It can plausibly be argued that much of economic backwardness in the world can be explained by the lack of mutual confidence.

—Kenneth Arrow, winner of the Nobel Prize in Economics

AT THE UNIVERSITY OF CHICAGO’S BOOTH SCHOOL OF Business, where I teach, students don’t just register for classes—they bid for them. True to market principles, Chicago Booth organized this system to maximize student satisfaction. By creating a market in which students compete for the opportunity to take classes with the professors they like best, Chicago Booth ensures the class assignments that maximize students’ desires.

To function properly, this market, like all markets, requires not only official rules but social norms as well. For evidence of the importance of social norms, consider a problem we encountered with the bidding system. The system gives each student a fixed number of bidding points at the beginning of his two-year program. Students can then use these points to bid for the courses they like. The “cost” of a given course is set by the number of students bidding for it and how many points they bid: less popular courses go for zero points, while more popular ones require students to dip into their precious points. When the demand for a course exceeds the supply, only the students who made the highest bids get to take the class. Each quarter features three rounds of bidding; after each round, students who win spots in a class can, if they like, give those spots to other students in exchange for points.

Years ago, students discovered a loophole in the system. The first round of bidding for the fall quarter took place before the first-year students showed up on campus—we wanted to give second-year students time to plan. As long as first-year students were bidding for first-year courses and second-year students for second-year courses, no problem arose. But second-year students soon realized that they could bid for popular first-year courses before the first-year students arrived and then “sell” them back at higher prices. This increased their number of points, which they could use to bid for other courses.

When this tactic—arbitrage, an economist would call it—became known, the faculty was divided on how to treat the students who had taken advantage of it. Some were furious and wanted to punish the students who gamed the system. Others thought that the students should be not punished but congratulated for their cleverness. I was not so sanguine. I thought it was unfair to punish the students, since they hadn’t broken any rule. But their opportunistic behavior had undermined the system, creating no benefits for the rest of the business school community and in fact producing a net loss.

This apparently simple question—Should we, as teachers, condemn, condone, or praise their behavior?—raises a broader one. Should economists be ivory-tower scientists who teach facts and not morals? Or should we take a moral stand—and if so, which one?

AMORAL FAMILISM

One of the most influential books I read in graduate school was The Moral Basis of a Backward Society, written more than fifty years ago by Edward Banfield, a political scientist at Harvard University.¹ Banfield’s wife was Italian, and they decided to spend a year in her small hometown in southern Italy. Banfield used this time to study the local habits. He grew curious about a particular question: why was this agricultural village so economically backward?

His answer was something that he labeled amoral familism. The villagers, he saw, pursued their own self-interest and that of their immediate family in a way that prevented cooperation. Southern Italian farmers, each owning minuscule plots of land, could never cultivate them efficiently because they were unwilling or unable to cooperate with neighboring farms. There was little civic engagement. And this amoral familism was self-fulfilling: since everybody looked after his own narrow self-interest, the widespread mistrust was justified, as was the general lack of hope that things would improve. The village was economically backward and seemingly doomed to remain so.

Banfield’s description resonated with me. Though I had grown up in northern Italy, my paternal grandfather is from Sicily, where I had several relatives. These southern relatives of mine, I recalled, distrusted not just northerners but everybody. They feared being cheated—fatti fessi (being made fools). It was more than the fear of an economic loss. It was an injury to their personal pride. Their desire to avoid being cheated was so strong that they never made a deal with anybody.

Trained as I am in economics, I believe that individuals’ pursuing their own interests leads to the common good. That’s what Adam Smith taught us, right? So why, then, did things prove otherwise in Banfield’s southern Italian town?

THE IMPORTANCE OF TRUST

Let’s try to understand the institutional context in which economic transactions take place. Just as fish are unaware of the water in which they swim, so we are frequently unaware of the institutional structures surrounding us, not just in terms of law but also in terms of norms and beliefs. One of the most important of these norms is trust. “Virtually every commercial transaction,” wrote economics Nobel Prize winner Kenneth Arrow, “has within itself an element of trust.”² When we deposit money in a bank, buy a share of stock through a broker, purchase a good over the Internet, or refinance a mortgage, most of us do not read the intricate details of the contracts we are signing. In bridging the gap between the knowledge that we have and the knowledge that would be required to make a decision in a fully informed way, we rely on trust. We trust our counterparties or, more broadly, we trust the system as a whole. We trust banks to let us withdraw our money, we trust the stockbroker not to abscond with our money, we trust the Internet vendor to deliver our goods, and we trust the Internet encryption system not to leak our credit-card information. Trust facilitates transactions because it saves the costs of monitoring and screening; it is an essential lubricant that greases the wheels of the economic system.

