Monday, March 30, 2009

Never A Theory of Markets

Jacqueline Best (a professor in the School of Political Studies at the University of Ottawa and the author of The Limits of Transparency),writes in Globe And Mail HERE:

Market's ‘invisible hand' is supposed to be just

We forget that Adam Smith, the father of modern economics, held a chair in moral philosophy at Glasgow University. He argued that the “invisible hand” of the market economy was not just economically efficient, but also politically and morally beneficial – ensuring that the pursuit of individual self-interest would ultimately provide for the public good.”

Comment
Jacqeline asserts the above with the authority of her professorship, but in doing so she purveys a major myth about Adam Smith and the ‘invisible hand’.

Adam Smith did not argue that ‘the “invisible hand” of the market economy was not just economically efficient, but also politically and morally beneficial – ensuring that the pursuit of individual self-interest would ultimately provide for the public good.

He did not relate the metaphor of ‘an invisible hand’ to ‘the market economy’. His detailed discussion of the ‘market economy’ was concluded in Books I and II of Wealth Of Nations without mentioning The Metaphor of ‘an invisible hand’ at all.

His sole use of The Metaphor occurs in Book IV in his critique of Britain’s ‘mercantile political economy’, which legalised several monopoly practices prevalent in the 18th century. In this instance, he showed how the legal colonial monopoly of trade with the British colonies in North America, under the Navigation Acts, enforced by the Royal Navy and customs officers in every British seaport, heavily distorted British domestic capital growth.

However, those British merchant traders who were risk-averse to the Atlantic sea trade, despite its greater profits, who preferred to invest their capital locally, also benefited British domestic capital investment – the whole is the sum of its parts, or and the more ‘parts’, the larger the ‘whole’.

After explaining the nature of the risks of distant overseas trade, and how some, but not all, preferred the home trade, he showed why this was beneficial for Britain (Smith was not too keen on the then colonial policy because of the inevitable costly wars with France).

As his argument was fairly complex (you must read the whole chapter in Book IV, chapter 2), and for those of his readers who found it difficult to follow, he followed with his, now famous, metaphor of these merchants being ‘led by an invisible hand’.

So inconsequential was his use of The Metaphor that neither he, nor anybody else until the late 19th century, commented upon it. It was never Smith’s view that the ‘invisible hand’ was ‘not just economically efficient, but also politically and morally beneficial – ensuring that the pursuit of individual self-interest would ultimately provide for the public good.’ That is a false attribution; worse, a pure ‘invention’.

He certainly preferred competitive (not monopoly) markets to non-markets (though he also preferred government action where necessary), but in both cases the ‘invisible hand’ played no role.

Moreover, it was only in Chicago in the 1930s that The Metaphor was generalised into Smith’s so-called ‘law’ of markets. Paul Samuelson (1948, 1st edition), in his famous textbook, Economics (16 editions), publicised this invention with the inevitable affect on modern economics, as tens of thousands of his readers took it on trust as true.

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4 Comments:

Blogger gbd said...

hi! but the spirit of the quote, that markets are efficient, is still true, correct?

this is what smith meant, formalized by modern economics. right?

3:54 am  
Blogger Gavin Kennedy said...

Gabby
That markets are more efficient than the known alternatives is correct.

The Smithian position is to favour markets where possible, and to use state interventions in specific instances where necessary and where circumstances show that the existing market organisation is in some kind of difficulty, it may be possible to temporarily intervene (emergency food supplies in a local famine, or infrastructure emergency construction in a natural or man-made disaster (earthquake, flood, or other catastrophes).

The role of the State has necessarily grown since Smith's day, even beyond what he recommended or knew about, but the state is now far too big for political reasons, including in the USA, Europe, India and China.

Adam Smith was not an ideologue. He preferred what works to what is invented by people who forget about people.

1:08 pm  
Blogger anon/portly said...

His sole use of The Metaphor occurs in Book IV in his critique of Britain’s ‘mercantile political economy’, which legalised several monopoly practices prevalent in the 18th century. In this instance, he showed how the legal colonial monopoly of trade with the British colonies in North America, under the Navigation Acts, enforced by the Royal Navy and customs officers in every British seaport, heavily distorted British domestic capital growth.

Isn't this a bit misleading? When Smith introduces the Invisible Hand metaphor, the discussion at that point concerns merchants trying to make their own "produce" or revenue as great as possible in doing so make the nation's revenue as great as possible. The truth or accuracy of this point does not depend on Smith's placement of it within a discussion of tariffs and import restrictions and so on.

[Smith] did not relate the metaphor of ‘an invisible hand’ to ‘the market economy’.

How can this be so? A discussion of merchants and their incentives to employ their capital in domestic trade, foreign trade or "carrying trade" has nothing to do with the market economy?

...and by directing that industry in such a manner as its product 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 [society's gain]...

So the invisible hand applies not just here, but elsewhere. Where else? Maybe in other places where a businessperson intends only his own gain but the result is beneficial to others? Maybe like in the discussion of self-interest in book 1, chapter 2?

6:27 am  
Blogger Gavin Kennedy said...

Thanks anon/portlyfor your measured critical comment. I think it deserves a full answer and to widen the readership (not everybody scrolls down the psots) I have responded on the main page today (Saturday).

You ask: [Smith] did not relate the metaphor of ‘an invisible hand’ to ‘the market economy’. How can this be so? A discussion of merchants and their incentives to employ their capital in domestic trade, foreign trade or "carrying trade" has nothing to do with the market economy?'

Many modern economists claim that the invisible hand is Smith's 'theory' of markets. My statement addresses that assertion. Theories ('paradigms' even) require more than a mataphor of a disembodies and invisible body part.

To claim that the invisible hand is about markets is absurd; it overturns economics as a science. Smith's use was about the unintentional consequences of human motivations; alluded to after he had thoroughly explained the motivations of the wholesale merchants (their own security). It was their risk-aversion that drove their individual actions that, in this ('and many other cases') had beneficial consequences.

The Metaphor added nothing to his original explanation. In fact, in Chicago's oral tradition in the 1930s, picked up post war (Lange, 18946; Samuelson, 1948) the metaphor became a 'theory' of markets: please explain the science of that so-called 'theory'. It is mysticism, even religion - the 'Hand of God' - and has nothing to do with science.

10:33 am  

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