Saturday, April 04, 2009

Invisible Hands Explain Nothing: a response to a critic

“anon/portly” comments on my post ‘Never A Theory of Markets’ below, and I respond here on the main page so that it will be read by a wider audience:

His sole use of The Metaphor occurs in Book IV in his critique of Britain’s ‘mercantile political economy’, which legalised several monopoly practices prevalent in the 18th century. In this instance, he showed how the legal colonial monopoly of trade with the British colonies in North America, under the Navigation Acts, enforced by the Royal Navy and customs officers in every British seaport, heavily distorted British domestic capital growth.

Isn't this a bit misleading? When Smith introduces the Invisible Hand metaphor, the discussion at that point concerns merchants trying to make their own "produce" or revenue as great as possible in doing so make the nation's revenue as great as possible. The truth or accuracy of this point does not depend on Smith's placement of it within a discussion of tariffs and import restrictions and so on.

[Smith] did not relate the metaphor of ‘an invisible hand’ to ‘the market economy’.

How can this be so? A discussion of merchants and their incentives to employ their capital in domestic trade, foreign trade or "carrying trade" has nothing to do with the market economy?

...and by directing that industry in such a manner as its product may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote [society's gain]...

So the invisible hand applies not just here, but elsewhere. Where else? Maybe in other places where a businessperson intends only his own gain but the result is beneficial to others? Maybe like in the discussion of self-interest in book 1, chapter 2?’

A fair comment to which I reply as follows:

By a selective choice of what a paragraph does and does not relate to, “anon/portly”, skews his case solely to make it credible.

“anon/portly” claims that paragraph 9 does not, apparently, relate to the immediately previous paragraphs within which it is embedded (Book IV, Chapter 2, of Wealth Of Nations), but it does relate to paragraphs ‘in other places’ in Wealth Of Nations, including (‘maybe’, according to “anon/portly”,) those places in Book I, chapter 2, 427 pages earlier!

This argument might be (remotely) sustainable if the invisible hand metaphor had appeared elsewhere throughout the book, especially where Adam Smith discusses markets in detail, as in Book I and II, that is, in the first 375 pages of the Wealth Of Nations. But he didn’t use The Metaphor elsewhere in Wealth Of Nations at all.

Smith’s argument is clear enough: the general industry of society can never exceed the amount of capital society can employ. Regulations of commerce can only distort the distribution of capital; there is no reason to believe that regulation directs capital more advantageously than where it would go ‘of its own accord’ (paragraph 2, 453). Each individual ‘exerts’ himself to find the ‘most advantageous’ employment for his capital (his own advantage in profits, not society’s advantage), and this ‘necessarily’ leads him to prefer the ‘most advantageous’ distribution for ‘society’ (paragraph 4: 454).

At the first level, individuals prefer domestic (‘near home’) employment for their capital, provided they can ‘obtain the ordinary, or not a great deal less than the ordinary profits of stock’ (paragraph 5: 454). The choice context is:

In the home-trade his capital is never so long out of his sight as it frequently is in the foreign trade of consumption. He can know better the character and situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress.” (paragraph 6: 454)

Thus, his concerns for the security of his investment are informed by his knowledge of local circumstances (which knowledge is better than his knowledge of distant foreign places) – the people with whom he deals – and, should these prove unreliable, he is familiar with the domestic legal circumstances and the likelihood of his relief and redress should he be ‘deceived’ (explained in the long paragraph 6) (454-5).

The effect of all this, fully explained, risk-averse motivation, is to:
a) support ‘domestic industry’ and domestic ‘employment’ (paragraph 6);
b) give the ‘greatest value’ to the ‘produce’ of ‘domestic industry’ (paragraph 7: 455).

But, note, there is still no mention of the ‘invisible hand’ yet, and note also that not all merchants shared the same degree of risk aversion - many tens of milions of trade were conducted abroad with the British colonies, and with Europe, by local merchants, which is the significance of Book IV of Wealth Of Nations that contains The Metaphor among Smith's detailed criticisms of the distortions to British domestic capital formation caused by the very mercantile political economy that Smith criticises so strongly in Book IV of Wealth Of Nations.

