Thursday, March 26, 2009

Thought for the Day 2

Security, therefore, is the first and the principal object of prudence. It is averse to expose our health, our fortune, our rank, or reputation, to any sort of hazard. It is rather cautious than enterprising, and more anxious to preserve the advantages which we already possess, than forward to prompt us to the acquisition of still greater advantages. The methods of improving our fortune, which it principally recommends to us, are those which expose to no loss or hazard; real knowledge and skill in our trade or profession, assiduity and industry in the exercise of it, frugality, and even some degree of parsimony, in all our expences.'
(TMS VI.i.6: 213)

I have made many references to the use by Adam Smith of the metaphor of ‘an invisible hand’ in Wealth Of Nations (1776) and I thought it relevant to quote the above passage from Smith’s Moral Sentiments [1759, ed 6. 1790].

He discusses security and specifically mentions how security is ‘averse’ to exposing ourselves and ‘our health, our fortune, our rank, or reputation to ‘any sort of hazard’.

I was recently criticised by a academically respected referee for using the more modern term, ‘risk averse’, to describe the motivation for why some (but not all) merchants, discussed by Smith in Chapter IV (ii.9: 456) of Wealth Of Nations, preferred to trade and invest locally rather than take the risks of trading or investing abroad, particularly in the American colonies.

The referee considered ‘risk-averse’ as being about the utility functions of players in modern game theory and not applicable to the merchants that Smith identified in his famous ‘invisible-hand’ paragraph.

Despite my reservations, I accepted the referee’s assertion, not being able to lay my hands of the relevant quotation at the moment I needed it. But I found it this morning while looking for something else.

I consider Smith’s comments on the ‘prudence’ of ‘security’ and ‘aversion’ excuse my original mentions of ‘risk aversion’ as the direct cause of these merchants investing locally and thereby, on the arithmetical law that the whole number is the sum of its individual parts, the behaviour of these merchants, which unintentionally made domestic national output and employment larger in total than it otherwise would be, completely explain what motivated them to do so.

The outcome was brought about, and is eminently explained by the causes identified by Adam Smith before he used The Metaphor of 'an invisible hand', thus making The Metaphor redundant as an explantion, and with its redundancy ,all the subsequent chatter that The Metaphor itself was an explanation are shown to be wrong.

The modern myths of invisible and disembodied hands, including the 'Hand of God' and other mysteries, were not part of Adam Smith's original explanation for the phenomenon, the merchant's 'risk-aversion' ('he intends only his own security' (WN IV.ii.9: 456).

The real mystery, in my mind, is why so many respectable and senior fellow economists can read the same passage from Wealth Of Nations and endorse the modern myth.

In these circumstances I feel permitted to use the term 'risk aversion' as being the cause of the merchants' conduct, without implying any connections to elements of modern games theory.

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Blogger Donald Pretari said...

From Burke:

" When a cold penury blasts the abilities
of a nation, and stunts the growth of its active
energies, the ill is beyond all calculation.
Mere parsimony is not economy. Expense,
and great expense, may be an essential part
in true economy. Economy is a distributive
virtue, and consists, not in saving, but in
selection. Parsimony requires no providence,
no sagacity, no powers of combination, no
comparison, no judgment. Mere instinct, and
that not an instinct of the noblest kind, may
produce this false economy in perfection.
The other economy has larger views. It
demands a discriminating judgment, and a
firm, sagacious mind. It shuts one door to
impudent importunity, only to open another,
and a wider, to unpresuming merit. If none
but meritorious service or real talent were to
be rewarded, this nation has not wanted, and
this nation will not want, the means of re-
warding all the service it ever will receive,
and encouraging all the merit it ever will
produce. No State, since the foundation of
society, has been impoverished by that species
of profusion. "

Don the libertarian Democrat

2:56 pm  
Blogger Simon Halliday said...

I find the comment by the referee odd. Surely risk aversion had a notional use prior to Arrow & Pratt formalizing their risk-aversion measure? The idea, therefore, that we cannot use risk aversion in its notional sense (people avoiding risks, or being prudent) is rather odd, if not disingenuous because it requires that we find another word to describe a concept that is similar to that used by Smith and others prior to Arrow and Pratt. Very strange.

7:53 am  
Blogger Gavin Kennedy said...


Most of the other comments from the referee were excellent, so a difference of opinion on one of them is proportionate.

As it's not a fundamental difference I chose to re-cast the sentences.

9:16 am  

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