How Adam Smith’s Invisible Hand Was Corrupted by Laissez-Faire Economics
If read correctly, Smith's invisible hand shows the limits of laissez-faire
By Jeff Madrick
Economics, April 15, 2016
As I learned my economics and further explored the
influence of the Invisible Hand, the power of ideas became clearer
to me. Economic ideas have had enormous influence on
economic conditions—and vice versa. Over the past thirty-five years,
the ideas at the center of orthodox economics, did damage and laid the
groundwork for the financial crisis of 2008 and the Great Recession that
followed. The Invisible Hand, though alluring, is highly
ambiguous—it does good and harm.
A beautiful idea can be described as one that explains a
lot with a little. Such ideas are often simpler than previous
explanations of a phenomenon. But they can be siren songs, and
throughout history many such ideas have been found to be wrong: the
Aristotelian belief that heavy items fall fastest to earth; the
once-dominant idea that the veins and arteries are separate circulatory
systems; the notion, which seemed undeniable to educated people at one
time, that the earth is the center of the universe.
The Copernican idea that the sun, not the earth, is the
center of the solar system is a classic example of the best kind of
beautiful idea. It is elegant and simple and, most important, ultimately
correct. But time was still needed to break the shackles of the
older, mistaken beautiful ideas. Once accepted, such ideas are hard
to shed. They become part of us and color how we think.
Physical observation alone did not pave the way to the
Copernican idea, which took some time to gain acceptance. There
were also cultural and philosophical changes that opened paths to
such thinking. Our sense of our uniqueness as a species may have
already been diminishing culturally and intellectually before
Copernicus’s astronomical theory took shape, making it possible to
accept the radical notion that the earth was not the center of it all.
History is more a circle than a line—a feedback loop rather than simple
cause and effect. I’d argue that economists too often overlook that.
Honest economists readily admit their oversimplifications;
confused economists take them more literally.
The beautiful idea of the Invisible Hand enraptured
economists as well as many political thinkers for more than two
centuries. But it is not an idea with the power of, say, the Copernican
discovery. It is more a loose metaphor for the way markets may work than
an ironclad law. The Invisible Hand is believed by economists to
demonstrate that markets where goods and services are freely
exchanged will result in the greatest benefit to buyers and sellers
alike, and as noted direct investment where it is most useful,
enhancing the rate at which the economy can grow. All of this takes
place without any outside government intervention.
Orthodox economists have made the Invisible Hand the
basic foundation of their work. They grudgingly agree that
sometimes government intrusion in the market is necessary. Usually,
though, government efforts are seen as harmful. Most extraordinary,
many economists claim that just as the market for cornflakes is
self-adjusting, so, too, is an entire economy. Supply and demand
automatically adjust to a “general equilibrium” that satisfies as
many people as possible. In a recession, prices, wages, and interest
rates will fall. More goods will be demanded, and production will
rise again. Excessively rapid growth will result in higher prices,
which dampen demand and will perhaps create a recession that lasts
until the economy readjusts. A recession will only be temporary, as
will excessive growth.
Unlike the Copernican revolution, however, the Invisible
Hand is an assumption, not a scientifically based law. Its obvious
limitations have not prevented its supreme influence. The alllure of
the Invisible Hand is its elegance. The profound weakness is that it
is not nearly as complete a model of markets as many economists insist
it is. Its underlying assumptions—that people have material preferences
that don’t change, that they are rational decision makers, and that they
have all the price and product information they need—are extreme. The
Invisible Hand is thus a limited proposition, elegant but impure.
It especially draws theorists toward the
laissez-faire model of governing, which holds that government
intervention should be minimized. Indeed, the free market, not
government, is accepted as the dominant organizing mechanism of society.
Smith used the term “Invisible Hand” just once in The Wealth of Nations
and only once in his earlier work, The Theory of Moral Sentiments. The
historian Emma Rothschild, in her book on Smith and the Marquis de
Condorcet, two towering Enlightenment scholars, argues that Smith was
more ironic than serious about the Invisible Hand, always assuming an
active role for government in creating the rules and regulations of
society and fully conscious of the need for compassion and community,
which he outlined rather beautifully in The Theory of Moral Sentiments.
