Monday, April 20, 2009

Top Behavioural Economist Invents New Mythical Role for the Invisible Hand

Dan Ariely, James B. Duke Professor of Behavioral Economics at Duke University and a visiting professor at MIT’s Media Laboratory, has contributed and article (20 April) for Technology Review (published by MIT) HERE: and for Predictably Irrational HERE

'Irrationality is the real invisible hand'

“Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating. The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so. This is a beautiful idea, but the question of course is how closely it represents reality.

In my mind this experience has taught us that Adam Smith ‘s version of invisible hand does not exist, but that a different version of the invisible hand that is very real, very active, and very dangerous if we don’t learn to recognize it. Perhaps a more accurate description of the invisible hand is that it represents human irrationality. In terms of irrationality the hand that guides our behavior is clearly invisible — after all recent events have demonstrated that we are largely blinded to the ways rationality plays in our lives and our institutions. Moreover it is also clear that irrationality does shape our behavior in many ways, pushing and prodding us along a path can lead to destruction. Whether we’re procrastinating on our medical check-ups, letting our emotions get the best of us, or letting conflicts of interest and short term time horizon ruin the financial market, irrationality is certainly involved.

In Adam Smith’s world the invisible hand was a wonderful force, and the fact it was invisible made no difference whatsoever. The irrational invisible hand is a different story altogether - here we must identify the ways in which irrationality plays tricks on us and make the invisible hand visible!

I am astonished that such a senior academic economist is unaware that what he asserts about Adam Smith is a myth invented in the mid-20th century, which, on the evidence above, he seems to have swallowed hook, line, and sinker.

The first three sentences of his piece above contain three errors.

Smith did not ‘[coin] the term The Invisible Hand’ – he used it twice previously, once in his Essay on Astronomy [1744-; 1795], and once in his Theory of Moral Sentiments [1759].

He was not ‘trying to capture the idea that the marketplace would be self-regulating’. He never mentioned the invisible hand metaphor when he analysed markets in Books I and II of Wealth Of Nations; his sole mention of the invisible hand was in Book IV (page 456) and the end of an analysis of why some (not all!) merchants preferred to invest their capitals in the local market rather than face the risks (and, incidentally higher profits) of sending their capitals abroad to the British colonies in North America.

It was a case of their risk-aversion (read the whole of Chapter 2 in Book IV of Wealth Of Nations; don’t rely on the 1930s oral tradition at Chicago University or your tutor’s misunderstandings emanating from Paul Samuelson’s Economics,1948).

For a professor of behavioural economics to assert that ‘an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy’ is astonishing. That wasn’t what Adam Smith said, nor does it correspond to his political economy.

He gives over 60 examples in Books I and II of Wealth Of Nations of instances where individual self-interested actions lead not ‘what’s best for the whole economy’, but what had negative consequences for those affected.

To turn these myths around and pose the ideas that ‘Perhaps a more accurate description of the invisible hand is that it represents human irrationality’ is breathtaking in its, er, error: there is no actual invisible hand, it doesn’t exist as an operator – it’s a only a mere metaphor, offered by Adam Smith after he had explained in detail why the risk-averse merchants behaved as they did, presumably for those readers who didn’t follow his argument (which apparently is the entire profession from the mid-50s in US and British universities).

Why did the brightest in the profession spread these errors? You’ll have to ask them, but remember the context. In the 1930s capitalism as an alternative to Soviet communist planning was struggling in the depression years (as it is just now) and once the Cold War was underway, the West was threatened militarily.

Someone got the bright idea to use an innocuous metaphor (fairly common in literary works in the 18th century) used by Smith, en passant, as a mysterious force, which they placed in market capitalism that had the miraculous powers of guiding individuals to benefit national goals without them knowing what they were doing. It didn’t require battalions of state planners, and the tyranny that came with them; it required liberty and freedom, both anathema to Communism.

