Tuesday, May 23, 2006

Part Two of a Review of 'Knowledge and the Wealth of Nations'

Review of David Warsh, ‘Knowledge and the Wealth of Nations: a story of economic discovery’, Norton & Co. New York, 2006

Part Two

I have now completed the book. It is a good read and will be enjoyed by both specialist economists and general readers alike; the former will know the theories Warsh refers to and the latter can get an idea of the theories from his verbal account of them. It also sparked my interest in re-looking over a few of the theorists’ models of growth from my student days, which says something about its ability to get at least this reader’s attention.

However, my disappointments, as expressed, perhaps a little too brusquely, in Part One after I had read six chapters, are not totally assuaged now that I have reached chapter 27 and the book’s conclusions. Of the controversies over the maths of competing economic growth theories, I shall say nothing. Like the sex life of a rhinoceros they are of compelling interest only to other rhino’s.

David Warsh presents a version of Adam Smith at variance to what Smith wrote about. If his book did not mention Adam Smith at all it would be a good read, but if a reader has read Adam Smith his mentions by Warsh are irritating in the extreme. Consider:

Ever since Adam Smith the most important proposition in economics has been the proposition that, left to their own devices, individuals will pursue courses that lead, as if arranged by an Invisible Hand, to the outcome that is “best overall” (Warsh, p 365).

This is just not true in respect of Adam Smith. It may be true as a proposition by modern economists, most of whom never read Adam Smith and take their notions about his work second- and third-hand from their tutors. Smaller point: note how Warsh has slipped in the words ‘as if’ before invisible hand; these were never used by Smith at all (see WN IV.ii.9: p 456).

Warsh continues: ‘Economists have refined Smith’s intuition to a very fine grain. The efficiency of decentralised competitive markets under certain conditions is what Kenneth Arrow and Gerard Debrue demonstrated mathematically in the early 1950s, leading to an eventual Nobel Prize. It was then that economists began to talk of the Invisible Hand theorems as propositions so well established as to have been proved.’

Unpacking the errors in this paragraph is necessary. Arrow and Debrue did ‘demonstrate that decentralised competitive markets’ were ‘efficient under certain conditions’; they did receive a Bank of Sweden Prize in memory of Alfred Nobel; and no doubt many economists did begin to ‘talk of the Invisible Hand theorems’ as being ‘proved’.

But what they did not do was work with ‘Invisible Hand theorems’, Smith’s ‘intuitions’ or ‘prove’ them, because there were no ‘Invisible Hand theorems’ from Smith’s ‘insights’ to ‘prove’. He was not advancing ‘theorems’ about competitive markets when he used the lonely metaphor, the invisible hand, to state a consequence of human motivations on an entirely different subject to ‘competitive markets’. The myth that there were ‘theorems’ of an invisible hand to prove is purely a fiction of modern economics, culled I think from Chicago economists in the 20th century.

Smith never argued the ‘the proposition that, left to their own devices, individuals will pursue courses that lead, as if arranged by an Invisible Hand, to the outcome that is “best overall”. He was talking about relately poor tradesmen who were concerned about the safety of their scarce capital, preferring to use it close by where they were and not to send it out of sight because of the risk (their ‘security’). He was not discussing markets at all (he had already covered markets in Book 1; his single reference to the invisible hand comes in Book IV). He was discussing the consequence in this circumstance of trading locally, where you could see the user and be more assured of being paid, or trading abroad at much greater risk (this was the 18th century) dealing with people you did not know or see. Insecurity inhibited international trade and the 18th and 19th centuries were about devising more secure means of international trade and payments.

On this occasion, if fear and risk drove owners of capital-stock (artisans and tradesmen) to keep their activities close to them, then whatever their intentions and lack of concern for the public good, it would mean that capital accumulation would be aided locally by their individual decisions and not dissipated by spreading it a long way from them.

However, it cannot be generalised into a theorem that any individuals ‘left to their own devices, individuals will pursue courses that lead … to the outcome that is “best overall”. Smith was a Professor of Moral Philosophy, not a naïve reformer of the world. Individuals ‘left to their own devises’ can, and do, act in a manner which most decidedly does not ‘lead … to the outcome that is “best overall”. One has only to think of the Tragedy of the Commons to realise that such a proposition would be absurd, plus pollution, fraud and dangerous products.

Generalising from this, as David Warsh does, leads to a sense of comfort in the maths of ‘perfect competition’, to which I would draw attention to Smith’s comments on ‘The man of system … who imagines he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess board’ whereas ‘in the great chess board of human society, every single piece has a principle of motion of its own’ (Moral Sentiments,VI.ii.2.18: p 234).

Finally, the Pin factory is not the entirety of Smith on the division of labour. It was a single, ‘trifling’ example ‘often taken notice of’ by others ,to open a discussion on the productive powers of labour (WN I.i.3: pp 14-15). Generalising from this partial point, Warsh and others have seen this as a statement of ‘increasing returns’, which, of course, collides with ‘diminishing returns’, if we conceive them as complete opposites. I should imagine that maths minded economists would be wary here; it depends on where on the curve a factor is at, and nothing is implied about infinite increasing returns.

Smith’s second example is that of the sectors that contribute to the manufacture of a common labour’s woollen coat (WN I.i.11: pp 22-24). These inter-sector linkages are what makes an economy grow, and not just a single item (pins). Economies that consist of many markets (not just one!) are growing towards opulence (here Smith compares the poorest Scottish labourer favourably in opulence to that of an ‘Indian prince’). It is not just the technology or knowledge of the pin makers, but of all labourers and capitals intersecting in ever more complex sets of markets within which growth operates.

By aggregating capital and labour factors to look for the causes of economic growth, a big something is missed. That it has taken 200 years to realise this, suggests our science has been a trifle myopic.

I found this aspect most interesting in Warsh’s book. I recommend that you read it, contemplate its messages, and, like me when I had finished it, think about what you were doing while the growth controversy was joined by only a few, albeit brilliant, giants who tried to look at the ‘big picture’ but they could not see what was going on around their feet.

Visit David Warsh's Blog at www.economicprinciples.com

I posted a comment on David Warsh's Blog but either I did it wrong or it was censored. If my rhetoric was a bit abrasive I apologise for any upset this may have caused.


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