A US Professor Tears into the Invisible Hand and General Equilibrium Theory
I came across an interesting article from a previously unknown (to me) web site, which is worth reading on the Invisible Hand Metaphor and on General Equilibrium. It is worth reading in full. Below are a couple of long extracts.
L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City. He writes on “MMT for Austrians in “Credit Writedowns” HERE:
“Conservatives tend to argue that the government’s scope should be very narrow, even given agreement on the public purpose. They believe that households and firms can provide for most economic needs and wants. Government is needed in narrowly confined areas—such as police and military. There is often reference to the benefits of “free markets” and to Adam Smith’s notion of the invisible hand. To be very brief, this is the idea that individuals pursuing their own self-interest are guided “as if” by an invisible hand to do what is actually in the interest of society as a whole. The guiding is done by the market, and more specifically by prices that act as signals. If more lawyers are needed, their salaries are bid up in the market and students react by switching to the study of law. You all get the picture. It is a very nice metaphor.
There are two problems with the story. First, it is not really Adam Smith’s view. Second, economic theory has pretty much destroyed any hope that real world markets could possibly work that way. And I am not talking about Keynesian or other critical economic theory—I’m talking about economists who desperately wanted to “prove” that the invisible hand works in the proffered manner.
Adam Smith and the Invisible Hand
One of the greatest scholars of Adam Smith, Warren J. Samuels, recently published a book on the invisible hand metaphor. (Erasing the Invisible Hand: Essays on an Elusive and Misused Concept in Economics. New York: Cambridge University Press, 2011. xxviii + 329 pp. $95 (hardcover) ISBN: 978-0-521-51725-6.) It was reviewed by Gavin Kennedy (here: EH.Net (February 2012). All EH.Net reviews are archived at http://www.eh.net/BookReview). Since handwaves about the invisible hand and references to Adam Smith as the father of the notion are so commonplace, I want to quote extensively from Kennedy’s review.”
[Comment
Which L. Randall Wray proceeds to do, extensively, I am pleased to say.
He then develops a critical account of General Equilibrium Theory, which largely concurs with the approach on Lost Legacy, only Professor Wray is much more decisive and I recommend you read it, as it is clear and not technical - and all the more worrying considering the credence given to this theory]:
“Postwar Developments in General Equilibrium Theory
To be sure there had been an attempt from the 1870s to demonstrate the idea that markets would tend to generate a “general equilibrium”—even if it did not refer to Smith or the invisible hand.
Discussion of this topic can get quite difficult, but what conservative economists wanted to show it that “demand and supply” for all produced goods and services could be brought into equilibrium by flexible prices and wages. If every market is in equilibrium, where demand equals supply, we call that a general equilibrium.
I am simplifying but this is good enough for now. In any case, it turns out to be a very difficult thing to show and believe it or not requires higher mathematics. Indeed, it is so complex that proof of the existence of general equilibrium was not accomplished until the 1950s—some 80 years after the project began. And even then the results were extremely disappointing.
First, the conditions required to demonstrate existence of equilibrium (technically a vector of relative prices that eliminate excess demand in every market) require a very simple and unrealistic world. For our purposes it is relevant to note that the hypothesized world would never use money! (Students of economics also know it requires no time, no uncertainty, a Walrasian auctioneer, and so on. Essentially, you contract at birth for all transactions you will ever make over your entire life, with perfect certainty and no regrets.)
Second, it turned out that the equilibrium is neither unique nor stable. Indeed, it turns out that there are many equilibria, perhaps an infinite number, and we cannot say that any one is better than any other. And if we do not happen to be in equilibrium, market forces will not move us to one of the equilibria.
Pretty darned disappointing since the whole claim was that “free markets” would move us to equilibrium with prices signaling how best to allocate resources.
They won’t. At least we cannot demonstrate that they will. The “invisible hand” is completely impotent. Might as well have a dictator. Or a dictatorship of the proletariat. Or a coin toss. Or winner-take-all. Or any other method of trying to allocate resources. We cannot show that markets would do a better job.
Anyone who tells you that economics shows that the invisible hand “works” is a fool or a liar or confused. Plain and simple, rigorous economic theory shows no such thing.
(In 1926 Keynes wrote a great essay on “The End of Laissez Faire”; I won’t go through it in detail but what he argued is that no economist had ever accepted the notion that the free market “works”. He said that only political ideologues pushed that idea, an idea he thoroughly destroyed in his essay. However, in the last third of the essay he tried, and failed, to produce an alternative view. It took him ten years—until 1936—to create the alternative, what became The General Theory. It wasn’t until he formulated his theory of effective demand and addressed the “special properties of money” that he could counter the free market ideology.)
Now, why did I devote so much space to a discussion of the invisible hand? Because so many “free market marketeers” rely on the notion, and on the supposed authority of Adam Smith, to push their ideological agenda.
