Freeman

BOOK REVIEW

Reputation: Studies in the Voluntary Elicitation of Good Conduct edited by Daniel B. Klein

A Valuable Contribution to Our Understanding of Free Markets

MARCH 01, 1998 by JOHN ATTARIAN

Filed Under : Free Market, Regulation

University of Michigan Press • 1997 • 318 pages • $57.50 cloth; $19.95 paperback

John Attarian is a freelance writer in Ann Arbor, Michigan.

“But a free market just can’t police itself. That’s why we need government regulation.” Many people find this argument plausible, even compelling. But how many stop to ask if the first sentence is really true? Reputation, an enlightening and provocative volume of essays, does just that. The answer explodes this argument for regulation.

Reputation, writes editor Daniel Klein (Santa Clara University), explores how “good conduct is sustained even in the absence of an external enforcement authority,” and shows how “social affairs can be self-policing.” Information tells economic agents which parties are behaving unethically. Markets punish misconduct by withholding business, cooperation, and other benefits. Hence a reputation for honesty is valuable, and ethical conduct is in one’s interest. The result? Trust, cooperation, and honesty—without government regulation.

Arranged in three sections of increasing rigor, the essays start, appropriately, with Adam Smith’s insight into reputation’s power. Probity—tried, proven honesty—always accompanies commerce, Smith argues, out of self-interest. “A dealer is afraid of losing his character, and is scrupulous in observing every engagement. When a person makes perhaps 20 contracts in a day, he cannot gain so much by endeavoring to impose on his neighbors, as the very appearance of a cheat would make him lose.”

Even in modern societies with large, mobile populations, Klein and Jeremy Shearmur (Australian National University) maintain, this self-policing mechanism can work. Our ability to gather information about the reputations of others allows us to decide whom we can safely do business with, and fear of negative consequences of gossip about ourselves gives us an inducement to cooperate with strangers.

Besides reputation, another valuable asset is an independent, trustworthy seal of approval for a firm or product. Two great American institutions arose privately out of local efforts to provide protection against poor quality: Underwriters Laboratories in electrical product testing, and Dun & Bradstreet in credit rating. Their reputation for rigor and objectivity make their seals of approval valuable and effective means of market self-policing.

Detailed but accessible specialized studies thoroughly explore other historical examples of free-market self-policing, presenting an impressive body of evidence supporting Klein’s optimism. For example, the medieval Jewish Maghribi traders formed a coalition that effectively used reputation and sanctions on unethical members to ensure honest conduct from their overseas agents. Bruce Benson (Florida State University) traces how modern commercial law evolved from the private Law Merchant, which developed in the 1000–1200 period, complete with courts, judges, and punishments; the evolution of that law shows that “the commercial sector is completely capable of establishing and enforcing its own laws.”

J. Bradford DeLong (University of California, Berkeley) observes that the presence of J. P. Morgan and Company partners on a firm’s board of directors added value to the firm’s stock, and argues that this was at least partly due to Morgan’s massive reputation as an honest broker and superior assessor of risk. The Morgan stamp of approval gave investors confidence that the firms would be well managed and monitored for financial soundness.

The existence of effective private self-policing efforts has radical implications for regulation. Professor Klein argues that “most, perhaps all, quality and safety regulations should be eliminated, that a system based on pre-1960 common-law principles and on voluntary institutions and customs would be an improvement over our current regulatory arrangement.” On the evidence, he has a strong case.

Reputation‘s arguments have powerful commonsense appeal, too. Government regulation, oversight, and auditing are recent inventions. Yet trade flourished for centuries without them. If the free market really were incapable of self-policing, this could not have happened; rational economic agents would not have risked exposure to rampant fraud and malfeasance, and trade would have remained local and low volume. Since it obviously did not, markets must have had effective policing mechanisms grounded in reputation. Evidence from our own lives offers further support. Is not a friend’s recommendation or bad report influential in deciding which business one patronizes?

Fascinating, stimulating, and highly enlightening, Reputation is a most valuable contribution to our understanding of free markets and how they work. More than that, it is a powerful and timely weapon in the struggle against statism, going far to disprove the canard that people cannot be trusted with freedom.

ASSOCIATED ISSUE

March 1998

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