Of course, when millions of dollars are on the line, trust on its own becomes insufficient. Lawyers are paid handsomely to review contingencies, and sophisticated contracts are put into place to protect the contracting parties. But in millions of everyday transactions, there is neither time nor resources for people to practice any serious due diligence. If trust is there, the transaction takes place. If it isn’t, there’s no deal. Millions of small transactions that never take place because of the absence of trust translate into billions of dollars lost to the economy and diminished human welfare.

Trust comes in two forms in economic life. First is the personal trust forged through a history of interactions, typically between partners, friends, or close business associates. This kind of trust is both positive and negative. It helps those who have built it up but can hurt those who find themselves excluded from the group and even discriminated against. While it benefits early economic development, personal trust may hinder development as an economy becomes more complex and requires communication and exchange among remote individuals and groups.

For modern economies, therefore, the second type of trust—generalized trust—is essential. This is the trust that people have in a random member of a group or society, somebody they don’t know and don’t necessarily expect to run into again. It allows markets to develop, trade to prosper, civilization to advance. And it is what is so desperately lacking in southern Italy and in much of the less developed world.

To measure generalized trust, many researchers (including myself) regularly include an odd-looking question in a popular survey, the World Value Survey, conducted in many countries around the world. The question is, “Generally speaking, would you say that most people can be trusted or that you need to be very careful in dealing with them?” In Sweden, 68 percent of people answer that most people can be trusted; in Brazil, only 9 percent do.³ Perhaps Swedes are more trusting than Brazilians because law enforcement in Sweden is more effective than in Brazil. The average Brazilian would then be foolish to trust others as much as a Swede does because the opportunities to cheat profitably in Brazil are greater than in Sweden.

Interestingly, though, a Swede who visits Brazil does not immediately adjust his level of trust, nor does a Brazilian who visits Sweden. In fact, people from countries with high levels of trust tend to extrapolate their high trust to countries with low trust levels, and vice versa.⁴ Immigrants to the United States take several generations to reach the average level of trust prevailing in America.⁵ Thus trust is not simply an outcome of a society in which nonlegal mechanisms get people to behave cooperatively: it is a long-lasting characteristic.

Generalized trust is mostly the product not of observations that people have collected but of preconceptions that they hold. Some of these preconceptions are rooted deeply in the past. When French managers are surveyed about whom they trust, for example, they rate their British counterparts second to last (above only Italians); every other European group rates the British much higher. The British managers reciprocate, trusting French managers less than their counterparts from other countries do. In my research, I have shown that countries with a long history of wars, like England and France, trust each other less, which stands to reason.⁶ Countries with the same religion trust each other more. And it’s even the case that countries whose populations look more alike trust each other more. This latter tendency may be left over from prehistoric times, when early human beings, needing to decide whether a stranger approaching in the savannah was a friend or foe, relied on somatic characteristics.

All of these attitudes influence economic decisions, even those made by sophisticated players. The lower relative levels of trust between France and Great Britain lead them to trade less and invest less in each other. When trust is low, a potential investor will compare the due diligence costs of an investment with the expected benefit. If the costs are large enough, the investor will pass up even highly profitable projects. Sometimes an absence of trust makes good sense, as in the case of too-good-to-be-true Internet offers, whose profitability few people spend time investigating. But lack of trust where it might be warranted may lead to considerable losses.⁷ In 1980, IBM, desperately looking for an operating system for its PCs, invited Gary Kildall, the founder of Digital Research, to a meeting. Fearing that IBM would extract all the surplus from any possible negotiation, Kildall declined to attend the meeting and consequently missed the opportunity that eventually went to Microsoft.

CIVIC CAPITAL

Trust is just one example of what I call civic capital,⁸ the values and beliefs that foster cooperation. One clever study unveiled a different variety of civic capital by examining the behavior of UN diplomats in New York.⁹ Until 2002, when the law was changed, UN diplomats from other countries were exempt from paying parking tickets. The New York City police, though, regularly issued them tickets, which piled up unpaid. The only obstacle to free parking was each diplomat’s civic sense. During a five-year period, the study showed, Italians accumulated fifteen tickets per diplomat, German diplomats one, Swedes zero, and Canadians zero. Fortunately for my national pride, Italy wasn’t the worst offender, though it performed poorly when compared with other developed countries. Brazilian diplomats, meanwhile, accumulated thirty tickets per person. Kuwait, at the bottom of the list, racked up 246!

