How to Mess Up an Interesting Essay

Stuart Kauffman (University of Vermont) writes an essay on utility theory (Edgworth Box diagrams, Gerald Debreu’s general equilibrium, and the Gund Institute, “value” of “bads” as opposed to “goods”) in NPR (?) (HERE):

“Current economic utility theory derives from the utilitarian ethical theories of Bentham and Mill: act for the greatest good (utility) of the greatest number. This becomes a "social welfare" function that Adam Smith's Invisible Hand was to insure.”

Comment
Modern utility theory (1870s onwards) has little to do with Adam Smith (despite Bentham’s early musings) and “social welfare” functions have even less to do with his singular use n Wealth Of Nations of the metaphor of “an invisible hand” in terms of the modern misleading and fallacious attributions of modern economists (post-Samuelson, 1948) and post-Pigovian (1923) Welfare Theorems to Adam Smith.

What is meant by stating that “Adam Smith's Invisible Hand was to insure” a “social welfare” function is a mystery beyond comprehension. Stuart Kauffman perpetuates a modern myth about Adam Smith.

New Book Exposes Modern Economics to Scrutiny

Yanis Varoufakis writes on a “A Manifesto for Modern Political Economics”
HERE

Yanis Varoufakis, Joseph Halevi, Nicholas J. Theocarakis,
MODERN POLITICAL ECONOMICS: MAKING SENSE OF THE POST-2008 WORLD. Routledge, 2011. £45.

‘Blanchard had this to say about the Nash-Debreu-Arrow formalist project and the theorems it spawned:

“More than 200 years ago, Adam Smith explained that in a market economy individual egoisms combined to bring about the best possible outcome for the community. This proposition was so surprising and so full of consequences that it became necessary to understand its nature and its limits. Thanks to Walras at the beginning of the 20th century, and furthermore thanks to economists like Arrow or Debreu fifty years later, and especially thanks to a huge effort of abstraction and to powerful mathematical tools, the conditions of Adam Smith’s theorem have been clarified.”

Leaving aside serious doubts that Adam Smith would approve of what Walras and the formalists allegedly did in his name, Blanchard goes on to interpret the Nash-Debreu-Arrow theorems as follows:

Having clarified the necessary conditions required to satisfy the Adam Smith theorem, research has been directed almost entirely into investigating what happens when the conditions are not satisfied. Namely, why some markets work badly, and what type of institutions have to be put in place in order to improve their working.”

Note the leap of undiluted faith from the formalist model to the real world. Blanchard’s claim is that the formalism can help us understand why some real markets work badly. It is as if Gerard Debreu had never issued his legendary warning that “…the theory…is logically entirely disconnected from its interpretations”.

The whole Blanchard argument is a complete non sequitur. No investigation of the circumstances under which a Walrasian General Equilibrium will not obtain can illuminate the causes of real market failures. Why? Because the theory hangs together only under assumptions that push it onto a universe in which real capitalist markets could not, physically, exist. Is it not the duty of a leading textbook writer to spell this out? Anything less, we submit, is intellectual poison, especially for the young minds who treat a famous textbook writer as an authority on the subject-matter.

Alan Kirman (1989), one of formalism’s leading lights, sums up our conclusion thus:

“In conclusion, then, it is worth repeating that recent theoretical work has shown how little the Walrasian model has to say about aggregate behaviour. Economists therefore should not continue to make strong assertions about this behaviour based on so-called general equilibrium models which are, in reality, no more than special examples with no basis in economic theory as it stands.”

Does Olivier Blanchard not know this? He ought to, and we think he does. But such is his ideological inner drive to argue that his policy recommendations are founded on a bedrock of good mathematics, that he is being economical with the truth. More disturbing even than this naked act of dishonesty is what Blanchard and his merry colleagues do in order to arrive at their policy recommendations (e.g. the ones he pushes onto the world community as Chief Economist at the IMF): Given the utter inability of Walrasian or Nash-Debreu-Arrow theorems to say anything tangible about the real world, they return to the single sector or Robinson Crusoe types of economies. There is nothing like strong (often austere) economic policies derived from false premises to inspire sheer horror in the hearts and minds of those in the know.

Comment
I am glad that Yanis Varoufoakis made this comment in passing because this otherwise treats the invention of Paul Samuelson in 1948 in his ‘Economics: an analytical introduction’ of Adam Smith’s use of the invisible hand metaphor as something that Smith actually said as regular readers of Lost Legacy will know by now.

However, the new book looks very interesting and gives a fierce critique of general equilibrium economics and much else in modern economics, which causes me to urge that it be consulted. From the article, of which the above is only a snippet, I recommend that your follow the link.

