Thursday, November 01, 2007

Myth of the Invisisble Hand, no 368

Ralph Thurm writes a Blog, ‘Sustainability Reporting Central’ and carries a post: ‘Recalibrating the Invisible Hand’, 1 November, (here) which manages to be half-right on some things, correct on a few others, and woefully wrong on his main theme.

The critics of the concept of sustainable development and CSR always argue with Milton Friedman’s famous quote that “the business of business is business” and also refer to Adam Smith’s theory of the “invisible hand of the market”… ..Even worse, these two famous quotes seem to permit amoral behaviour if there are no laws against a certain ways to pursue self-interest."

The statement attributed to Milton Friedman may be accurate but the statement attributed to Adam Smith (which Ralph Thurm mistakenly calls a ‘quotation’) most certainly isn’t anything that Adam Smith wrote. He never linked the invisible hand to the market, which he comprehensively analysed in Books I and II of Wealth Of Nations without mentioning anything about ‘invisible hands’.

His used a metaphor, which was not a ‘theory’, nor a ‘concept’, nor a ‘paradigm’, and was strictly in relation to statements he made about the effect of risk aversion risk among merchants faced with a choice of investing locally or among foreigners. It appears (once only!) in Book IV of Wealth Of Nations, chapter ii, paragraph 9, on page 456. For his so-called theory it is remarkably absent from his major book. That’s because he didn’t have an invisible hand theory of markets.

The elision of Adam Smith’s metaphor in a theory of markets was a creation of modern neo-classical economists, centred on Chicago University, who found in the use of the metaphor some kind of justification of their mathematical theories of general equilibrium.

Decades of teaching graduates their false association of one of Smith’s metaphors, which itself was a common literary metaphor in the 17th and 18th centuries, though its antecedents go back to classical times in Greek and Latin literature, and the subsequent teaching of its graduates across US campuses for sixty years, has resulted in almost universal belief that Adam Smith had an invisible hand theory of markets.

The fact is that he didn’t have such a belief. So why is the belief so entrenched? Because almost al graduates of economics do not read, nor are they required to read, Wealth Of Nations at any time. They may read the odd quotation but as there are none linking Adam Smith’s single use of the metaphor in Wealth Of Nations to his theory of markets, we find the final insult to scholarly standards in the running together of sentences from page 27 in Book I to the metaphor in a sentence from page 456 Book IV ( a gap of 429 pages!) and claiming that this is Adam Smith’s theory of the invisible hand!

And this is not just passable economists who scraped through their courses; this applies, sadly, to those at the very top of the economics’ profession, including several who have won Nobel Prizes.

Hence, not surprisingly, Ralph Thurm, is misled as well and he uses the invisible hand myth as the core of his post.

But wait a minute! When Adam Smith published “An inquiry into the nature and cause of the wealth of nations” in 1776, partnerships were the dominant form of enterprise in which ownership and management meant the same thing. Adam Smith was against the idea of corporations, or "joint stock companies."

Most "lobbyists of the invisible hand of the market are not aware that Adam Smith did also publish “The theory of moral sentiments” in 1759, where he explains that the self-interest of the market players (buy and sell side) needs to be pursued by people of conscience and with a clear moral capacity; he argues that sympathy is required to achieve socially beneficial results. The self-interest he speaks of is not a narrow selfishness that allows whatever market transaction, but something that involves sympathy. He regards pure selfishness as inappropriate, if not immoral, and that the self-interested actor has sympathy for others. He continues that the self-interest of any actor includes the interest of the rest of society, since the socially-defined notions of appropriate and inappropriate actions necessarily affect the interests of the individual as a member of society. This context is useful to understand why Adam Smith was against the idea of corporations or joint stock companies, where he already envisaged the problems of a disconnect between ownership and management.”

By partnerships I assume Ralph means the 17th-18th-century institution known as ‘co-partneries’, which I discussed last week with Mark Hodak, and the appearance of Regulated Companies and Joint-Stock companies, discussed in detail in Book V of Wealth Of Nations (see last week’s posts).

Adam Smith was not ‘against the idea of corporations, or "joint stock companies’; he was against those chartered corporations and joint stock companies that were formed by Act of Parliament or by Royal warrant as ‘exclusive' monopoly entities.

I shall not repeat the evidence from Wealth Of Nations that Adam Smith did not oppose all joint stock companies (he recommends such arrangements for such as banks, insurance, viaducts, and canals, provided they were not awarded monopolies).

His main complaint about the chartered trading companies were their monopoly status, their lack of supervision (18 month’s round trips of messages from London and back via India) and their integral part in the mercantile political economy of the day which he criticised severely in Book 4 of Wealth Of Nations.

These comments have little to with Raph’s promotion of CSR and therefore he should make his case for or against CSR without reference to Adam Smith.


Blogger Paul Walker said...

Gavin you write "The elision of Adam Smith’s metaphor in a theory of markets was a creation of modern neo-classical economists, centred on Chicago University, who found in the use of the metaphor some kind of justification of their mathematical theories of general equilibrium." But I would not think of Chicago as the centre of "mathematical theories of general equilibrium". I would have seen Chicago as having more of an emphasis on basic price theory in its partial equilibrium form. General equilibrium followed from Walras's work and found its modern form in the works of McKenize, Arrow and Debreu etc. This is not, to my way of thinking, the Chicago tradition. Overtveldt (2007: 93-4) makes the point that "At the end of World War 11, the Cowles Commission for Research in Economics was installed at the University of Chicago. The fact that leading members of this Commission-such as Jacob Marschak, Trygve Haavelmo, Lawrence Klein, and Tjalling Koopmans-were heavily involved in the development of Walrasian general equilibrium economics and building sophisticated econometric models was a constant source of friction between them and the group around Friedman at the University of Chicago's department of economics." The Commission left and Friedman stayed.

7:46 pm  
Blogger Gavin Kennedy said...

Thank you Paul Walker, for correcting my sloppy compression of a far more complex story of the adoption by modern economists of Adam Smith’s metaphor of ‘an invisible hand’ into theories of partial and general equilibrium, and the working of markets than I summed up by locating its source uniquely among Chicago economists.

The various trends within the Chicago economics department (from the 20s) also represent a spectrum rather than a central orthodoxy.

My presentation of the idea I have in mind ignored not only the varying trends but also did not acknowledge that these trends were not necessarily co-existent, nor all located in Chicago.

I also missed the flowering of the mathematical school from the 1940s (Samuelson). Covering about 80 years, the story is far richer than I acknowledged in my brutal compression.

Making the charge, as I do regularly, ‘Chicago’ has become a useful tag to place on what has become a widespread set of beliefs, and this has led to the sloppiness that you correctly bring to account. I shall be more careful in future.

By melding the two approaches, I lump them together because both Friedman, Stigler, et al, (partial equilibrium price theory) and Debreu, Arrow, et al, (general equilibrium theory), broadly, the neoclassical synthesis, use the invisible hand metaphor (unnecessarily – it does not appear in any of their equations) to somehow sanctify the ‘miracle’ of market, when their versions of markets are explained competently without it. There are no miracles in our understanding of how markets work.

Similarly, Adam Smith’s explanations of risk aversion and its consequences in Wealth Of Nations (Book IV,ii,9. p 456) were explained before he used the metaphor, which was not about or in relation to markets.

Thank you for the reference; it reminds me to order J. Van Overtveldt, “The Chicago School: How the University of Chicago Assembled the Thinkers Who Revolutionized Economics and Business”.

10:27 am  

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