Thursday, December 24, 2009

A Reader is Perplexed by Lost Legacy on the Invisible Hand

[A Reader, Ian B, comments on yesterday's post and his question deserves a fuller treatment than afforded by space on the comments page. It raises issues which may of wider interest. My reply follows.]

Thank you, Ian B, for asking your question and for the polite manner by which you express your perplexity and disagreement.

You will note that the blog is about Adam Smith’s Lost Legacy and has been published since February 2005, during which time I have addressed the “invisible hand” on many – probably on most – occasions.

Economics as a discipline has many problems when dealing with the history of its ideas. Among these we can list several ideas wrongly attributed to Adam Smith, the invisible hand being a prime example.

Few people who quote from Wealth Of Nations, 1776, or his earlier, Moral Sentiments, 1759, have read either of his works and many know very little about him. The minority who have read his works, often attribute to him ideas he never had nor expressed. They go with the flow, like a crowd of latter-day flatterers cheering the proverbial ‘naked emperor’.

The metaphor of the “invisible hand”, used only three times by Adam Smith, once only in each in his two books, and once in his ‘juvenile essay’ on Astronomy, commenced when he was a 21-years old student at Oxford. It was published posthumously in 1795.

The metaphor itself, however, was a popular literary metaphor in both classical times, before the fall of Rome, and from the 17th century through to the 21st century (it appears in one of the “Tarzan" novels). I know of over 40 independent instances of its use, many in books in Adam Smith’s library.

Hence, on the starting-line for a debate on the significance of the “invisible hand” for Adam Smith, we have a popular literary metaphor, his use not commented upon in his lifetime by his readers, and hardly commented upon until the late 19th century by anybody. From mid-20th century until today, floods of references to “Smith’s invisible hand” appear – nowadays daily - and so frequently, that the metaphor and Adam Smith are almost synonymous.

Most comments upon his isolated use of the metaphor impute various meanings to it, for which there is scant evidence that Smith regarded it as imputed(your example is fairly common; but there are many others that are complex, general, and even theological).

In brief then, what do we make of the metaphor of “an invisible hand”? You state that the metaphor is: “simply the (surely reasonable) observation that the economy is self ordering due to the selfish actions of its agents.”

With that view you jump two centuries from Adam Smith’s in Wealth Of Nations. My observation is that whatever the truth of your view, perfectly fine if it is your name only, but it was not Adam Smith’s, and the claim that it was is a “myth”.

You may protest that whatever Smith said or meant is less relevant than the “surely reasonable” observation of many economists that the economy is “self-ordering due to the selfish action of its agents”.

Well, of course, Adam Smith did not consider self-interest to be “selfish”; in fact he went some ways to reject selfishness as an operational motive in economic (and social) transactions. In his earlier work, Moral Sentiments, he explicitly rejected such ideas, as expressed by his earlier “licentious” contemporary, Bernard Mandeville in his “Fable of the Bees” (“Public vice, public virtues”), 1734. (There are several earlier posts on Lost Legacy discussing these particular points.)

I shall move on. You confirm that the metaphor of an “invisible hand”, as understood today, is derived from Adam Smith’s use of it in Wealth Of Nations and you assert that there is “plenty of evidence that confirms Smith's invisible hand - the less regulated the market, the more ordered it is”.

Two problems with your assertion: first Smith never said anything like this in Wealth Of Nations, and second, he found in the case of banking in mid-18th-century Scotland that the absence of certain necessary regulations caused turmoil in the banking sector and required the intervention of law, noting, en passant, that even though this was “a manifest violation of natural liberty” it was necessary because their actions otherwise “endanger[ed] the security of the whole society” (WN II.ii.94: 324).

Let us now look at Smith’s actual use of the “invisible hand” metaphor. First, he used the metaphor only once in Wealth Of Nations; second his use had nothing to do with markets, supply and demand, the absence of regulations, or prices. Those associations for it were invented in the second half of the 20th century by modern economists.

Smith discusses the distortion of the British economy by the diversion of merchants’ capital from the home trade to foreign trade in Europe and with the British colonies in North America. From the British monopoly of all trade with its colonies, and the monopoly influence of the Acts of Navigation (imposed since Cromwell’s time), merchants’ foreign trade could be highly profitable compared to local trade. Likewise, in respect of trade with Europe. However, there were higher risks in such profitable trade: shipping losses, poor investments, local fraud in foreign countries and the colonies, and long delays in turning-over capital for re-use.

Some merchants, but manifestly not all, preferred to invest locally in Britain because, though less profitable, it was more secure for them. It was these merchants that Smith focused on:

“…the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, 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” (WN IV.II.ii.9: 456).

All merchants are motivated to use their capital most profitably and the only difference between those merchants who engage in foreign trade and those who engage in domestic trade is that the latter do so because of their concerns for their “own security”. We now call this risk aversion. Smith explains that it is their insecurity that leads them to do what they do. In fact, no other explanation is given nor needed.

However, he goes on to point out that their actions have unintentional and unintended consequences, specifically that “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it”, and it this outcome (society is wealthier, measured by the “annual output of the necessaries, conveniences, and amusements of life”, or what we now call GNP) that people are “led by [NOT “as if by”] an invisible hand”.

But he has already identified the subject of the metaphor: their “own security”. And here we can agree: “no such hand actually exists”, but much of the profession, since the 1950s, has come to believe that there is “an invisible hand”, guiding the market, prices, supply and demand, general equilibrium, social harmony and so on, and on most campuses teach their students to believe that the metaphor is a real object, that it exists, when manifestly it doesn’t, at least to Adam Smith.

It is that “part of Smith's invisible hand [which] is mythical” in my view.

I hope I have elucidated the issues which you raise and reduced, if only a little, your “perplexity” upon reading Lost Legacy for the first time.