The Misunderstood Invisible Hand (Part 94)

‘amv’ posts in ‘coffehouse eonomics’ (A Tour Guide to Economics–Field Reports of Four Hohenheim Grads) HERE:

'Again the invisible hand: I just can't get enough (amv)'

“Adam Smith‘s ‘invisible hand‘ is a poetic expression of the most fundamental of economic balance relations, the equalization of rates of return, as enforced by the tendency of factors to move from low to high returns.[...] Smith also perceived the most important implication of general equilibrium theory, the ability of a competitive system to achieve an allocation of resources that is efficient in some sense. Nothing resembling a rigorous argument for, or even a careful statement of the efficiency proposition can be found in Smith, however.”
(Arrow, Hahn 1971: 1-2) [General Competitive Analysis, San Francisco: Holden Day]

Comment
Arrow and Hahn in the same article described the invisible-hand ‘as surely the most important contribution [of] economic thought’ for something they invented themselves. For Smith the invisible hand certainly could be described as a ‘a poetic expression’, but it had, for Smith at least, nothing to do with ‘the equalization of rates of return, as enforced by the tendency of factors to move from low to high returns’, nor did Smith actually write anything about ‘the most important implication of general equilibrium theory’, and as for it achieving ‘an allocation of resources that is efficient in some sense’ that is hardly a recommendation – an efficient allocation, or a Pareto optima, could include a grotesque maldistribution of income such that millions starve and a few don’t, but nobody can be made better off without a few others being made worse off.

‘amv’, a graduate, would know about the limitations of welfare ‘efficiency’ criteria, but having bought into Arrow, Hahn and others’ expositions of the ‘invisible hand’, and not having read Smith closely enough, she/he makes a mistake.

‘amv’ even quotes paragraph 9, Book IV, chapter ii, page 456 of Wealth Of Nations, but clearly has not read and understood the immediately previous 8 paragraphs of Smith’s exposition. If she/he had done so, the idea might have dawned that Smith was writing about something other than what Arrow, Hahn, Samuelson others imagined and invented in mid-20th century.

Arthur Pigou and the Invisible Hand

Thom Lambert writes (19 April) in the Truth on the Market Blog http://www.truthonthemarket.com/2010/04/19/some-warnings-for-modern-pigovians-from-pigou-himself/:


“Some Warnings for Modern Pigovians (from Pigou Himself)”

“These various interventions to correct for externalities are the brainchild of Cambridge economist Arthur Cecil Pigou. Writing in the 1920s, Pigou recognized that negative externalities would result in “too much” of an activity and that positive externalities would result in “too little.” He thus concluded that when externalities exist “[n]o ‘invisible hand’ can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts. It is therefore necessary that an authority of wider reach should intervene.”

Specifically, he asserted, [i]t is … possible for the State, if it so chooses, to remove the divergence in any field by ‘extraordinary encouragements’ or ‘extraordinary restraints’ upon investments in that field. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes.

In other words, the government should tax activities that create negative externalities and subsidize those that create positive externalities, thereby ensuring that the actors at issue bear the full costs and benefits of their conduct. If they do, they’ll act optimally, taking all actions that create benefits in excess of cost and none that don’t. Thus was born the idea of “Pigovian” taxes and subsidies — the notion underlying the proposed climate change legislation, President Obama’s bank tax, the various subsidies for electric vehicles, and scads of other government interventions into private affairs.”

Comment
This is a relevant point by Arthur Cecil Pigou (1877-1959), author of The Economics of Welfare, 1920 because it illustrates what his generation of economists were thinking of the phrase, the invisible hand, in those decade before Keynes’ General Theory. Pigou developed an economic rationale for welfare intervention in the externalities evident in a complex capitalist economy, and it sparked a massive interest in what became known as welfare economics that peaked in the post-war years up the 1960s (Kaldor, Hicks, Coase) and led to several spin-offs, including public choice theory. (‘Welfare economics’ was not just about social welfare re-distributive policies of modern states.)

The sentence: ‘“[n]o ‘invisible hand’ can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts’ recognizes a conventional and mistaken treatment of the ‘invisible hand’, later popularized by such as Paul Samuelson, and comments on its practical validity.

This created the divergence between those of saw the need for a theory justifying intervention and those who preferred to rely on markets to act out what they claimed for them, using the ‘invisible hand’ as the ‘miraculous’ power of markets to create the ‘best of all possible worlds’.

Memories of a Wasted Youth

The Hesitant Hand by Steven Medema (Princeton University Press, 2009) Part Four: Chapter 3

This book gets more and more interesting as the author develops his theme of tracing how self-interest was gradually addressed by successive generations of economists and how it both changed its meaning and its application from the classical through to the neoclassical schools.

