Tuesday, March 06, 2012

How Modern Economists and Journalists Fail

Christine Shearer, a postdoctoral fellow in Sociology at the University of California, Santa Barbara, reviews John Cassidy: “How Markets Fail: The Logic of Economic Calamities”, (Farrar, Straus and Giroux, 2010). She is a journalist at “The New Yorker” and posts on Left Eye On Books HERE

“Is faulty economics at the root of t he global financial crisis?”

“Cassidy begins with Adam Smith’s “The Wealth of Nations,” widely regarded as the precursor to the modern discipline of economics. Smith laid out a vision in which rational self-interest and competition can paradoxically lead to the greater good for everyone and national economic prosperity. As Smith put it, each individual “intends only his own gain, and he is in this [is] led by an invisible hand to promote an end which was no part of his intention.” In making this argument, Smith’s vision of how societies and economies operate was highly utopian, as Robert Heilbroner’s “The Worldly Philosophers” explores

Christine Shearer (a postdoctoral fellow), does not say where in his texts Adam Smith claimed that “rational self-interest and competition can paradoxically lead to the greater good for everyone and national economic prosperity”, nor what is meant by “rational” self-interest (a similar popular assertion often presented as “enlightened” self interest”). It is too easy to slip from modern language to read into Adam Smith what is not there, as it is to find in his Works a “leftwing” Adam Smith.

She also allows Cassidy to get away with doctoring a quotation from Adam Smith to give an entirely different slant on it compared to Adam Smith’s clear language:

“Here is the full quotation from Adam Smith (with Cassidy’s rather reduced and brutal version emphasised):

But 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 domestick 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 publick interest, nor knows how much he is promoting it. By preferring the support of domestick 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.9: 456 – also read paragraphs 1 – 8 to confirm the Smith’s restricted context).

Smith’s was not a general statement of what every individual merchant in a society did, but what some specific merchants did, who “intend their own security” and who were averse to sending their capital out of their direct sight and control, into the “foreign trade of consumption” - see the previous 8 paragraphs of Book IV, chapter 2, Wealth Of Nations.

Cassidy (like many others who quote but do not report Smith’s entire argument) misses out Smith’s clear statement of the specific case he identified of some, but not all merchants, preferred to invest in “domestick to that of foreign industry”. This group “intend only [their] own security”, and, in consequence, they “direct that [domestick] industry [so] that its produce may be of the greatest value”. This means that “every individual” in the specific group he identified (not necessarily every individual merchant in a commercial society), so motivated, “necessarily labours to render the annual revenue of the society as great as he can.”

This is not a general statement of what happens universally across an economy in every individual merchant. Adam Smith states the simple consequence of the actions of those specific merchants who invest only at home: they necessarily add to annual domestic revenue (GDP) by exactly the arithmetical amount of their domestic capital investment – the whole is the sum of its parts! It is not a “vision” or anything like one. It was a limited quantitative consequence of the risk aversion of some, but not all “individual” merchants.

Clearly, foreign trade was an important element of British GNP, but a sizeable number of other merchants did send their capital abroad in the quite extensive British merchant marine (thanks to the Navigation Acts from Cromwell’s time), thereby denuding “domestick industry” of that quantity represented by their capital, which necessarily reduced UK “annual revenue and employment”, though for other reasons not gone into here, annual GDP would be smaller if nobody invested abroad. Smith, remember, favoured overseas trade. Exports to buy imports added to the range of domestic consumption in the form of imports, assuming domestic “merchants and manufacturers”, and other self-interested parties did not prevent imports by agitating to impose mercantile tariffs and prohibitions, the main target of Smith’s “violent attack” in his critique in Wealth Of Nations.

That modern economists continue to misread Adam Smith – or more correctly, simply quote blindly the assertions of others without reading Wealth Of Nations – is itself a comment on modern ‘scholarship’, and perhaps on modern journalism too that repeats these myths – what happened to news journalism’s fabled “fact checkers”?