Why do people with identical incentives behave so differently? This is a flagrant violation of an economic idea—admittedly, an extreme version of it—that all rational individuals respond to incentives in a similar way. Is the Swedish diplomat less rational than the Kuwaiti one? No; she merely incorporates civic values into her decision. Swedish diplomats are willing to sacrifice their own self-interest, at least when the stake is small. I am not claiming that the rules of economics do not hold in Sweden. Quite the contrary: it is precisely because Swedes can be relied upon not to be too opportunistic that markets work better in that country than in Italy, to say nothing of Brazil and Kuwait. Such civic capital is as important a factor of production as physical and human capital. In countries or regions where it is higher, one finds less corruption and greater public safety. Public administration works better, and private companies can grow more efficiently.¹⁰

To increase physical capital, we know, you invest in machinery. To increase human capital, you invest in training. But how do you increase civic capital?

WHERE DOES CIVIC CAPITAL COME FROM?

Research on how civic capital is accumulated is still in its infancy. We know that one kind of civic capital, a general willingness to cooperate with others, is enhanced by particular episodes of successful cooperation. In one study, Colombian welfare mothers were required to participate in meetings where they discussed topics of mutual interest. Two years later, these women as well as a control sample were asked to participate in an experimental game that measured their willingness to cooperate. The mothers who had earlier participated in the meetings exhibited 30 percent more willingness to cooperate.¹¹

Again, history clearly plays a fundamental role. Political scientist Robert Putnam conjectured that the differing attitudes exhibited by northern and southern modern-day Italians had to do with the free city-states that formed in northern Italy after the fall of the Holy Roman Empire. Those city-states did exhibit a high level of cooperation.¹² But can an experience more than five hundred years old really leave traces today? With two Italian colleagues, I tried to find out.¹³ Not all important cities in northern central Italy became free city-states. Both Faenza, a town of 54,000 thirty miles southeast of Bologna, and Senigallia, a town of 44,000 sixty miles south of Faenza, were important medieval towns. But Faenza became a free city, while Senigallia never did. And in all our measures of present-day civic capital, Faenza beat Senigallia. The number of nonprofit organizations per capita was 42 percent higher in Faenza, and participation in public referenda there was 89 percent (versus 86 percent in Senigallia). Faenza had an organ donor organization, while Senigallia did not. And so on.

Other researchers have found a similar persistence in civic capital. The level of trust among different African ethnicities today reflects their ancestors’ chances of being captured and sold as slaves between the fifteenth and early nineteenth centuries. Because selling people to slave traders had a high payoff, indigenous people would sell members of their own ethnic group, close friends, and even relatives. The climate of suspicion that resulted seems to have carried over into mistrust of local leaders and others today.¹⁴

Civic capital is hard to build up but relatively easy to depreciate. As mentioned above, it takes several generations born in the United States for an immigrant Italian family to reach the average level of trust in America (I’m counting on my grandchildren). But a single prominent politician can undermine trust for an entire group. In March 2011, a coauthor and I commissioned a survey of US citizens to analyze the effect that the extravagant personal life of Italian prime minister Silvio Berlusconi had on Americans’ trust of Italians and their willingness to buy Italian products.¹⁵ Half of the subjects, chosen at random, were primed, as psychologists call it, by being reminded that Berlusconi had been indicted for sex with a minor. The other half were not so primed. The survey was then performed, and it turned out that the primed group reported a lower level of trust—a statistically significant one—toward Italians than did the control group. This difference in trust also translated into a lower willingness to buy Italian products. Given a choice between a German car and an identical Italian car that costs $1,000 less, only slightly more than a third of nonprimed Americans chose the Italian option. Among the primed group only 20 percent did so.

