Sunday, September 13, 2009

Modern Versions of Invisible Hands Are Not Compatible with Adam Smith's

Robert H. Frank, an economist at Cornell University, finds (New York Times 13 Sept) the
“Flaw in Free Markets: Humans” (HERE)

Adam Smith’s theory of the invisible hand, which says that market forces harness self-serving behavior for the common good, assumes that markets are competitive, and most markets have in fact become more competitive over time. Today, if an opportunity exists anywhere in the world, information-age entrepreneurs can seize it more quickly than ever.

The invisible hand, however, requires not just strong competition but also two other preconditions. The economic models that spawned Mr. Greenspan’s former optimism simply assume those conditions, despite compelling evidence of their absence.
First, those models assume that rewards depend only on absolute performance, but in the real world, payoffs are often tightly linked to relative performance. When a valuable new piece of information becomes available to the investment community, for example, the lion’s share of the gain goes to whoever trades on it first. For an individual firm like Goldman Sachs, it is thus completely rational to invest millions of dollars in computer systems that can execute stock trades even a few seconds faster than others. But rivals inevitably respond with similar investments. Taken together, these expenditures are wasteful in the same way that military arms races are.

A second problematic assumption of standard economic models is that people are properly attentive to all relevant costs and benefits, even those that are uncertain, or that occur in the distant future. In fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift.

Given the conditions under which human nervous systems evolved, these aspects of our behavior are unsurprising. Because immediate threats to survival were pervasive, those who didn’t seize short-term advantage often didn’t survive.

Such nervous systems provide an erratic guidance system for the invisible hand
."

Comment
I shall separate the opening quotation with the last sentence because Robert H. Frank has said enough of his linkage to Adam Smith to show a mixture of sensible analysis mixed by self-contradictory mythology, of which he appears to be unaware.

Adam Smith’s theory of the invisible hand, which says that market forces harness self-serving behavior for the common good”.

Which particular theory of Adam Smith’s “market forces” makes that statement? True, Smith makes a statement in Book IV of Wealth Of Nations similar to that credited to him by Robert Frank, but it was not about “market forces” at all. It was about some merchants, but not all, who were risk averse towards the risks of foreign trade to their capital that he preferred to invest locally, thus adding to local domestic capital investment and local output and employment.

Robert Frank, in line with modern thinking, generalizes Smith’s limited statement to involve “market forces”, even though the evidence for the generalization in Smith is absent and the evidence for it working as a generalization in modern markets is sparse to say the least (pollution, negative externalities, monopolies, conspiracies against consumers, price-fixing, outright fraud, government interventions, and the behaviour of capital owners vulnerable to Smith’s tirades against 18th-century “merchants and manufacturers”.

The invisible hand, however, requires not just strong competition but also two other preconditions.”

How does this work? If the two conditions are not met markets are compromised. Whether the mystical entity of ‘an invisible hand’ ceases to function is of no interest – it’s a metaphor not an actual force! Why not stick with the analysis of “market forces” as Smith did in Books I and II of Wealth Of Nations, where Smith’s text is noticeable for the absence of any mention of “invisible hands”.

Robert Frank partly gives the game away with “A second problematic assumption of standard economic models…”. Originally he was talking about the working of the “invisible hand”, now he talks about “standard economic models”, of which his conditions may apply. He would be clearer if he stuck to “standard economic models” and left the “invisible hand” out of it.

Indeed, Smith’s single example of the invisible hand in Wealth Of Nations contradicts Robert Frank’s conflation of “standard economic models” with the metaphor of an “invisible hand”, namely that “that people are properly attentive to all relevant costs and benefits, even those that are uncertain, or that occur in the distant future.”

We can agree that people are not so wise as to consider everything that can affect the perfect model. Robert Frank notes that “in fact, most people focus on penalties and rewards that are both immediate and certain. Delayed or uncertain payoffs often get short shrift.” Agreed.

And that is what drove the psychic anxieties of the merchants Smith was talking about who were considering the security of their investments in foreign trade in distant countries, where the wrong choice of trading partners, ship owners and crews, foreign warehousing and distributors, and foreign remitters of payments, could spell disaster, even bankruptcy, if they overcame their aversions and went into business abroad.

It is interesting that Robert Frank sees the “focus on penalties and rewards that are both immediate and certain” and “Delayed or uncertain payoffs often get short shrift”, as being detrimental to the working of the invisible hand, whereas Adam Smith used the very same focus on “penalties and rewards that are both immediate and certain” as the relevant cause of these merchants being “led by an invisible hand”! (WN IV.ii.9.:456) Something surely is wrong with Robert Frank’s analysis?

I could add, the turn the screw further, that Robert Frank’s “Delayed or uncertain payoffs often get short shrift” was another of Adam Smith’s reasons why the uncertainties of foreign trade, where the turn round of foreign investment could take 4 -5 years, led some, but not all, merchants to be “led by an invisible hand” and to invest locally to benefit from its turnround of their capital 2-3 times a year.

Robert Frank’s analysis of the “invisible hand”, at least in respect of Adam Smith’s use of the metaphor, is upside down. I must conclude he has not read Adam Smith on the “invisible hand” and that he is slavishly following the modern version, invented post-1950, and ascribed to Adam Smith without a shred of supporting evidence.

That the modern version has legitimacy in its own right is fine by me; it is the ascription of it to Adam Smith’s legacy to which I object.

PS: Robert Frank strange assertion: "Such nervous systems provide an erratic guidance system for the invisible hand." So the "invisible hand" supposedly is guided by market forces as it "guides market forces". This needs to be sorted out.

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