DO MODERN ECONOMIC IDEAS REALLY MATTER?

Behind The ‘Invisible Hand’: Why Economic Ideas Still Matter (2)

Paul Frimpong, Ch.E., Chartered Economist and the founder of Young Professional Economists Network (YPEN) and also a fellow of the Bastiat Society –Ghana:

"From the first edition, we saw the development of the ‘invisible hand’ theory by Adam Smith during the 18th century.

“The theory of ‘Invisible Hand’ states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community, and hence to the community as a whole.”

… Adam Smith in his 1776 book "An Inquiry into the Nature and Causes of the Wealth of Nations" states that:

"…every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it ... 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 society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good."

Individuals in a free market are expected, as rational beings, [to] maximize their own self-interest, and through a two way or multi-faceted interactions, the exchange of information in the markets enable each participant to be better off than when simply producing for himself / herself.

This means that in a free market, no regulation of any type would be needed to ensure that the mutually beneficial exchange of goods and services took place, since this "invisible hand" would guide market participants to trade in the most mutually beneficial manner.

Behind the ‘invisible hand’
Harvard economist Stephen Marglin argues that while the "invisible hand" is the "most enduring phrase in Smith's entire work", it is "also the most misunderstood."

“Economists have taken this passage to be the first step in the cumulative effort of mainstream economics to prove that a competitive economy provides the largest possible economic pie (the so-called first welfare theorem, which demonstrates the Pareto optimality of a competitive regime). But Smith, it is evident from the context, was making a much narrower argument, namely, that the interests of businessmen in the security of their capital would lead them to invest in the domestic economy even at the sacrifice of somewhat higher returns that might be obtainable from foreign investment. …”

… Behind the ‘invisible hand’ is just a philosophy and the belief that, perhaps, there are even profound forces that are working against the forces of demand and supply to establish a market efficiency– a ‘visible hand’.”

Comment

Regular readers of Lost Legacy will be familiar with why I consider Paul Frimpong’s general interpretation of Adam Smith’s use of the metaphor of “an invisible hand” is quite unrepresentative of Smith’s meaning.   All Smith said in fact was that a merchant concerned for the security of his capital  if he sent it abroad might instead choose to invest it ocally, which if he did, his action would add to domestic “revenue and employment”. The consequence of doing so was an arithmetic addition to the domestic economy, which he considered generally to be good outcome that was of public benefit to the community. 

The "Invisible hand"  quotation comes from Book IV of the Wealth Of Nations (p 456), which Book IV Smith described as his “violent attack” on the prevailing mercantile political eocnomy of Great Britain.  He said nothing at all about “Individuals in a free market” were “rational beings”, who “maximised their own self-interest”.

True, we can deduce that “markets enable each participant to be better off than when simply producing for himself / herself”, which is true as well as for every system by which people acquire their subsistence from nature in all previous “ages of mankind” from hunter-gathering, shepherding, farming, and exchange in markets because all benefited from the “division of labour” instead than living hermit-like and doing everything for themselves. Man depends on the co-operation of others, and always has, and likely, I venture to suggest, always will for the foreseeable future.

Whatever is meant by the “visible hand”, it does not mean that it is an antonym for the use of the “invisible hand” as a metaphor.  Like all metaphors, the “invisible hand” does not exist as an entity; it simply describes in a “more  striking and interesting manner” its “object” (see Smith ”Lectures on Rhetoric and Belles Lettres”, 1762, p. 29).  Its “object” in this case was the ‘hidden” motive in the merchant’s mind that prompted him to actions that had the intended consequences of making his capital more secure than exporting it facing the risks of sending it abroad.  But actions can also have unintended consequences too. In this case the original motivated actions of security can also add to “domestic revenue and employment”, which Smith regarded as a “public benefit”.

Some actions can have negative consequences too, such as pollution, higher prices, tariff wars and hostilities between countries. Indeed, Smith considered that the mercantile policies prevalent at the time did cause wars, invasions, large spending on wars and regime changes, let alone higher domestic prices, plus the absence of foreign-sourced products (French wines replaced by poorer quality Portuguese varieties). Whatever else it was, it was a long way from “the so-called first welfare theorem", or "Pareto optimality of a competitive regime”.

Stephen Marglin’s quoted observation that the “invisible hand” is the "most enduring phrase in Smith's entire work", is wrong and unintensionally misleading: the “invisible hand” “metaphor” was not “a phrase”, and only endures today because modern economists - in particular Paul Samuelson in 1948 - lazily picked out the phrase and have spread it around the profession since the 1960s, as if it was true. Marglin’s “observations” demonstrate that he does not understand the limited metaphoric purpose behind Smith’s use of it and his explanations are misdirected - it had nothing to do with 18th century theories of perfect competition or product distribution. 

Nor is there a “visible hand” - there are visible prices because no market can work without visible prices.  Markets have never been “perfectly competitive and state regulations are absolutely necessary. For example, Smith mentioned the need for state banking regulations and limits to interest rates, the absolute necessity for mandatory laws of justice, without which society would crumble.
Ideas matter, modern or ancient, except where they are wrong.