AMERICA’S ORIGINAL ADVANTAGE

The level of civic capital in a country can affect views of government—and how government is perceived can in turn influence civic capital. The first time I experienced a hurricane watch in the United States—I was in Boston—I was shocked by how faithfully people took the advice of local authorities to stay at home, tape the windows, and so on. My instinctive reaction when I received any official instruction was to doubt it and possibly do the opposite. If an Italian mayor had told me to tape my windows, I would assume that his brother sold tape. My skepticism was reinforced by my knowledge of what happened to Italians who did follow official instructions. During a fire in one of the major tunnels under the Alps, for instance, the drivers who followed official instructions and went to the public shelter died from lack of oxygen; those who decided to walk out on their own survived.

This fundamental difference in attitudes stems in part from the American and Italian experience of government. Most Americans (especially those who have not felt the sting of racial discrimination) perceive the government as serving the people, however imperfectly. For Italians, government is the expression of the will of the latest dictator or boss. When I was born, Italy had been a democracy for less than twenty years. My mother remembered the Nazi occupation, and her grandmother, who had helped raise her, remembered when Austrians ruled her city, Venice. The effect of all these rulers on civic capital is described beautifully by Martin Scorsese, an Italian American, in his film My Voyage to Italy. He says, “The lesson of survival that has been passed on for centuries and that was carried over to the new world by Italian immigrants is a pretty brutal one: you think twice before you trust anybody outside your own family. Think about it. Your country, your homeland, changes hands again and again over thousands of years. So who can you trust: the government? The police? The Church? No, only your family, your own blood.”

Education also contributes to American civic capital. Italian schools try to inculcate their students with blind obedience and respect for authority. For example, students must stand up when the teacher walks in as a sign of respect, and they are punished for asking provocative questions. While I was fortunate enough to attend a gentle Montessori elementary school, some of my friends actually had to endure corporal punishment in their classes. In the United States, by contrast, I have watched my children be treated by their schools as citizens in the making, not dumb subjects. Asking tough questions is rewarded, not punished. Children learn that it is their duty to stand up and speak out against unjust acts—even those committed by the teachers, who, like all human beings, are not perfect. A recent paper documents the way teaching practices differ across countries: students work in groups more often in Nordic countries and the United States, while in eastern Europe and the Mediterranean, teachers spend more time lecturing and students copying from the board.¹⁶ The paper also finds that various measures of civic capital are higher in countries where there is more group work and lower where teachers lecture more.

Like trust, a tendency to be engaged and critical is a component of civic capital. An engaged citizenry will complain a lot. Though such complaints have costs—from the time and effort spent to file the written complaint to the risk of retaliation that the complainant faces from his superior—they also make authority accountable and provide essential critical feedback. This can increase the support for, and the functioning of, markets. Even the most visionary business leaders can make mistakes and find it difficult to identify them if they receive only positive feedback. Criticism is extremely useful to society in general, which is why Americans try to teach it as a value in school. We condemn those who are afraid to speak out, and we celebrate people like Rosa Parks who have shown the courage to stand up against injustice.

MORALS AND MORTGAGES

A good example of the way civic capital affects the economy is strategic mortgage default: the decision to walk away from a mortgage because it exceeds the value of the house, even when the mortgagee has the ability to pay. If too many underwater homeowners—the nation is filled with them in the wake of the financial crisis—decide to abandon their mortgage commitments, the results could be catastrophic. The more people walk away, the more houses get auctioned off, further depressing real-estate prices. This additional decline would push more homeowners into negative territory, leading to still more defaults. Thus, society has a strong incentive to prevent strategic default from getting out of hand.

The law, however, doesn’t provide much incentive for people to stay put. It’s true that thirty-nine states permit a lender to come after a borrower’s other assets and income if he defaults. And it’s also true that even in the eleven states that don’t allow that, the restriction applies only to original home loans used to purchase property, not to home-equity lines of credit, while there is some legal uncertainty regarding mortgages issued to refinance existing mortgages. Nevertheless, lenders rarely slap borrowers with a deficiency judgment—a court injunction to pay the difference between the face value of a mortgage and the proceeds that the lender earns by repossessing and selling the house. The procedure is costly and generally not worth the expense because of the limited assets that most Americans own aside from their homes.

The tax code likewise doesn’t impede people from defaulting strategically. Until recently, it’s true, people had to pay taxes on any forgone debt. If you walked away from a house worth, say, $100,000 less than you owed the bank for it, that $100,000 was essentially income, and you had to pay income tax on it. However, in December 2007, Congress made mortgage debt cancellation nontaxable for personal residences. Congress’s aim was to facilitate the renegotiation of underwater mortgages, but the move had an unintended consequence: reducing the cost of walking away.

