A Step Towards Clarity on the Invisible Hand

Stephen LeRoy, professor emeritus at the University of California, Santa Barbara and fellow of the Reserve Bank of California, writes in the FRBSF Economic Letter
HERE


Is the “Invisible Hand” Still Relevant?

The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.

The single most important proposition in economic theory is that, by and large, competitive markets that are relatively, but generally not completely, free of government guidance do a better job allocating resources than occurs when governments play a dominant role. This proposition was first clearly formulated by Adam Smith in his classic Wealth of Nations. Except for some extreme supporters of free markets, today the preference for private markets is not an absolute. Almost everyone acknowledges that some functions, such as contract enforcement, cannot readily be delegated to market participants. The question is when and to what extent—not whether—private markets fail and therefore must be supplanted or regulated by government.

Comment
This is a sensible and timely article on an important economic issue provided that readers ignore the headline, which has nothing to do with its content. It doesn’t mention the invisible hand again, so, presumably it is the work of a sub-editor and not that of the author.

In fact it follows a line of argument that Paul Samuelson wrongly cast ad being about Adam Smith’s invisible hand. Samuelson linked the invisible hand directly to Pareto Optimality and Arrow and Debreu’s formulation of the General Equilibrium thesis. Stephen LeRoy casts Pareto and Debreu’s mathematical ‘proof’ of competitive markets as an alternative to Adam Smith’s views on competitive markets (sans the invisible hand).

The difference between this approach and Samuelson’s is instructive. In retrospect, if Samuelson had confined himself to LeRoy’s approach it would have saved the entire economics profession from raising the invisible hand from only being a ‘more striking and interesting’ metaphor to that of an invented ‘doctrine’, ‘theory’, ‘idea’, even ‘paradigm’, now ubiquitous in discourse of former students of economics in the last 6o years, in the upper reaches of government, public service, media opinion formers, legislators and those who influence them.

Despite what Adam Smith says in his Wealth Of Nations about the use of the metaphor of an invisible hand, most economists (though there are signs now of dissent appearing among some of them – Stiglitz for instance) do not even read the objects of the many metaphors that Smith used in his books. They leap to the conclusion that the invisible hand for him was about markets. It certainly is believed to mean that for most economists since the 1950s.

In both examples, once in Moral Sentiments and once in Wealth Of Nations, the context was definitely not about competitive markets. There was nothing competitive about life for labourers and their families in the quasi-feudal regimes of ‘Rich landlords’ (TMS IV.ii: 184-85), nor for merchants in 18th-century mercantile Britain (WN IV.ii.9: 456).

Neither circumstance was driven by market considerations: the landlords had no choice but to feed their serfs out of their grain stores if they were to be fit to labour for them on the land each season and survive the winters each year, and the merchants who chose to invest locally were led by their insecurity over sending their capital abroad, hence the preferred to stay at home within their sight and control. Necessity led landlords to supply food to their labourers and the insecurity of merchants led them to invest locally. These were the objects of the metaphor of ‘an invisible hand’.

The metaphor of an invisible hand expressed his descriptions of these considerations in a ‘more striking and interesting manner’, as Smith put it in his lectures on metaphors in his Rhetoric (1763-63; 1983: 29).

As more economists become aware of the truth about the origins of the invisible hand and de-couple the modern interpretation from Adam Smith's name, the better it will be for the reputation of the discipline from false doctrinaire myths about how markets work.

Invisible Hand as a Metaphor

“James” writes in “Bubble Meter” HERE

“Adam Smith's "invisible hand" in context”

“Princeton University economics professor Alan Blinder puts Adam Smith's concept of the "invisible hand" in context:

When economists first heard Gekko's now-famous dictum, "Greed is good," they thought it a crude expression of Adam Smith's "Invisible Hand"—which is one of history's great ideas. But in Smith's vision, greed is socially beneficial only when properly harnessed and channeled. The necessary conditions include, among other things: appropriate incentives (for risk taking, etc.), effective competition, safeguards against exploitation of what economists call "asymmetric information" (as when a deceitful seller unloads junk on an unsuspecting buyer), regulators to enforce the rules and keep participants honest, and—when relevant—protection of taxpayers against pilferage or malfeasance by others. When these conditions fail to hold, greed is not good.”

[“James”]:
“Greed is a natural human vice, just like aggression. As much as we may try, we cannot get rid of them because they are part of human nature. But just as sport channels aggression into productive use, free enterprise does the same for greed. Free enterprise is only productive when its goal is to benefit consumers. When it becomes acceptable to screw consumers (or taxpayers) in the quest for wealth, the benefit is entirely lost.

Greed is not good. It is the productive work and investment we do as a result of our greed that is good.”

Comment
A muddle, I am sorry to have to say. Blinder’s point is discussed in a reader’s comment in an earlier post this week.

Adam Smith had no time for espousers of “greed” in their books (such as Bernard Mandeville, 1734, whose ideas he called “licentious” in Moral Sentiments (TMS VII.ii.iv.6-14).

It’s a bit like that modern combination that starts of asserting the cliché of their being only two motives for human action, “fear” and “greed”, and then proceeds to elaborate on some silly “theory” or other. I recently refereed a proposed book applying this to defence economics (my earlier specialty before the fall of communism) and found it projects a prejudicial imperative onto its author’s conclusions.

