Thursday, October 16, 2008

A Nobel Prize Winner on the Financial Crisis Misquotes Adam Smith

An article by Joseph Stiglitz in the New Statesman is fine until he draws in Adam Smith to make a point:

"This crisis is a turning point, not only in the economy, but in our thinking about economics. Adam Smith, the father of modern economists, argued that the pursuit of self-interest (profit-making by competitive firms) would lead, as if by an invisible hand, to general well-being. But for over a quarter of a century, we have known that Smith's conclusions do not hold when there is imperfect information - and all markets, especially financial markets, are characterised by information imperfections. The reason the invisible hand often seems invisible is that it is not there. The pursuit of self-interest by Enron and WorldCom did not lead to societal well-being; and the pursuit of self-interest by those in the financial industry has brought our economy to the brink of the abyss.

No modern economy can function well without the government playing an important role. Even free marketeers are now turning to the government. But would it not have been better to have taken action to prevent this meltdown? This is a new kind of public-private partnership - the financial sector walked off with the profits, the public was left with the losses. We need a new balance between market and government

Professor Joseph E Stiglitz is chair of the Brooks World Poverty Institute at the University of Manchester and a 2001 Nobel prizewinner

I sent the following comment to New Stateman:

Adam Smith did not say that ‘competitive firms’ pursuing self-interest would be led ‘as if by an invisible hand to general well-being’.

In Book IV – the only place in Wealth Of Nations he mentions the popular 18th-century literary metaphor of ‘an invisible hand’, he was referring to merchants choosing between investing locally or abroad (the American colonies) and, because most (not all) of them were risk-averse to the dangers and uncertainties of foreign trade and foreign investment, they naturally preferred the relative security of their home market and, by the arithmetical law of the whole being the sum of its parts, thereby domestic investment would he higher and more local people would be employed. (WN IV.ii.9: page 456).

The ‘invisible hand’ metaphor had nothing to do with markets, the behaviour of firms, supply and demand, nor price theory which are all covered in Books I and II with no mention of invisible hands. Nor, incidentally, was the invisible hand metaphor prefaced with ‘as if’; that’s another myth!

Hence, ‘the reason the invisible hand often seems invisible is’ because its alleged association with Adam Smith on markets and firms’ behaviours is wholly fictitious.

The myth was created by mid-20th century neoclassical economists, including Nobel Prize Winners, and gives a misleading aura of a mystical force at work, though markets were thoroughly analysed by Adam Smith without mentioning invisible hands.

However, Adam Smith gives over 50 instances in Books I and II of Wealth Of Nations (Book III and IV are replete with such instances) of self-interested individuals acting against the interests of society generally; this is ignored (most economists do not read Wealth Of Nations) in favour of associating Adam Smith with ideas he never had to purvey ideas that should stand on their own and be judged as such.


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