To be clear, the inability to demonstrate that an invisible hand “works” does not settle the issue. It does not in any way “prove” that “big government” is better than “small government”. It does not “prove” that the best way to ensure the public purpose is to rely on government rather than markets. And it does not demonstrate that we should adopt an expansive, progressive view of the public purpose. But it does make one highly skeptical of “invisible” handwaves about “free markets”.
Yet, it must be admitted that in truth, economics, alone, cannot answer those questions.”
Comment
I think Professor Wray’s contribution (follow the link) is excellent, though I have missed out the debate on “Austrians and MMT”. Unfortunately, joining a debate on MMT without knowledge of what MMT is about, places the reader at a disadvantage.
I certainly sympathise with the notion that “economics, alone, cannot answer [all] questions.”
L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City. He writes on “MMT for Austrians in “Credit Writedowns” HERE:
“Conservatives tend to argue that the government’s scope should be very narrow, even given agreement on the public purpose. They believe that households and firms can provide for most economic needs and wants. Government is needed in narrowly confined areas—such as police and military. There is often reference to the benefits of “free markets” and to Adam Smith’s notion of the invisible hand. To be very brief, this is the idea that individuals pursuing their own self-interest are guided “as if” by an invisible hand to do what is actually in the interest of society as a whole. The guiding is done by the market, and more specifically by prices that act as signals. If more lawyers are needed, their salaries are bid up in the market and students react by switching to the study of law. You all get the picture. It is a very nice metaphor.
There are two problems with the story. First, it is not really Adam Smith’s view. Second, economic theory has pretty much destroyed any hope that real world markets could possibly work that way. And I am not talking about Keynesian or other critical economic theory—I’m talking about economists who desperately wanted to “prove” that the invisible hand works in the proffered manner.
Adam Smith and the Invisible Hand
One of the greatest scholars of Adam Smith, Warren J. Samuels, recently published a book on the invisible hand metaphor. (Erasing the Invisible Hand: Essays on an Elusive and Misused Concept in Economics. New York: Cambridge University Press, 2011. xxviii + 329 pp. $95 (hardcover) ISBN: 978-0-521-51725-6.) It was reviewed by Gavin Kennedy (here: EH.Net (February 2012). All EH.Net reviews are archived at http://www.eh.net/BookReview). Since handwaves about the invisible hand and references to Adam Smith as the father of the notion are so commonplace, I want to quote extensively from Kennedy’s review.”
[Comment
Which L. Randall Wray proceeds to do, extensively, I am pleased to say.
He then develops a critical account of General Equilibrium Theory, which largely concurs with the approach on Lost Legacy, only Professor Wray is much more decisive and I recommend you read it, as it is clear and not technical - and all the more worrying considering the credence given to this theory]:
“Postwar Developments in General Equilibrium Theory
To be sure there had been an attempt from the 1870s to demonstrate the idea that markets would tend to generate a “general equilibrium”—even if it did not refer to Smith or the invisible hand.
Discussion of this topic can get quite difficult, but what conservative economists wanted to show it that “demand and supply” for all produced goods and services could be brought into equilibrium by flexible prices and wages. If every market is in equilibrium, where demand equals supply, we call that a general equilibrium.
I am simplifying but this is good enough for now. In any case, it turns out to be a very difficult thing to show and believe it or not requires higher mathematics. Indeed, it is so complex that proof of the existence of general equilibrium was not accomplished until the 1950s—some 80 years after the project began. And even then the results were extremely disappointing.
First, the conditions required to demonstrate existence of equilibrium (technically a vector of relative prices that eliminate excess demand in every market) require a very simple and unrealistic world. For our purposes it is relevant to note that the hypothesized world would never use money! (Students of economics also know it requires no time, no uncertainty, a Walrasian auctioneer, and so on. Essentially, you contract at birth for all transactions you will ever make over your entire life, with perfect certainty and no regrets.)
Second, it turned out that the equilibrium is neither unique nor stable. Indeed, it turns out that there are many equilibria, perhaps an infinite number, and we cannot say that any one is better than any other. And if we do not happen to be in equilibrium, market forces will not move us to one of the equilibria.
Pretty darned disappointing since the whole claim was that “free markets” would move us to equilibrium with prices signaling how best to allocate resources.
They won’t. At least we cannot demonstrate that they will. The “invisible hand” is completely impotent. Might as well have a dictator. Or a dictatorship of the proletariat. Or a coin toss. Or winner-take-all. Or any other method of trying to allocate resources. We cannot show that markets would do a better job.
Anyone who tells you that economics shows that the invisible hand “works” is a fool or a liar or confused. Plain and simple, rigorous economic theory shows no such thing.
(In 1926 Keynes wrote a great essay on “The End of Laissez Faire”; I won’t go through it in detail but what he argued is that no economist had ever accepted the notion that the free market “works”. He said that only political ideologues pushed that idea, an idea he thoroughly destroyed in his essay. However, in the last third of the essay he tried, and failed, to produce an alternative view. It took him ten years—until 1936—to create the alternative, what became The General Theory. It wasn’t until he formulated his theory of effective demand and addressed the “special properties of money” that he could counter the free market ideology.)