Chapter 3 is headed : ‘Marginalising the Market: Marshall, Pigou and the Pigovian Tradition’. It sets out the story of how Marshall, followed by his successor, Pigou, changed the terms of the debate through to the 1930s.

In what is called the classical school, ‘laissez-faire’ dominated the policy debate, though whether the participants in academe and the policy makers in the state (and those who influenced them), plus of course the business entrepreneurs, all agreed on what their respective roles were, or even what they thought the roles of the other participants were, is an altogether different matter.

One thing had certainly changed since Smith’s time. The size, importance, and independence of the state (legislators and civil service), and its prospective roles as the decades slipped by, certainly was very different from the smaller, more widely corrupt and corrupting, and largely not very competent performer, of the 18th - early 19th centuries, was by the 1870s onwards a larger, less criminally corrupt (though persuadable by informal relationships, now professionalised as lobbyists), and more competent administration than ever before.

The duties of the state were no longer only as set out in Wealth Of Nations, or Mill; they had become diverse at national and local government in levels. Public finance was giving way to what became public choice, with political and economic analysis to match.

Marshall was suspicious of old ideas of laissez-faire, which in the form it had taken was regarded all round (Sidgwick) as less than reliable, and anyway did not address how public goods fitted into the frame. Much was spoken about how markets were better than alternatives – they were, but not in isolation from the burgeoning roles taken on by governments, and nor was laissez-faire typical of competition (certainly as seen by business – and politicians – who, it is suspected never really understood what laissez-faire meant in practice.

Marshall sought a means to justify the social superiority of competitive markets and came up with ‘consumer surplus’; Pigou took it further with his model of market failure in ‘net social product’ and ‘net private product’, both entwined with notions of ‘decreasing’, ‘constant’ and ‘increasing’ returns. Their cases were almost convincing, though whether anybody could apply them in practice was another matter.

Pigou’s ideas were the most developed and appealed at the macro-level, at least to theorists and politicians (and their civil servants). In the latter case, the theoretical case for bigger roles for the state was welcome; in the former the incitement to theoretical development was irresistible, and fashioned a spate of high theory in welfare economics, competition theory, including monopoly, oligopoly, and monopolistic competition, and, of course, the Keynesian decades. All of which was accompanied by the longish march to mathematics and the goal of economics as the undisputed champion of science among its less scientific sister and, more distant, co-disciplines.

Pigou’s role is clearly explained by Steve Medema – the best part of The Hesitant Hand so far – and it is all the more instructive for that. It was not a case of state action and laissez-faire being sharply different – even at odds with each – but of their necessary dependence on each other (massively increased by the vast public expense of the recent war).

A modern state could not finance itself adequately without the productivity of the competitive market and a competitive market cannot be productive without the functions of an efficient state (‘unless robbery under arms is restrained by law, fraud repressed, and contracts which have been formally accepted enforced’, wrote Pigou in 1935).

Perceptive readers will find much in Pigou that lines him up with Adam Smith, although vulgar epigones will confront an Adam Smith , from Kirkcaldy, who is a complete stranger to those who have never seriously read his books, and who spout with the total conviction of the ill- informed a completely alien set of thinking about what Adam Smith actually observed and pragmatically advised.

Pigou had the measure of the those who went beyond the role of the state within its level of competences, who looking backwards and can see where current business policies began to go wrong – firms both made money and lost it because their futures are unknowable, except afterwards - whereas armed with the certainties of the present about the past, the public servants develop an overblown enthusiasm for state planning (‘spotting winners’, etc.,), for which Britain, among other European countries, adopted a taste for from the 30s onwards.

With laissez-faire (the name awarded to the fiction that Britain had such an economy) and the fiction that business and government were separate entities, run by disinterested public servants (actually as self-interested as anybody else, but with the public funds and the weight of public problems self-evident before them), the debate about policy issues became completely muddled, mixed as it was with the electoral arithmetic complicated by notions of socialism in its various guises.

As Steve concludes, quoting Pigou:

‘What this theory (neoclassical welfare analysis) demonstrated, in a nutshell, was the perfect markets work perfectly, imperfect markets work imperfectly, and perfect government can cause imperfect markets to also function perfectly. ....The role of government vis-a-vis the market was no longer an a priori set of assumptions nor an opinion based upon casual empiricism; it was demonstrable in a “scientific” sense’ (p76).

As a student of the 1960s, I recognise the truth of Steve’s summary, and the analysis of Pigou’s largely unread work, somewhat overshadowed by Keynes (I have a copy of Pigou's Welfare Economics in my library) leading up to it, and all the events following it.

What a wasted youth that amounts to!

I recommend readers to read Steve Medema’s Hesitant Hand (Princeton University Press).

[Next up is my review of Steve’s treatment of Italian public finance.]