What does prevent people from strategic default, it seems, is their sense of what’s right. More than 80 percent of Americans think that it’s immoral to default on a mortgage if you can afford to pay it, according to a recent paper by Luigi Guiso, Paola Sapienza, and myself, and these people are 77 percent less likely to declare their intention to default strategically than people who don’t find the act immoral.¹⁷ Perceived social norms also seem to affect the propensity to walk away: knowing somebody who defaulted strategically, or living in an area where many people have done so, makes a person much more likely to declare his willingness to follow suit.

Seeking to undermine the social norm to repay mortgages, as some economists and journalists have done by saying that it is the rational course of action for underwater homeowners to default strategically, is thus a very bad idea. You might just as well say that when a theater is going up in flames, it’s rational to trample other people in rushing to the exits.

ETHICS AND ECONOMICS

Most economists recoil at the word ethics. Like all the social sciences, economics became a “legitimate” discipline when it distinguished itself from moral philosophy. Adam Smith, a moral philosopher, started the field when he decided to analyze the production, distribution, and consumption of goods and services apart from moral considerations. Economic analysis of the behavior of economic agents should start not from moral considerations (how people should behave) but from objective ones (how they do behave), just as the analysis of atoms starts not from the way they should behave but from the way they do behave. Consequently, economists are hypersensitive about letting moral considerations back into their discipline.

However, this position is hypocritical. First, physicists don’t teach atoms how to behave. If they did (and if atoms had free will), the physicists would be concerned about how the atoms being instructed could change their behavior and affect the universe. Economists should have that concern for the people they teach. Experimental evidence suggests that people who choose to study economics not only are more selfish to begin with, but become more selfish and less concerned about the common good by studying economics.¹⁸ So economics does seem to teach people how to behave, even inadvertently.

Second, economists routinely engage in normative analysis—how things ought to work. Indeed, an entire branch of economics, law and economics, rationalizes laws on the basis of economic principles. Why are economists happy to say what the optimal laws are from an economic standpoint but afraid to say what the optimal social norms are for a successful economy?

Last but not least, economists who reject morals are hypocritical because the distinction between positive (“scientific”) and normative analysis is sometimes so tenuous that it gets lost on most students. My colleague Gary Becker pioneered the economic study of crime, one of the contributions that earned him the Nobel Prize in economics.¹⁹ In determining the resources that society should allocate to fighting different types of crimes, Becker employed a basic utilitarian approach in which people compare the benefits of a crime with the expected cost of punishment (that is, the cost of punishment times the probability of receiving that punishment). Becker’s model had no intention of telling people how they should behave. But a former student of Becker’s once admitted to me that many of his classmates were remarkably amoral. He attributed this to the fact that they took Becker’s descriptive model of crime as prescriptive. They perceived any failure to commit a high-benefit crime with a low expected cost as a failure to act rationally—almost a proof of stupidity. The student’s experience bears out the experimental findings that I mentioned above.

The idea that people act in their own self-interest is a useful methodological assumption, of course, and it has brought tremendous insights. But it must be placed in context. It may be useful to know that most market mechanisms operate when everyone acts in narrow self-interest, but that doesn’t mean that markets always prosper when people act in narrow self-interest. Above all, the fact that Smith taught that economic systems can work effectively when people pursue their own interests is not the same thing as saying that they should pursue their own interests. Greed isn’t good. Smith would have been the first to oppose anybody who said that it was.

It is also not empirically true that all individuals always operate in narrow self-interest. The real question is whether there are sustainable social norms that can nudge people to act in a way that benefits society when narrow self-interest fails to deliver a desirable outcome. If so, what are those norms? And who has an interest in codifying and teaching them?

HOW TO DETERMINE SOCIAL NORMS

I am not a moral philosopher, and consequently I have no particular competence to determine what is ethical and what is not ethical. As an economist, though, I am able to identify behaviors that are welfare-enhancing and those that are not. For instance, I can contrast the Chicago Booth students’ arbitrage, which generated no gain for the school or the student community, with financial arbitrage, which provides useful social functions. Most traders do not have to worry whether prices are aligned because arbitrageurs do the job for them. This alignment ensures that corporations can finance themselves at the lowest possible cost, with greater benefit to society. Speculators may earn a greater return than the benefit they generate to society warrants (hence their lousy reputation), but at least their work isn’t completely at odds with the greater good. While self-interest motivates both types of arbitrage, only the latter demonstrates Adam Smith’s “invisible hand,” the self-interest of the agent leading to a benefit to society.