Now, why did I devote so much space to a discussion of the invisible hand? Because so many “free market marketeers” rely on the notion, and on the supposed authority of Adam Smith, to push their ideological agenda.
To be clear, the inability to demonstrate that an invisible hand “works” does not settle the issue. It does not in any way “prove” that “big government” is better than “small government”. It does not “prove” that the best way to ensure the public purpose is to rely on government rather than markets. And it does not demonstrate that we should adopt an expansive, progressive view of the public purpose. But it does make one highly skeptical of “invisible” handwaves about “free markets”.
Yet, it must be admitted that in truth, economics, alone, cannot answer those questions.”
Comment
I think Professor Wray’s contribution (follow the link) is excellent, though I have missed out the debate on “Austrians and MMT”. Unfortunately, joining a debate on MMT without knowledge of what MMT is about, places the reader at a disadvantage.
I certainly sympathise with the notion that “economics, alone, cannot answer [all] questions.”
6 Comments:
You can see the entire series of which that post was the most recent entry at its original location here:
http://www.neweconomicperspectives.org/p/modern-money-primer.html
It also serves as a good step by step introduction to MMT.
Karl
Many thanks. I shall follow the link and comment. Lost Legacy has been somewhat Neglected this week, due to my attention to University business (I retired in 2005!).
Gavin
It seems somewhat ironic that is a article which complains about the misrepresentation of one economist's views we find reference to "a Walrasian auctioneer". But as Mark Blaug notes that the fictional auctioneer famous from Walras's model of general equilibrium isn't in fact due to Walras.
"[..] Walras never mentioned the concept of a fictional auctioneer announcing and changing prices until an equilibrium price is agreed upon - this is one of those historical myths that subsequent generations invented [..]"
Also the group that got GE excepted within economics where the market socialists in the Socialist Calculation Debate.
To find a good defence of GE we need go no further than the Review of Austrian Economics! See "Should Austrians Scorn General-Equilibrium Theory?" by Leland B. Yeager, vol. 11, pp. 19-30, 1999.
Karl
Having read through the Link, I an not much wiser, though still interested.
It was complicated by no explanation of what 'MMT' represented. It was only by looking up the book on amazon that it clicked : MMT = Modern Monetary Theory?(!), and find out what it meant in detail, I ordered the book. That's bad for public relations: avoid jargon, without regular clarifications for new readers, otherwise you risk talking to yourself.
After I have read the book, I shall return to the debate.
Gavin
Paul
Thanks for your insightful comments on General Equilibrium (GE).
I noted Mark Blaug's comments on GE before when he pointed out that Smith's use of the Invisible hand metaphor had nothing to do with the 'welfare theorem'.
I shall enquire on Leland B. Yeager's article in Review of Austrian Economics.
Gavin
These criticisms of GE theory are a rehash of complaints that are largely outdated and out of touch. Read some Frank Hahn and Roy Weintraub if you are interested in a more serious discussion.
All models are simplifications. Serious economic discussions take place in the context of models. Sure, one could return to the German Historical School approach and write atheoretical 800-page tomes on the Flemish flax spinning industry. But most realized a long time ago that that was a dead end.
The math required for GE isn't that bad. One just needs some convexity, so results don't jump around, some optimization theory (covered in 2nd semester calculus), and a fixed-point theorem. Anyone who complains about that is a math wimp or a poli sci type who's an economist wannabe. Buck up.
The notion that GE theory was developed as an ideological crusade is ridiculous. Does anyone believe Oskar Lange, Gerard Debreu, Kenneth Arrow, and Lionel McKenzie had any political beliefs in common? The issue was whether the ideas of a market economy could be explained in a coherent and consistent framework.
Frank Hahn's point (On Equilibrium) is that one would like some tools to distinguish between statements that might be logically coherent and statements that are just noise. GE theory suggests that key statements about market economies might be more than noise.
The set-up of the classic Arrow-Debreu (AD) model is restrictive in some ways -- although extremely flexible in other ways too. Lots of research has extended the AD model to include uncertainty, externalities, limited markets, and irreversible investment (i.e, so time matters). Extensions of GE theory to include those issues are at the core of modern financial theory. Complaining that GE theory cannot handle those things is just a signal that one is unaware of the relevant literature. Of course, like all models, GE is better suited for some questions than to others, which is why economists have more than one model to use. For instance, GE theory is not a sensible way to predict short-term macroeconomic trends. Still, dynamic computable general equilibrium has become a widely used tool in development economics.
MMT (modern macro theory) appears to be a relabeling of neo-Keynesian theory, which seems to have been stagnant since the 1970s. Austrian economics, by contrast, has been stagnant since the 1930s.
Experimental economics suggests that markets work pretty well, even in some situations where theory suggests they shouldn't. One can screw up markets by taking away convexity, so that supply or demand curves include jumps, which can create chaotic market dynamics. For instance, large fixed costs can create such non-convexities, which is what makes the field of industrial organization so interesting.
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