Friday, May 07, 2010

Samuel Brittan on the Invisible Hand

The venerable economist and top journalist, Samuel Brittan, writes on “A credo for a revived capitalism”, HERE:
In the Financial Times HERE

Shorn of these extremist statements, the basic case for competitive markets is still Adam Smith’s invisible hand. A trader or a manufacturer will make most profit if he supplies what consumers most want at the lowest possible cost. There is the American saying that if you invent a better mouse trap, the world will come rushing to you. This core statement says nothing about capitalism. You could have state-owned enterprises or workers’ or consumers’ co-operatives competing for profit. It is just a fact that wholesale “market socialism” has never worked, even though there have been outstanding individual successes such as the John Lewis Partnership or Mondragon.

What, then, are the main exceptions to the doctrine of the invisible hand or, to put it more positively, the areas requiring state intervention. I leave aside the antitrust case against monopoly, which is relatively uncontroversial, except to note that many monopolies owe their strength to state barriers or subsidies, especially in foreign trade. The other main areas of “market failure” are:

1. Externalities.

2. Public goods.

3. Income and wealth distribution. .

These categories were analysed nearly a century ago by a Cambridge economist, A.C. Pigou. They can only provide a framework, which has to be filled in by case-by-case examination and broad political judgment. We also need to remember a further consideration not discussed by the pioneering economists. This is “government failure”. It is a controversial category. But there are aspects that can be analysed, such as the incentive to undertake activities whose benefits are highly concentrated, perhaps in key constituencies, but whose costs are thinly spread. Support for the arms trade is an obvious example

You should read the whole article (copyright considerations, etc.,) from the FT (follow the link).

With some respectful diffidence, I offer some criticism of Samuel Brittan’s take on ‘the basic case for competitive markets is still Adam Smith’s invisible hand’. Adam Smith certainly made strong cases in Wealth Of Nations for ‘competitive markets’; he also mentioned the metaphor of ‘an invisible hand’ only once in Wealth Of nations (and only once in Moral Sentiments), but he did not mention the metaphor of ‘an invisible hand’ in connection with ‘competitive markets’. The notion that he did is an invention from the 1950s onwards.

Check it out: WN IV.ii.9: 456.

His single reference in Wealth Of Nations uses the invisible hand as a metaphor, not as a noun. In short, the invisible hand did not exist in Smith’s thinking. But as a metaphor, Smith’s use was purely literary. He used the metaphor to describe its object in a ‘more striking and interesting manner’
We know this from students’ notes of Adam Smith’s Lectures on Rhetoric and Belles Lettres (1762-63; 1983, page 29: Oxford University Press).

The object of the metaphor was not a competitive economy. He was explaining why some, but not all, merchants preferred to invest their capital locally (obviously, other merchants then as now did invest their capital abroad). He put this preference down to the degree of risk that they perceived present in home versus foreign investment. Having explained through 8 paragraphs the phenomenon of the merchants’ sense of his ‘own security’ he described the consequences of local investment – it added to national profitable output and employment – basically from the arithmetic rule that the whole is the sum of its parts.

The metaphor he used for this purpose of describing these behaviours was the popular 18th-century literary metaphor of the merchants being ‘led by an invisible hand’. The was certainly ‘more striking and interesting in a ‘word or two’ than 9 paragraphs of close argument. We know it was close argument because most modern economists regard the metaphor as a noun – they believe it describes something that exists, that it resides and operates in some unspecified manner in markets (sometimes described as ‘miraculous’ or ‘magical’).

We also know that Smith was not referring to perfectly competitive markets – nobody would consider that18th-century foreign trade markets were competitive (mercantile political economy, Navigation Acts, Chartered trading monopolies, tariffs, protection and prohibitions, which Smith railed against in Book IV) and neither would they consider domestic, local markets were competitive (Statute of Apprentices; Settlement Acts; Trade Guilds in Incorporated Towns).

Perfect competition in no way describes 18th-century markets, hence the invisible hand was not a metaphor for such markets as its object.

One origin of such notions was Paul Samuelson’ otherwise excellent textbook, Economics: an introductory analysis, 1948, page 36, and through the following 18 editions. This textbook dominated economic teaching for 62 years, selling 4½ million copies in 40 languages.

It’s time for the discipline realize this modern error. Interestingly, Samuelson in the 1948 reference above said of the invisible hand had caused ‘more harm than good’ among students, who then went on to become ‘leading citizens’ with an inbuilt complacency about market failures and related state interventions.

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