Friday, April 18, 2008

Adam Smith's Use of the Invisible Hand Metaphor is about Risk Avoidance Not a Theory of Finance

Jame DiBiasio writes (18 April) in the Asian Investor (Hong Kong: sorry no url given) on

Leverage through technology to blame for credit mess”:

[Some extracts]:

And like any market externality – something that harms society while benefiting only a few – it requires regulation, argues think-tank exec Woody Brock.

To explain this, Brock goes back through a bit of financial academic theory. In 1950, there was no theory of finance or way to explain the existence of securities markets, beyond Adam Smith’s “invisible hand”. This changed with John Von Neumann, a Hungarian-born American polymath whose work confirmed Smith’s insight that the price mechanism allows for the efficient allocation of capital – while adding his observation that such allocation takes place in an environment of uncertainty.

This uncertainty principle led to the realisation that capitalism works only if participants can hedge against uncertainty. From there he explained that markets exist to optimise the reallocation of risk, and that risk was just another commodity, like wheat or pork bellies.

From this promising theoretical start, however, came what Brock calls a “disaster”: the advent of the Chicago School of thought, a statistics-heavy philosophy of monetarism and rational expectations. Proponents assumed everyone knows the correct probability of default rates, or the outcome of unknowns, based on crunching historical data; the implication was that hedges are correct and therefore markets can’t suffer meltdowns.

Adam Smith wrote that capital is efficiently allocated when the government does not interfere – except when it leads to market externalities. The textbook example of an externality is pollution: a company left to its own devices will pour waste into a river to save costs, but this hurts society at large, mainly people who had nothing to do with the company and never entered into a voluntary contract with it.”

Wonderful thing having an economic theory, especially if you can link it somehow to Adam Smith by taking advantage of popular myths about him which, admittedly, are linked to the most prestigious modern names in the profession.

No, I am not saying that Jame DiBiasio is engaged in any form of skulduggery; his theory about the causes of the current financial problems may well be true and have some merit.

What I am saying is that the references to Adam Smith from his quotong from Woody Brock, a ‘think-tank exec’ in the article are wrong and untrue. There was still some hope that Brock was in the clear with the comment: ‘there was no theory of finance’ in the 1950s ‘beyond Adam Smith’s “invisible hand” but this evaporates with the statement that John von Neumann ‘confirmed Smith’s insight that the price mechanism allows for the efficient allocation of capital’.

Here, the loose thread begins to unravel. Adam Smith’s comprehensive theory of the ‘price mechanism’ is indeed very clear. It’s in Books I and II of Wealth Of Nations, which I encourage you to read – you will find no mention whatsoever in them of ‘an invisible hand’.

The habit of joining Adam Smith on prices seamlessly with his use of the metaphor of ‘an invisible hand’ borders on misleading, which only continues because the perpetrators of this literary sleight-of-hand are safe in the fact that almost all of their readers have not read, and are unlikely to read, Wealth Of Nations (and not only their readers; almost all senior authorities in the profession have not read Wealth Of Nations either).

As I have explained many times on Lost Legacy (and will continue to do so). Adam Smith uses the metaphor of the invisible hand in Book IV of Wealth Of Nations at the end of a discussion in Chapter ii (pp 452-72) of the problems of individuals choosing between exporting their capital to earn profits from investing in colonies and importing goods for consumption in Britain, and choosing to invest locally in Britain to produce goods for sale in Britain. Now that’s a simple enough exercise in economics.

Adam Smith points out that individuals consider the relative risks of their choices. Sending their capital to the colonies removes it from their immediate supervision, there are risks in shipping both ways across the ocean, risks in security of their possessions in places where a different legal regime operates, in the hands of people whom they do not know well, and in the long delays between their capital being applied and the goods it transports back home and being returned, plus a profit, from its sale.

From this, Adam Smith concludes that the risk averse merchant would prefer to invest it at home, where transport is local, where the law is familiar to him, where the people he deals with are known to him, and where his capital will turnover in shorter intervals. These advantages become decisive where the profits expected from home production and sale are the ‘same, or not very much less than the same’ from higher risk and higher profit ventures abroad.

In consequence, of this conclusion, Adam Smith concludes, that by investing locally, individuals who do so (for the reasons outlined above) will seek to deploy their capitals in the most advantageous (profitable) ways and thereby, all individuals who do so, in aggregate, will increase local output (wealth) and local profits by a greater amount than if they behaved differently and invested their capital abroad, thus increasing national output (wealth) more than otherwise.

His metaphor for this process was their being guided by ‘an invisible hand’ (his only reference in Wealth Of Nations to the metaphor, p 456). This was not a statement that there was an invisible hand (it’s a metaphor), but a summary of the effects of risk avoidance among individuals.

It is also an obvious truism by the laws of arithmetic: if the parts invested locally are greater than they would be in the absence of risk avoidance, then the total that is invested locally will be greater as the sum of the parts. This raises local wealth (the annual output of the ‘necessaries, conveniences, and amusements of life’) greater than it otherwise would be.

What this has to do with modern capital markets is interesting, but it has little to do with Adam Smith’s critique of mercantile political economy (the target on Book IV), which favoured exporting more than is imported (to accumulate gold), favoured monopoly markets domestically (tariff protection, prohibitions), favoured colonial monopolies (the Navigation Acts, monopoly of trade), and resisted competition with neighbouring potential trading partners (‘jealousy of trade’ policies) and wars for trivial ends (projection of power).


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