One way of putting the difference between these two situations is that in financial arbitrage, individual incentives are aligned to societal incentives; in the students’ arbitrage, they were not. When a theater catches fire, the individual incentive is to rush to the exit as fast as possible. Yet if everyone in the audience rushed at once, the crowd near the door would allow fewer people to escape—indeed, many could die. Not surprisingly, there are social norms against this behavior. People who violate those norms are judged rude, egotistical, ill-behaved, or in certain cases even negligent. The individual and social incentives aren’t aligned.

Economists have a way of determining whether a policy intervention is economically efficient: it must increase the utility of at least one person while not decreasing the utility of anyone else (economists call this Pareto optimality, after the Italian economist Vilfredo Pareto). If we applied this criterion to social norms, we would consider a norm economically justified if, followed by all, it made no one worse off and at least some better off. A social norm against financial speculation, for example, fails to satisfy this criterion, since it would leave speculators worse off. By contrast, a norm against rushing to the exits in a burning theater would be justified, since if everybody followed it, everybody would be able to exit safely.

Economically based social norms allow small communities to solve the free-rider problem mentioned earlier. Think, for example, about donations to build a gym in your kids’ school. The typical economic argument is that the probability is minimal that your small donation will make any difference about whether the gym gets built or not. Knowing this, you are better off not contributing, since if the gym does get built, your kids will get to enjoy it regardless. If everybody reasons this way, of course, the gym will never be built.

But this argument ignores the fact that your donation may create social pressure for others to donate. This increases your individual payoff from donating. If the effect is strong enough and the community is small enough (so that inducing a few other people to donate increases the proportion of people who contribute), then donating is in your personal interest. Particularly if the cost per person of building the gym is less than the benefit each one would receive from it, this social pressure—that people should donate an amount similar to what their acquaintances donate, if they can afford to—fits the economic criterion for a good social norm, since nobody is made worse off and many are made better off.

Some economically useful norms are shared by most religions. My research has found that on average religious people exhibit attitudes that are conducive to better market functioning.²⁰ Yet this is not true of all moral and social norms. In many African countries, for instance, people who become rich are expected to support all their relatives. By acting as a high marginal tax rate on entrepreneurship, this practice is harmful, from an economic point of view.

Thus there is no perfect coincidence between social norms and economically useful norms. Nevertheless, sensible social norms can be useful in getting individuals to internalize the likely consequences of their actions. While most economists advocate taxation and regulation to deal with these consequences, I prefer (when feasible) to rely on norms, which draw their power from social consensus rather than from the political process. The problem lies in identifying who has an interest in creating this social consensus.

THE ROLE OF BUSINESS SCHOOLS

Most successful firms tend to develop a corporate culture that centers on key values that are shared by the employees and enforced throughout the organization. Integrity, for example, is a value identified by 70 percent of the companies belonging to the Standard and Poor’s 500 Index.²¹

In part, these values are meant to make companies look good, but there is more to them than that. Employees often face trade-offs between the company’s interests and their own. Should I push for higher sales at the end of the quarter to make my yearly bonus, even if this reduces the quality of the product? Should I overlook the declining value of the company’s assets, so that the reported profits are not affected, leading to a higher bonus? Should I discount my product so that I can temporarily boost sales and sustain the perception of high growth that supports my stock price (and thus my stock options)? While incentives can be designed to minimize these problems, they can hardly eliminate them; the problems are inevitable, short of a complete identification between the individual goals and the corporate goals. So companies create values that draw the line beyond which trade-offs aren’t acceptable. When a company touts excellence as a value, for instance, it communicates to its employees that no compromises will be allowed in the pursuit of excellence. The same could apply for integrity and other values.

The role of these values is twofold. First, they establish a rule of behavior for employees who might not know how to operate in certain situations. Second, they make it easier to screen out employees whose own values are most at odds with the company’s. It is much easier for a firm to enforce a zero-tolerance policy than a more nuanced one. Thus the corporate world does recognize the benefits of internal norms.

When it comes to market-wide norms, however, no company is big enough to reap the benefits of creating a better market system. Why should any company care about making norms that enhance the functioning of the whole market? Companies, as we saw earlier, prefer to consolidate their market power. So who does have an interest in creating market-wide norms?