It was game, set, and match, and given scientific credibility with the success of theorists of general equilibrium (Samuleson and Debreu), and propagandized across the world’s campuses. It was also given historical credibility by linking it to Adam Smith, even the linkage was dubious in the extreme.

But the question never answered is: which term in the theory of general equilibrium represents the invisible hand and what does it consist of and what does it do?

Dan has introduced a new role for it: irrationality; so it both invisible and part of cognition and behaviour!

For Dan to write: ‘In Adam Smith’s world the invisible hand was a wonderful force, and the fact it was invisible made no difference whatsoever’, frankly is embarrassing.

Smith never discussed it elsewhere in any of his writings – near on a million words – other than as a metaphor on the three occasions he used it. If it was true that ‘the invisible hand was a wonderful force’, one would expect it have been more central in Wealth Of Nations when he discusses markets in Books I Nad II, but he didn’t, nor did his contemporaries or anybody else, including critics at the end of the 19th century. It’s in the mid-20th century that the metaphor was re-invented as ‘a wonderful idea’.

It was so ‘invisible’ that none of Malthus, Lauderdale, Playfair, Ricardo, McCulloch, Mill, Marx, or even Bright and Cobden, mentioned it.

To get the invisible hand into perspective, download my paper: Adam Smith and the Invisible Hand: from metaphor to myth, HERE:



Blogger Dan said...

I don't know if you take requests, but I would love to see one of your posts on the recent interview at the Freakonomics blog about "The Invisible Hook", a new book about the economics of piracy. Here's the link:

And here's the most relevant passage:

"In Adam Smith, the idea is that each individual pursuing his own self-interest is led, as if by an invisible hand, to promote the interest of society. The idea of the invisible hook is that pirates, though they’re criminals, are still driven by their self-interest. So they were driven to build systems of government and social structures that allowed them to better pursue their criminal ends. They’re connected, but the big difference is that, for Adam Smith, self-interest results in cooperation that generates wealth and makes other people better off. For pirates, self-interest results in cooperation that destroys wealth by allowing pirates to plunder more effectively."

Perhaps you could get some attention from the blog as well!

6:24 p.m.  
Blogger michael webster said...

Do I get a point for telling Airely that he should be looking at your blog?

2:24 a.m.  
Blogger Gavin Kennedy said...

Dan I am preparing a comment on your post. It requires a comment from me!

Michale, yes, indeed. Thanks for the helpful comment (I noted it last night at 10 pm)

9:02 a.m.  
Blogger M.K. said...

Dear Gavin Kennedy,

I think the author is incorrect in his statement that Smith was attempting to show that a market IS self-regulating. In the sense of the ('total') market as an autonomous natural phenomena, with no need for 'external' government regulation. However the statement would -in my opinion- be correct if you put "partly" before self-regulating.
It is quite clear from any basic gramatical analyses of the combined sententences which contain the 'invisible hand', that Smith is talking about individual preferences: "By preferring the support of domestic to that of foreign industry, he intends[..]."

With regard to the general proposition of the Duke professor:
"Perhaps a more accurate description of the invisible hand is that it represents human irrationality."
I have to conclude statement is (quite) true. Not just in a literal sense which is only logical: as his previous analyses is quite wrong - many other ways of describing it will -almost by definition- be more accurate.

I believe the statement to be true because to Smith an individuals preferences are the same as human cognative biases. To Adam Smith and other great thinkers of his age (such as his close friend David Hume), rationality can only be applied to that which is observable; i.e. that which can be seen or counted. To classical liberal thinkers like Smith our needs, preferences, and cognative biases are by definition part of the 'irrational' as they cannot be observed, and therefor explained by Smith by the 'invisible hand'. They are in Smith's view part of our 'passions'.
Most of confusion that has surrounded 'the invisible hand' as also your (in my opinion mis)interpretation of the professors statement is the result of -post Smith- developments in our understanding of what it means to be (perfectly) rational, and to have (perfect) self-interest.

Best regards,

5:55 p.m.  

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