Christine Shearer takes from Cassidy that Adam Smith held the view “that individual self-interest operating in a competitive marketplace produces the conditions under which a society thrives paved the way for utility maximization theories [from the late 19th-century] and general equilibrium theories, [from post-1940s] leading to models of self-equilibrating, rational markets balanced out by the forces of supply and demand. Cassidy notes [she tells us] that many of these same modern theorists are aware of the shortcomings of their ideas: that “they often only held up under certain conditions (and often very restrictive ones), or could not be demonstrated empirically, making them grounded more in abstract equations and theory than observable reality. He argues that, in fact, it is well-established in mathematical economics that there are several problems with the theories, particularly that there is no guarantee that an economy will settle on an “efficient” rest point. These theorists, Cassidy argues, therefore rarely posed their studies as prescriptions for government policy.”

This type of thinking gave “credibility to the ideology of the ‘Efficient Markets Hypothesis’ as the best approximation for how financial markets operate”, with results that are evident today. True, some financial firms made profits on such theories, but as many others made losses. None of this had anything to do with Adam Smith. He was dragged into supporting these theories, and especially those associating him with the “invisible hand”, when, in fact, he was innocent of any connection with them. The views that he was complicit are inventions and distortions (of the kind that originated in misquotations of the famous “invisible-hand” paragraph, like those of Christine’s above), from the 1940s, which had more to do with the Cold War decades, than they had in historical fact. For which, Paul Samuelson was a major instigator of the claim from 1948 that Adam Smith supposedly set the “invisible hand” myth running, so that today that belief is rampant.

I note (not as criticism – people have a right to believe what they like) that Christine Shearer is of a “leftish’ disposition. It is somewhat ironic that she criticises “rightish” theories but, apparently, she too has bought into the same myths about Adam Smith, which myths achieved traction during the Cold War in the Western effort to counter Soviet central planning as an alternative to commercial markets, with the planners taking over the invented role of the “invisible hand” (see Oscar Lange’s books from 1938-47). Such myths impugn Adam Smith’s legacy. He died over 150 years before the Cold War came to be part of modern intellectual discourse and lasted until around the 1990s.

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Blogger Paul Walker said...

Let us assume for the moment that Smith never used the term “invisible hand” at all. Could we not still use to phase to describe the general thrust of Smith’s argument? As Eamonn Butler has noted,

“In fact, the critics read too narrowly. The invisible hand idea, as commonly understood, pervades Smith’s work, and would do so even if these two specific references had never existed. For the phase is a very convenient shorthand for Smith’s idea that human actions have unintended consequences; and that provided a few fundamental rules such as the principles of justice are followed, the self-serving actions of individuals can unintentionally produce a well-functioning and beneficial overall social order”

or as Craig Smith has written,

“It is the idea of the invisible hand, or more generally the idea of social evolution through unintended consequences, which represents Smith’s chief legacy to the modern world. The recognition that many of the most important human achievements are, as Smith’s friend Adam Ferguson observed, the results of human action, not the product of human design, is a profound lesson to us all. It is this observation which leads Smith to his deep scepticism towards ‘mean of system’ who would organise humanity to achieve noble ends.”

Thus can we not, in the above sense, apply the phase “invisible hand” to Smith’s work?

3:15 am  
Blogger Gavin Kennedy said...

Hi Paul
We may use any metaphor for any purpose we wish. Some metaphors work and some don't, as Smith recognised in his writings, comparing his use of 'a very violent metaphor' in WN, and in his explanation of the grammatical rules for using metaphors in his Lectures on Rhetoric.

The IH metaphor only works for 'unintended consequences', in Eammon's and Craig's sense, when the positive qualifications you adduce ("that provided a few fundamental rules") operate. But as there are as many, if not more, negative consequences of human action, I consider it misleading to adduce its benefits in the way you, Eamonn and Craig intend.

Smith identifies over 70 instances of negative outcomes from self-interested actions in Books I, II, III of WN. And, anyway, without showing the presence of the operation of the 'rules of justice' in each case, in what manner is the IH metaphor of value. We can see the consequence of wild attribution to Adam Smith in today's economics discourse - partially captured on Lost Legacy and in 'Looney Tunes'.

That the IH metaphor has elided into assertions about 'selfishness' promoting the general ends you mention as meeting a 'well-functioning and beneficial social order' (Mandeville and Ayn Rand), I doubt very much that suggests it "describes the general trust of Smith's argument".

I know Eammon and Craig's views -we have discussed our differences and we agree to differ. I think the considered views of Warren Samuels recently ("Erasing the Invisible hand") suggest my approach to Smith's work is more, not less, realistic.


6:56 am  

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