Business schools. They have the greatest interest in the long-term survival of capitalism, especially the superior American version of capitalism. They are—or should be—the churches of the meritocratic creed. So they should lead the effort to impose some minimal norms for business—norms that discourage behavior that is purely opportunistic even if highly profitable. For this reason, we should have frowned on the Booth students who exploited the loophole in the bidding system. We should likewise frown on behavior that we recognize as detrimental to the long-term survival of the free-market system.

Asking business schools to stigmatize all behavior that does not maximize welfare would be absurd. They shouldn’t be expected to shame or criticize a company for using the market power that it has legitimately acquired through innovative patents. They also shouldn’t be expected to denounce a company for taking advantage of the tax loopholes present in the system. I regularly teach my students how to exploit the tax benefits associated with corporate borrowing, and I don’t consider it unethical. The preferential tax treatment of debt is—at least in principle—designed to stimulate companies to borrow more, just as the deductibility of mortgage interest is designed to subsidize people who borrow to buy a house. While I do not consider it a good law, I do not feel bad about advocating its use as long as it is on the books.

There is a difference, however, between taking advantage of existing tax loopholes and lobbying aggressively to have those tax loopholes created or expanded. What about marketing policies targeted to prey on addiction or to induce young customers to smoke? Is making money the only metric we should reward and admire in business leaders?

Business schools have a powerful enforcement mechanism: the way they treat their alumni. The schools celebrate their most prestigious alumni, for instance, and they reward the others by providing access to a valuable network of connections. In awarding prizes to outstanding alumni who adhere to economically useful norms, and by expelling from the network those who do not, they could send a powerful message. But they generally choose not to do so. In fact, they often seem to tolerate, if not foster, business behavior that is immoral and sometimes even illegal.

Consider the insider trading case involving the Galleon hedge fund. Raj Rajaratnam was convicted and sentenced to eleven years in prison; McKinsey director Anil Kumar pleaded guilty, and Rajiv Goel, a managing director of Intel, pleaded guilty too. They had all been classmates in the same business school earlier in their lives. Was this just a coincidence? Unfortunately, academic research seems to suggest that university friends, such as Kumar, Goel, and Rajaratnam, may well share confidential information.²² The research shows that portfolio managers place larger bets on firms with directors who are their college friends and acquaintances, earning an 8 percent higher annual return on these investments. A benign interpretation of these results is that college friends know each other well; thus a portfolio manager would have an advantage in judging the quality of a CEO he went to school with. But this benign interpretation is difficult to reconcile with the finding that the positive returns are concentrated around corporate news announcements. Why would your intimate knowledge of the CEO’s personal qualities help you earn a better return . . . right around the time of a corporate news announcement? Isn’t it more likely that some information has leaked your way? Business schools should do more to eradicate such behavior.

While insider trading is illegal and should be punished by the law, behaviors that are legal but not socially desirable could be effectively stamped out with a shaming from the business community, including the business school alumni network. Money should not be the only criterion of success by which alumni are recognized. A business school would never honor a businessman who made his fortune selling pornographic movies. Why should it honor somebody who has become wealthy preying on people’s addictions or marketing a financial instrument designed to dupe unsophisticated investors? In fact, business schools should actively shame this kind of behavior by criticizing it publicly.

Most business schools do offer ethics classes. Yet these classes are generally divided into two categories. Some classes simply illustrate ethical dilemmas without taking a position on what people are expected or not expected to do. It is as if students were presented with the pros and cons of racial segregation, leaving them to decide which side they wanted to take. Other classes hide behind corporate social responsibility, saying that social obligations rest on firms, not individuals. I say “hide” because a firm is nothing but an organized group of individuals. As the 2010 Supreme Court decision Citizens United v. Federal Election Commission affirms, we should not impose burdens on corporations that we do not want to impose on individuals. So before we talk about corporate social responsibility, we need to talk about individual social responsibility. If we do not recognize the latter, we cannot talk about the former. Business schools should stand up for what they think is the individual responsibility of a good capitalist.

CONCLUSIONS

The question posed at the beginning of this chapter—Should we, as teachers, condemn, condone, or praise their behavior?—led us to a consideration of social norms. Not cutting in line is a useful social norm that elementary school teachers happily teach our children. Similarly, there are several types of norms relevant to the flourishing of a market economy that we can and should teach. One of them, a limit on lobbying, is the topic of the next chapter.