Wednesday, February 04, 2009

A Classic Example of the Misuse of a Metaphor

John McCarthy writes in Florida Today HERE:

Gas-price rise 'illogical'
AAA spokesman can't equate it with the fall in demand and crude oil cost

One supposedly inviolable law of classical economics is that when the supply of a resource is greater than demand for it, the price of that resource will fall. The "invisible hand" of the marketplace should see to that, the father of economics, Adam Smith, said.

I know of no ‘inviolable law of classical economics' that ever mentions ‘an invisible hand’ and I am sure that John McCarthy or anybody else does not know of one either.

I do know of countless statements since the 1950s that says there is a ‘theory’, ‘concept’, even ‘paradigm’, and now a ‘law’ that Adam Smith believed that market places were managed by ‘an invisible hand’, but that is not the same as Adam Smith actually having done so.

In fact, he didn’t; he mentions the 18th-century literary metaphor on ‘an invisible hand’ only once in Wealth Of Nations, but not in reference to his theory of markets, which he analyses and elaborates in Books I and II of his classic work.

His sole reference to ‘an invisible hand’ occurs in Book IV in his brilliant critique of mercantile political economy – the very same economic system practised by Georgian Britain, which caused the American rebellion in 1776-83, and produced eventually the United States of America.

And for the record, Smith didn’t mention the metaphor in the other two books of Wealth of Nations (Books III and V).

His reference to ‘an invisible hand’ occurs after he has explained how the risk- avoidance behaviours of some merchants prompts them not to send their scarce capital abroad to the British colonies in North America (dangerous sea passage, unknown trading partners, backed by local colonial laws and practices, and uncertain, though high, profits).

Their risk avoidance prompted these merchants (but by no means all, of course – those prepared to trade in the colonies did well because of the British monopoly of colonial trade, backed by the Royal Navy’s enforcement of the Navigation Acts) to invest their capital domestically, without the risks of sea voyages, where they knew with whom they traded and had knowledge of the reliability of the local courts, and were more certain about their, albeit perhaps lower, profits.

So, risk-avoidance, and the obvious arithmetical law that the whole is the sum of its parts, led to domestic British capital formation to be higher than it would be if more merchants had sent their capital abroad. Additional domestic capital invested locally added to the total of domestic investment, which in turn added to local employment and to national output.

Having said all these over several pages in Book IV, Adam Smith added the metaphor that these merchants – but clearly not the others! – were ‘led by an invisible hand’ to add to domestic investment and output, though they only intended ‘their own security’.

Look it up in Wealth Of Nations (WN IV.ii.9: p 456). That is all Adam Smith meant by the invisible hand- a summary explanation of what he had explained in straight economic terms, but never a ‘theory’, and certainly not a ‘law’, except, perhaps, of arithmetic.

Indeed, John McCarthy uses the rest of his article to explain with potential facts what is causing gas prices to remain high – real prospects of a refinery strike by the US Steel workers Union in Florida, causing retail gas companies to stock-pile gas inventories in the event of the strike. The higher the price of gas at the pump at present, the more of their future supplies will remain in their inventories for use during the strike. That will keep gas customers driving for longer during a strike.

Correct analysis from John McCarthy without any need to misuse Adam Smith’s literary metaphor. He could have re-cast his wrong reference to Adam Smith by, perhaps, suggesting that the oil companies are being restrained by an ‘invisible hand’ from reducing their prices in the prospect of the strike-bound near-future situation! (Just joking.)

But that is not how modern economists, and those influenced by them, see how Smith’s use of the famous metaphor was quite different from their 20th-century invented attribution to him.

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