“Adam Smith's "Invisible Hand"—which is one of history's great ideas” is actually a recent invention among modern economists. It certainly is one of our discipline’s “great” re-defined and heavily promoted metaphors.

Smith’s point was not that “greed is socially beneficial” (please give us a direct quotation from Adam Smith showing that he ever made this absurd assertion!).

What he argued – once only – was that when some, but clearly not all, merchant traders were concerned about risks to their capital (remember, in the 18th century, the alternative to safety and prudence in one’s investments was utter ruin and its associated severe, and perhaps life-threatening, deprivation) they preferred to invest locally rather than invest their capital in riskier foreign ventures.

The greater the number of merchants who invested locally as individuals, the greater would be annual national investment and the greater the consequential national output and employment (always a concern of Smith’s for lifting working people out of their unemployed deprivation), because it’s an arithmetic law that the whole is the sum of its parts. Yes, that’s all it is.

He added, to describe the process by which individuals seeking the most profitable investment of their capital (prudence, not greed!) and to explain the arithmetic consequences to his readers, most of whom were not political economists, that individuals who behaved in this manner were led by “an invisible hand”.

This was not original to Adam Smith . It was never Adam Smith's invisible hand".

It was a popular literary metaphor, widely used by theologians in their sermons (Augustine), political writers in their weighty tomes, playwrights (Shakespeare in Macbeth), fiction authors (Daniel Defoe in Moll Flanders), philosophers (Voltaire) and classical writers from Greece and Rome. The metaphor was easily recognizable among literate readers of Wealth Of Nations.

I have a list of nearly 50 separate uses of the invisible hand metaphor, most of them probably known to Adam Smith, plus scores of other authors using the metaphor in other contexts up to the 20th century.

Smith taught his students that a metaphor should be used to give “due strength of expression” in “a more striking and interesting manner” (see Adam Smith’s “Lectures on Rhetoric and Belles Lettres”, 29 November 1762, Oxford University press, 1983, p 29).

His use of the metaphor of ‘an invisible hand’ (only once in Wealth Of Nations and once in Moral Sentiments, and once in his ‘juvenile student’s essay) certainly achieved his literary intention. Pity that modern economists from the 1950s burdened Smith’s achievement with a wholly invented content – not that they can agree on exactly what he meant by it, as a perusal of modern interpretations soon shows careful readers.

So James takes one step towards understanding Smith’s legacy and two steps back by obfuscating his literary meaning with the burden of the wholly invented charge of explaining why “greed” might be “good” under certain conditions of perfect competition (another modern idea unknown to Adam Smith).

Update:
I received a comment from "James" which since has 'disappeared' after I clicked 'publish';

Here it is:

"Sorry, but no one believes an invisible hand actua... Sorry, but no one believes an invisible hand actually exists. Everyone understands that it is only a metaphor. Your claim that "most campuses teach their students to believe that the metaphor is a real object, that it exists" is just plain wrong. It is not just wrong, it is ridiculously wrong."

Update 2:

James, have you read recent economics 101 textbooks lately, let alone those major ones since the 1970s? Also, scroll through Lost legacy and note the comments I make on references to the 'invisible hand of Adam Smith'.

These are all actual refernces spread across the world and media sources.

Look at the professional, refereed, journals, which with few exceptions pass for publication references to the invisible hand in its many guises.

No doubnt, you can find a few examples that contradict my statement, but they are swept aside by the scores that justofy it.

Gavin

Another Great Smithian Metaphor

Peter Boettke writes in The Austrian Economists (HERE):

“Is Adam Smith's discussion of governmental "juggling trick" relevant to our policy discourse today?

Scott has already talked about this at The Economic Way of Thinking, but we should dig a bit deeper into the discussion from Smith's Wealth of Nations, Vol. 2, pp. 929-230. Smith argues in those pages that: (1) when the public debt reaches a certain level, the fiscal system is threatend, but there is not a single instance where a government has paid off the debt fairly and completely; (2) rather than pay down the debt with increased taxes, government's choose "pretended payment"; (3) the prefered method of pretend payment is repudiation through debasement of the currency; (4) this method extends the 'calamity to a great number of other innocent people'; and (5) rather than do the right thing -- which would be least dishonorable to the debtor, and least hurtful to the creditor -- government instead choses to engage in "juggling trick".

Comment
This is a case of the appropriate use of a quotation from Adam Smith’s Wealth Of Nations because it is still relevant, as government debt has increased significantly since the 18th century – in those days debt was raised mainly to fund wars or bribe foreign powers – whereas nowadays government debts fund just about anything that modern, BIG, governments spend taxpayers’ and lenders’ money upon.

Smith wrote while governments were happily inventing new forms of raising revenue for governments from the private economy. ‘Sinking Funds’ to pay-off debt soon became sources of new funds to spend more money, not always, if ever, wisely. Then they added, on a ‘temporary’ basis, income tax , and so it has gone on and on. Today, in Britain’s case, we have ‘stealth taxes’ and ‘quantitative easing’ (printing money), and unheard of levels of debt.

Smith observed that governments managed to avoid paying back all of their debt through various “juggling tricks” (beware: another one of Smith’s metaphors!).

Congratulations to Peter Boettke for picking upon Scott's (HERE) references to government debt and 'juggling tricks'.

I recommend that you follow the links.