something like 22 percent of homeowners now who owe more on their house than the current market value. You don't feel like spending money; you're paying down debt.

reason: What do you do? Do you just sit it out until enough of the debt is paid down?

Smith: That's probably the way we're going to do it. It was a mistake to subsidize new home buyers. Existing homeowners'"many of them have been given a break in their payments, but they've done it by giving them a lower interest rate and stretching the loans. They haven't even changed the principal.

reason: But that's a disturbing intervention, isn't it?

Smith: Of course it's disturbing! Forgiving debt is not a good idea. But you have to realize we don't face any good options. If it hadn't been done, the banking system likely would have collapsed. We'd have the same problem we had in the '30s.

reason: If this is the second worst economic crisis'"except for the Great Depression'"how does it stack up?

Smith: I remember the '30s like it was yesterday. See in 1932, I was 5 years old. My father worked for the Bridgeport Machine Company in Wichita, Kansas. He was a machinist. We had a farm. So in 1935 we moved to that farm. In times of stress there often is this reverse migration from cities to farms, because on the farms you can eat. We grew our own vegetables, chickens, hogs, all of that. They were very, very difficult years in terms of wheat harvests and that sort of thing.

reason: You grew up in Kansas in the '30s and then, in terms of high school'"

Smith: I finished high school in January 1944. I was working at Boeing at the time and continued until the following August, and then I went to Friends University, a Quaker college not many blocks from where I lived. And the reason that I went there was to make up for my high school education. I was not a good student in high school, and I did not have the math, physics, chemistry that I needed if I was going to go into science. I made up for all of that at Friends University.

reason: Did either of your parents go to college?

Smith: No.

reason: So how did you gravitate to even thinking of that as a possibility?

Smith: My parents always expected it of me, even though they only had an eighth-grade education. They were people who read. My mother was a socialist and was a political activist.

reason: When you say socialist'"she believed that the means of production should be collectively owned by the state, etc.?

Smith: Oh, yes! But that was really common of people in the 1930s. 

reason: Especially in that part of the country.

Smith: Oh, yes.

reason: You got a master's in economics from Kansas, and then you went to Harvard for your Ph.D. What were they teaching in economics classes?

Smith: General equilibrium theory. The course I took from Wassily Leontief, which was the first-year theory class at Harvard, was a very good one. We read Irving Fisher. I'm still a great admirer. 

reason: What do you like about him?

Smith: Fisher was a very clear writer. I remember a student once asked Leontief in class why there was no school of economics built around Fisher. And Leontief said: Well, it's because he wrote so clearly'"everyone could understand what he was saying. 

reason: Were people free market enthusiasts at that point? Or were they all talking about a command economy? 

Smith: I think the only clear-cut free market enthusiast at Harvard would have been Gottfried Haberler. He'd come out of the Austrian school. There was a tremendous exodus, of course, out of Germany and Austria of not only physicists but economists'"Fritz Machlup, Jacob Marschak, [Joseph] Schumpeter, of course. And when I got to Harvard, Schumpeter had died only two years earlier and his legacy was very strong.

reason: Was there a sense that FDR's economic policies had succeeded and that economists could just sort of follow through on that project?

Smith: Yes. Roosevelt, in a way, kind of saved capitalism.

reason: Just like George Bush did more recently.

Smith: Yeah. He kind of saved it. In fact, my grandfather, my mother's father, who had been a supporter of Eugene Victor Debs in 1932, became a Roosevelt fan, and I think that tells you a lot about what happened in the '30s.

reason: Let's talk about that then. It's also a personal journey for you. And I know you said your first presidential vote went to Norman Thomas, the Socialist in 1948. And then the other presidential vote that was easy for you to make was Ed Clark in 1980, the Libertarian candidate. In a way, your journey'"as demarcated by those votes'"is part of a larger American story of leaving behind a kind of rule by elites, or control by elites, where "we'll take care of everything," to a much more individualistic understanding that it's a libertarian country.

Smith: Experimental economics destroyed whatever was left in me of the notion that somehow you could do better than to find institutions that organized this decentralized information and create. That's the engine of wealth creation.

reason: In America since 1950, there's been a vast increase in the appreciation of and understanding of economics. Will we be better at not being stupid about how we're acting if we know more about economics?