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Blogger Ian B said...

Gavin, thank you very much for your full answer. It has given me a great deal to think about. I freely admit that I had no idea that the "invisible hand" was a literary metaphor which long predates Smith.

To discuss all the points you raise would require a very long comment. I'll pick a couple.

Firstly, my use of the word "selfish" should be read as "self interest". "Selfish" is a moral(ist) judgement which implies, um, an unfair self interest (e.g. seeking for everyone at a meal to pay equally towards the bill when one has been a glutton and consumed far more food and wine than other diners). I would normally say "self interest" but it's a bit of a clumsy construction and one's writing isn't always at its best in these tiny comment fields. And, if I'd had longer, I'd have written less as the saying goes :)

One other point is that banking isn't a very good economic sector in which to compare free market versus regulation. In our society at least, it is inextricably linked with government, as are some other sectors e.g. military equipment manufacturers, whose primary customers are the State. It can be not unreasonably argued that "regulation" of such sectors is really an attempt to offset the non-market aspects of their very existence. Austrians argue for totally free banking, and that no regulation would be required of a truly free banking system. All we can say about reality as we find it is that we are so far removed from free banking that attempting to apply a market analysis to banking and financial services is a long way removed from their real operation.

You also said,

And here we can agree: “no such hand actually exists”, but much of the profession, since the 1950s, has come to believe that there is “an invisible hand”, guiding the market, prices, supply and demand, general equilibrium, social harmony and so on, and on most campuses teach their students to believe that the metaphor is a real object, that it exists, when manifestly it doesn’t, at least to Adam Smith.

I'm not quite sure what to make of this part of your answer. If we consider the Invisible Hand (whether correctly attributable to Smith or not) as being a statement that markets self organise- that is, that order arises from complexity- it is simply an observational law which applies not just to economics but other fields which study complex systems such as biology. The "invisible hand" functions in an ant colony, in which ants following simple (genetically hardwired) rules at the individual level produce complex colony-wide organisation. I don't see that stating that is declaring the ant colony's "Invisible Hand" to be a "real object".

I think there is a eulogisation of market forces which (incorrectly IMV) implies that they are some kind of control mechanism which deliberately maximise some arbitrary statistic, such as GNP. In fact, they don't. They tend towards improving an unmeasurable thing, the satisfaction of personal desires, and that happens to generally coincide with improvements in productivity and thus economic growth (and thus this thing, "GNP"). It seems to be widely believed on "the Left" that economic growth is designed into the economy by choice, and thus that it can be designed out to save the planet, or whatnot. But growth is simply a by-product of improvements in productivity, which tend to occur as we all pursue our self interest.

I'm not sure I'm putting this very well. My reading of classical economics is that it is the investigation of how such things as equilibrium or growth arise out of the spontaneous behaviour of individuals. I don't think Smith, Say or Bastiat would treat these phenomena as "real objects" if I understand your use of the term correctly, so in that case I would agree with you. But I'm not sure I've understood you correctly :)

11:42 am  
Blogger Gavin Kennedy said...

Hi Ian B:
In discussing self-interest and selfishness in relation to economics, your viewpoint may have validity, because the distinction between these ideas is not as apparent as it was to Adam Smith and his philosophical contemporaries, and there is a major distinction because of this among those discussing Smith’s ideas today.

Self-interest is central to Smith’s philosophy and, of course, his political economy is distinct because of it – we all have self-interests, but we are not all selfish all of the time.

When we discuss the extent to which Smith opposed government regulation (a view expressed in debates today) we refer to the early days of banking (each bank issued its own currencies in Scotland and the Act Of Union with England in 1707 asserted the right of Scottish banks to do so. This was changed in subsequent British legislation in World War II, though leaving the right to issue their own designs of bank notes, but as a ceremonial addition only to the Bank of England currency, still practiced today.

Smith is presented as opposed to all government regulation by many today (he is even identified as responsible for those who allegedly ‘de-regulated’ the banks before the current recession), but the facts are, taken from Wealth Of Nations, that Smith, in two clear examples, was concerned that the Banks needed regulation in the cases of usury or very high interest rates, and in issuing low denomination ‘promises to pay’ (in gold) the face value of such notes. Hence, this has nothing to do with modern-day practices. Smith was dealing with mid-18th century banking practices, but the claim/charge that he opposed banking regulations falls on the evidence of these two instances.

The existence or otherwise, actual or metaphorically, of the invisible hand is not an issue on Lost Legacy. But since mid-20th century, most modern economists have taken the metaphor used by Smith and, so to speak, “re-purposed” it (after Hayek and others) as being a perfect image (if we can see the “invisible”) for modern ideas about “spontaneous order” and associated ideas. Now while such rhetoric is legitimate, it is not legitimate, in my view, to associate it with Adam Smith’s limited use of a popular literary metaphor of his day to implicate his use as of the same order as Hayek’s and others.

Also, mathematical models of general equilibrium in markets also seek their paternity in Adam Smith to legitimize their ‘proof’ that markets clear without the aid of human interventions, and thereby they are superior to state planning. (Remember, this was the early period of the Cold War and very real threats were felt in the US from the intentions and practices of the Soviet Union – the communist take-over of Eastern Europe.)

Now, I believe that commercial societies are superior to state planning – and state capitalism – but I do not believe that mathematical models of general equilibrium are a necessary part of the proof of that superiority. The state is necessary to create, preserve, and operate the liberal-capitalist institutions that are necessary for all markets – from village fairs to the Stock Exchange – to function to their full effect.

This takes us back to Adam Smith’s political economy, both its economics and the politics (justice, separation of powers, liberty, moral sentiments and sociability). It brings humans back into the imagined economy.

Best regards


11:06 am  
Blogger James said...

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.

11:37 pm  

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