Monday, September 04, 2006

People Fail, Not Markets

When people try to fit Adam Smith into a modern mould they often attribute things to him of which he had no knowledge or misattribute things to him of which he never said. What they write, be clear, makes sense to a modern trained economist, but whether it meant anything to Smith is another matter. But by quoting his name they give their article an authority, which on its own it may not deserve.

Take the following from Cielito Habito, writing in Inq7money (Philippines) (read it at: http://www.inq7.net/index_network.htm).

He writes:“No Free Lunch: no business being in business” by Cielito Habito:

Adam Smith, considered the father of modern economics, had argued in the eighteenth century that left to themselves (laizzez[!] faire), markets would be guided by an "invisible hand" that ensures the most efficient outcomes.When markets failBut perhaps what Adam Smith did not explain enough was that markets are far from perfect. They often fail to yield efficient outcomes, and more often, fail to yield outcomes that are equitable or fair. Economic textbooks give at least three reasons why markets fail: public goods, externalities and economies of scale.Some goods and services are public goods that, in the words of economists, are non-rival and non-excludable. When you buy a nice dress for yourself, you keep everyone else from using it; it is a rival good. But when you benefit from the security of having a national defense system in place, others can benefit from it as much as you do (non-rival), and neither can anyone prevent everyone else from enjoying that benefit as well (non-excludable). In such cases, people will want to "free-ride" and avoid paying for these services, or at least pay less than what it really means to them. Thus, it won't work for a private firm to produce and sell such public goods. Government must step in and provide them directly.”

Comment

The first sentence is as wrong as it could be. Smith never argued anywhere in Wealth of Nations, or in Moral Sentiments, that “markets would be guided by an "invisible hand" that ensures the most efficient outcomes”. His single use of the metaphor of ‘an invisible hand’ in Wealth of Nations (p 456) had nothing to do with markets, how they worked, or how, in this context, they might fail to work. That is a myth from Chicago trained neo-classical economists, who created an imaginary ‘theory of markets, guided by invisible hands’ that had absolutely nothing to do with the Adam Smith from Kirkcaldy in Scotland.

Why Cielito Habito considers Smith to have been lax in not explaining “enough that markets [were] far from perfect”, I cannot fathom at all. All of Wealth of Nations and much of his Lectures in Jurisprudence (1762-3) are about the failures of markets leading up to the 18th century.

Wealth of Nations is about how wealth is created, despite all the legislative interference in commercial society, guided, not by ‘invisible hands’, but by the very visible nonsensical policies (he calls them ‘ridiculous’) introduced by false theories, wrong notions and ‘absurd’ doctrines, and how, nevertheless, commercial markets, the division of labour, and the propensity to ‘truck, barter, and exchange, gradually, and slowly (certainly slower than necessary), managed to raise the real wealth of a country over the centuries.

He paints the picture clearly; at the time of Caesar’s ‘invasion’ of Britain (more a visit), its inhabitants were nearly at the same living standard as the ‘savages’ of North America and had been ‘improving’ ever since; by the 18th century, the poorest common labourer was incomparably better off materially than the same North American hunters (WN II.iii.33-4: p 344).

He noted how the national wealth of England had grown from the Restoration of Charles II to his ‘present day’, despite the ‘profusion of wars’, the wasted expenditure on ‘unproductive labour’, and the fire and plagues in London, which together and in succession reduced national wealth (defined as the annual output of goods for consumption and investment), though, except in short periods, still could not stop the economy growing, though slowly.It was not the natural economy that failed; it were the events (man made) that afflicted it, as mentioned above.

I have no doubt that ‘Economic textbooks give at least three reasons why markets fail: public goods, externalities and economies of scale’ (I have a large collection of them from the 19th, 20th and 21st centuries), and I agree that the three causes identified (‘public goods, externalities and economies of scale’) feature strongly in the textbooks. But these are modern textbooks about economies stripped of everything that Smith wrote about, economies that exist in the minds of economists but not necessarily reflective of real world economies ran by real people. Modern textbooks are noticeable by the absence of people (and, as Smith put it, appear to be run by ‘wooden chess pieces’ moved about the board by the agency of men of ‘system’).

Smith went to the heart of the matter. Not only were there events that caused sub-optimal performance, but the very instruments of commercial society, the ‘merchants and the manufacturers’ that people his book, driven by their self-interest, often acted in ways contrary to the Chicago image, or Shakespeare’s metaphor, of a benign ‘invisible hand’. They could act malignly against the public interest in their proclivity for monopoly practices, restrictions on competition, conspiracies to riase prices and mean behaviours. Smith was very well aware of the imperfections of how actual markets worked. He explained these imperfections more than ‘enough’ for those who actually read Wealth of Nations and not just a few third- or fifth-hand quotations from it.

He explained it so clearly he must have considered he could not be clearer, especially to those trained to think of the economy as a set of equations in perfect equilibrium, absent people and the inconveniences of their multi-motive behaviours. His assumption that his readers had been educated to think (and look outside their windows!) was, perhaps, in retrospect, unwarranted.

He did not anticipate that successive generations of economists a hundred years later would be seduced into abstraction to a degree unmatched even by his own age’s obsession with 'logic', and that they would adapt ‘an artificial method of reasoning’ (mathematics), which would come to occupy ‘the universal attention of the learned’.Modern economists assume away general market failures, caused by people inside the system, to concentrate on the three textbook market failures identified above. They also say little about how state failures (caused by people inside the state system) can be ‘corrected’. I suggest there is a rich Smithian research agenda here of great relevance to modern economies (and it might help to make neo-classical abstractions more relevant for policy purposes).

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