Smith: The work that has to be done to keep us from getting off track has to be expressed in terms of institutional constraints, when what we do has serious implications for innocent other parties. Margin rules in the stock market confine the damage for the people who are doing it. There's no external blindsiding of all kinds of people that are innocent. I see it as a property rights problem. And you know what? We got it right in most markets. The vast majority of markets work fine. And the reason why they work is that you can't steal; you have to trade. Essentially, what we're doing is asking whether there was a type of theft going on that was not being controlled by the right property rights regime.

reason: Federal spending is currently 25 percent of the economy, a figure that hasn't been seen since World War II. Deficits loom large in absolute numbers as well as a percentage of the economy. Is that a form of theft as well? Is that something that concerns you and needs to be reined in?

Smith: We're primarily going to solve that problem by inflating out of it. 

reason: I'm very sorry to hear that.

Smith: I'm sorry to say it! But I think that will be the way we reduce the burden of the debt. It won't be intended. [Federal Reserve Chairman] Ben Bernanke talks about the tools he has. One of the tools he has is to raise the interest rate he pays on excess reserves'"in other words, pay them to not expand loans rapidly. But right now he's got the other problem.

reason: But is this also the delusion of the economic planner, that once things start happening'"he's very smart, he's going to be able to control this? We've seen this before, where inflation isn't a problem until it's beyond control.

Smith: It's really interesting to look at the Federal Open Market Committee press releases in 2007. On August 7, 2007, the press release said the housing market is going through an adjustment; we're still concerned about inflation. Three days later, because of the collapse in the credit default market, that completely changed. The Federal Reserve, Bernanke realized they had a financial crisis on their hands. That's how quickly it happened, and the signal came from a market. It did not come from the econometric models. I think to Bernanke's credit that he changed. He turned on a dime. How many times had he said it was not the business of the Federal Reserve to rescue investors from the consequences of their own decisions? That's exactly what he ended up doing. I don't believe he wanted to do it. I think he meant the earlier statements, but he had no choice.

reason: If we hadn't bailed out the banks, if we hadn't passed TARP, the economy would have ceased to exist?

Smith: I think the more important thing is what the Federal Reserve did, not the Treasury program. You can always go back and say, well things should have been done earlier to prevent that from happening. Yes, yes, I agree. But the point is, what do you do in that case? Here it is, in spite of whatever mistakes had been made before. And Bernanke is testing the Friedman-Schwartz hypothesis right now'"that if the Fed had acted and flooded the system with liquidity in the early '30s, that we'd have prevented the Great Depression.

reason: Economists enjoy a possibly unprecedented kind of cultural power now. They can write best-selling books. They can run the world economy. Where does economics as a serious discipline need to be moving next?

Smith: To me, the major problem in economic theory is the preoccupation with modeling for its own sake and not asking the fundamental questions. These fundamental questions have to do with dynamics; they have to do with property rights. Basic questions like: "How can it be that specialization, exchange, and property rights came about?" You can't have one without the other. We think today of property rights as something that comes from the state. That couldn't possibly be how they originated. Our small-group experiments are trust games. Imagine a trust game in which I'm a first mover and you're the second mover. I move first. I can choose $10 for each of us, or I can pass to you. If I pass to you, the $20 becomes $40. You can give me 15 and keep 25, or you can give me nothing and get the whole 40. Game theory says I should never pass to you, because if you're self-interested, you'll take the 40. But what's remarkable is half the people we recruit in the undergraduate lab'"half of the first movers [pass] to the second. And two-thirds to three-quarters reciprocate with 15/25'"they don't take the total. You can't understand that with game theory. You can understand it by reading The Theory of Moral Sentiments.

reason: Is that a learned behavior, or is that an innate behavior? Or is that dichotomy not really relevant?

Smith: It's Adam Smith! He says imagine a human being is brought up in complete isolation from any member of the species. That person can't have an idea of what it means for his mind to be deformed any more than he has an idea for what it means for his face to be deformed. Bring him into society, and you give him the mirror he needs. In The Theory of Moral Sentiments, Adam Smith is saying munificence is the only thing that requires reward. You don't reward justice; what you do is punish injustice. Justice is what's left over after you prevent injustice. Property rights come out of human sociality and then eventually get into civil government. But they arise originally in small groups.