Smith next relates how ‘industry’ adds value to the materials it employs, and this activity ‘proportionally’ adds to the ‘profits of the employer’, and it is ‘only for the sake of profit that any man employs a capital in the support of industry; and he will always, therefore, endeavour to employ it in the support of that industry of which the produce is likely to be of the greatest value, or to exchange for the greatest quantity either of money or of other goods’ (paragraph 8: 455).

Now paragraph 9 on pages 455-56, from which “anon/portly” wishes to detach the critical ‘invisible hand’ and transfer it, ‘maybe’ elsewhere, brings the arguments in the previous 8 paragraphs together:

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” (WN IV.ii.9: 455-6)

Note that the employer of capital ‘intends only his own security’ – his aversion to the risks of the foreign trade of consumption, as summarised in earlier paragraphs, are, in this particular case, the motivating drivers for the employers of capital who consider where to trade when faced with the circumstances alluded to: invest capital in foreign trade, which necessarily meant dealing with foreign partners whose “character and situation” he knows less about than the local persons “whom he trusts”, and in the event of them deceiving him “he knows “ not very well “the laws of the country from which he must seek redress”. Foreign trade, despite the higher profits from the Navigation Acts, enforced by the Royal Navy and British customs officials in all British seaports in Britain and the colonies, contributed extra and higher profits to the traders but at some cost to British capital formation, and, therefore, to British domestic employment and profits.

In these circumstances, Smith asserts, that merchants who are concerned with their security, would prefer to invest locally, a wholly unsurprising conclusion, fully explained and understood, or at least understandable, from paragraphs 1 to 8, and confirmed in summary in paragraph 9, complete with, at the end of his argument, with his sole use of ‘an invisible hand’ metaphor, to make it easier for those of his readers (surely not modern economists!) who did not follow his arguments. I have discussed all this in my paper: “Adam Smith and the Invisible Hand: from metaphor to myth” (HERE), and why Smith felt a need to support his technical argument with a well-known (to him) popular literary metaphor.

anon/portly” closes with what he considers to be a devastating final ‘proof’ of his assertions:

Maybe in other places where a businessperson intends only his own gain but the result is beneficial to others?”

If “anon/portly” is asserting that the invisible hand is at work wherever “a businessperson intends only his own gain but the result is beneficial to others” he is not saying much. Of course, we may all gain from the unintended actions of others, especially from the productive sector of the economy (that's the power of commercial markets), but not all unintended actions of ‘businessmen’, politicians, and those who influence them, are beneficial to others (today's main story!).

This is true now as it was in Adam Smith’s day. Indeed, Smith gives over 60 instances in Books I and II of Wealth Of Nations where the actions of individuals for their own ‘gain’ have less than beneficial consequences on those around them: WN: BK I: 40; 43; 51-2; 77; 78; 79; 80; 84; 89; 90; 91; 95; 96; 106; 111-12; 115; 116; 124; 125; 126; 135; 136; 137; 139;140; 141;142; 143; 144; 145; 146; 151; 152; 153;154; 156; 157; 158; 160; 163; 171; 174; 266-7 [47]; BK II: 285; 302-03; 304-05; 308; 310-17;321; 323-24; 326; 339-42; 344; 346.

The invisible hand is a metaphor, not a reality. Economists can examine any set of actions for the explanation of their consequences (that’s our claim to being a science), but in no cases does The Metaphor of ‘an invisible hand’ explain anything at all. That many modern economists believe that it does is a comment on the state of mysticism in the subject, not shared by Adam Smith, nor by any economist who is not a ideologue.

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Blogger michael webster said...

I am not sure that I posted this before, but when I was at Stanford in the late 80's as a post-doc, Kenneth Arrow said on numerous occasions that he had not realized before, how complicated institutions that real markets were.

I sincerely doubt that Arrow thinks that the "invisible hand" is a metaphor that explains anything.

Hope that you get people to focus on what type of regulation we need and want as opposed to whether regulation is needed or wanted.

4:28 pm  

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