Saturday, November 18, 2006

Adam Smith's Invisible Hand: simple literary metaphor or deep theory? (Part One)

A correspondent asks me why I am hostile to the common attribution of ‘the invisible hand’ to Adam Smith as a ‘theory’, to which I replied as below (I shall add some other comments later as Part Two):

Book IV of Wealth of Nations contains Smith’s critique of mercantile political economy. To understand the metaphorical role of ‘an invisible hand’ in its proper context in Smith’s Work it is essential to follow his application of his growth model to a particular set of problems that dominated (and in many senses, still dominates today’s) public policy, namely that of international trade.

Chapter II is headed: ‘Of restraints upon the importation from Foreign Countries of such Goods as can be produced at home.’ It is not about a theory of markets (covered in Book II).

Import duties and prohibitions are part of the policy of securing monopolies for domestic producers. He gives examples in live cattle, salt provisions, woollen goods, silk, linen and many other unnamed goods coming under outright prohibitions. The result is that various species of industry enjoy a greater share of labour and capital than in the absence of tariffs and prohibitions they would obtain, but whether this adds to or lowers a country’s wealth is open to empirical testing.

Smith states an earlier proposition that industry cannot exceed what society’s capital can employ, and therefore, no regulation of commerce can exceed this barrier at any one moment; regulations only divert the amount of capital and labour distributed across industry in the absence of such regulations, i.e., how capital and labour would be allocated if left to its own accord. Combine this technical constraint with the assertion that each individual exerts himself to find the most advantageous outlet for his capital and labour for ‘his own advantage and not that of society’, he establishes why this can result in the most advantageous distribution of capital and labour for society.

His first assertion is that individuals endeavour to employ their capital as near home as they can, which consequently benefits domestic industry (in the sense that capital accumulation and the employment of local labour are local).

Smith’s growth model is fairly simple: ‘stock’, initially the form of a ‘grub stake’, evolved to maintain the hunter between kills, some times lasting a few days; the basic features of saving from today’s kill (inclusive of gathering) to maintain the hunter’s productivity until the next kill, remains right through to shepherding/farming, and latterly commerce (his Four Ages of mankind in LJ). Out of frugality, the primitive accumulation of capital commences, driven by the ‘propensity to exchange’ and the ‘division of labour’. That is not a perfect relationship because with each production round – capital and labour combined to produce an output – there are leakages from the output in the form of above necessary consumption (prodigality) above a subsistence minimum, losses from disastrous investments or futile hunts, robbery and fraud, wars and ostentatious frivolities, as well as capital moved abroad.

The reproduction cycle consists of the separation of products into immediate consumption (inclusive of longer lasting items like consumer clothes, shelter, and furniture, etc.) and productive investment to replace used up capital, plus net increases to employ additional capital and labour. Where the former is ‘too high’, net investment will be negligible, and may barely maintain the capital base; where the latter is optimal, net growth of the economy will proceed fastest, and progress towards opulence will be quickest.

The wholesale merchant prefers the home trade to the foreign trade for consumption (imports) and both to the carrying trade on ‘security’ grounds – capital stock necessarily is small and losses not easily absorbed (ruin is only one or two disasters away). Smith makes the point that capital circulates back to the home trade quicker than foreign trade. The merchant knows the people he deals with better than foreigners (including people in distant parts of the same country) and he trusts or avoids those he knows best. He is also familiar with his country’s laws and how to go about redress, in contrast to dealing with traders in foreign countries, where the law may be less certain and the magistrates biased against foreigners.

These circumstances dictate higher returns for greater risks and great prospects of ‘trouble’ in foreign trade. For equal profits or slightly less, a merchant still prefers the home trade (and local business). Capital in the home trade necessarily puts into motion a greater quantity of domestic industry, putting into employment a greater quantity of local labour and a greater revenue than the same capital engaged in distant sales and purchases (because they employ foreign labour, which spend in their locality). This causes individuals to employ their capital in a manner that supports domestic industry and gives employment and revenue to a greater number of local people.

This is a summary of the logic of Smith’s assertions. It is a natural outcome of his growth model (local net revenue after replacing capital used in the production cycle, paying the wages of labour and paying profits and rents to the merchants and landlords).

At the merchant level, each individual necessarily endeavours to direct his industry so as to produce the greatest possible value (he would be ‘perfectly crazy’ to do otherwise). This manifests itself in the added value supplied by labour to raw produce. Profits are the marker from adding the greatest value, and merchants have an identifiable quantity to measure their success or likely success in their ventures, or failures.

At the macro-level the annual revenue (GDP) of society is the sum of the exchangeable value of the total produce of industry, it follows therefore that with every individual merchant attempting to maximise their profits also necessarily maximises the annual revenue of society, the aggregate being the sum of its individual parts.

Now, this is a case where the public interest coincides at the aggregate level with the personal endeavours of those individuals endeavouring to maximise their own gains. For this to be affected, it does not require that the individuals recognise, or intend, the aggregation of their endeavours to be maximised on behalf of society. In this case, ‘as in many others’, the aggregated outcome follows from the sum of the disaggregated parts, provided they are motivated in the manner suggested by Smith.

The twin motivations of preferring domestic to foreign industry (security) and applying scarce capital and employing labour so as to maximise profits (personal gain), they cannot help but maximise national output and annual revenue. The rhetorical metaphor for this process (the whole is the sum of its parts) is that it is ‘led by an invisible hand’!

Nothing magical, nothing mystical, and nothing particularly Smithian. Add water by the teaspoonful to a tank at any moment it is the sum of the individual teaspoonfuls. What physicist would require a metaphor to describe this outcome, especially by calling it ‘an invisible hand’?

Moreover, it does not require a statesman, lawgiver or planner to tell individual merchants how to go about their business of maximising their profits. They are incentivised to do so by the penalty-threatened judgements of the proper, secure, and profitable use of their scarce capitals and the employment of available labour. They know that to make what they can buy cheaper from elsewhere (including abroad) reduces the available capital for productive investment in the business of transforming capital into added values that rewards them with profits after meeting their costs. If it doesn’t, they withdraw from one business and enter others (under Perfect Liberty).

I might comment that if prices shift, consumers (not all of them) often shift their consumption patterns and in aggregate the revenue of the sellers’ rises or falls (led by ‘an invisible hand’ or the predictable consequence of aggregation of flows?). Likewise, when taxing a commodity to raise revenue or discourage consumption, or both. Micro changes have macro consequences. Big deal!

This is a summation of Smith’s analysis of the first part of Chapter II of Book IV.

(Part 2, Monday)


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