But Smith took the Invisible Hand very seriously, I’d
argue, even as he assumed a large role for government. He was a
complex thinker, breaking new ground in many areas, and too much
time has been spent trying to make his abundant ideas consistent
with one another. He could believe in limiting government in some
ways but expanding it in others. Even though he explicitly mentioned the
Invisible Hand only once in The Wealth of Nations, elsewhere in his masterpiece he addressed it at length.
Smith was formally a moral philosopher at the University
of Edinburgh, and he had come to believe that individuals could
often make their own decisions without help from a higher authority,
a staple idea of the Enlightenment that was rapidly gaining
cultural acceptance. A market undirected by government fit this
philosophical disposition very well. Smith was determined to show
that such self-oriented behavior on the part of individuals led to a
common good. “Man has almost constant occasion for the help of
his brethren,” he famously wrote, “and it is in vain for him to
expect it from their benevolence only. He will be more likely to prevail
if he can interest their self-love.” And then follows his most quoted
line: “It is not from the benevolence of the butcher, the brewer, or the
baker, that we expect our dinner, but from their regard to their own
interest. We address ourselves, not to their humanity but to their
self-love, and never talk to them of our own necessities but of their
advantages.”
Emma Rothschild, appropriately skeptical of the Invisible
Hand, emphasizes its “loveliness.” To many, she observes, it is
“aesthetically delightful.” Rothschild notes that for the Nobel laureate
Kenneth Arrow and his highly regarded coauthor Frank Hahn the
Invisible Hand was “poetic.” Arrow and Hahn wrote that it is “surely the
most important contribution of economic thought.” Another Nobel
laureate, James Tobin, called it “one of the great ideas of history and
one of the most influential.” The American conservative philosopher
Robert Nozick is impressed by how it finds an “overall pattern or
design” out of a seeming jumble of decisions.
Its simple elegance, as I’ve said, is part of the reason
for its influence. Rebuttals of it tend to be intricate, but this does
not make them wrong. A rare readable rebuttal of Smith’s moral
contentions
can be found in Adam’s Fallacy, a short book by
the nonmainstream economist Duncan Foley. Others have built economic
systems that give less credibility to the central proposition that
economies are a collection of markets driven by the Invisible Hand and
more to the influence of tradition, culture, power, war, and the
development of the law, the banking system, and other institutions.
Economic growth cannot, it turns out, be explained by the simple
mechanism of the Invisible Hand, however key a role it played. These
other less traditionally economic factors matter enormously. Foley is
part of this tradition, as is the similarly nonmainstream Lance
Taylor, whose Maynard’s Revenge is a variation on the failures
of Smith’s theory. The Invisible Hand, however, overwhelmingly trumps
all these insurrectionary ideas in the practice of economics today.
With the stakes so high, how could I not have wanted to
understand the way economies create wealth? How could I not have
embraced the Invisible Hand? Was there some set of conditions and
choices that underlay prosperity, a set that could be maintained
and enhanced? In short, was there a universal key to economic
growth? Political decisions, the tides of history, scientific
breakthroughs, the spread of literacy, the rise of rapid
transportation—all these and more affect growth. But my college
textbooks, even when they included sections on Keynesian government
stimulus, by and large agreed that prosperity is mostly a consequence of
the Invisible Hand—that is, a free market.
Adam Smith may not have been an economist per se, but to
my mind he was an economic historian of his times. Better said, he was
an economic sociologist. He wanted to understand the causes of the
prosperity that existed in Scotland and the rest of Britain. History’s
leading theoretical innovators were trying to make sense of what they
saw as surprising and robust economic advances since the 1700s. They
noted how wealthy many individuals were becoming; how cities were
growing; how agriculture was feeding more people; how new water mills
and factories were producing goods more cheaply; how many new businesses
were being started; how canals and, over time, railway lines were
proliferating; and how technology was advancing rapidly. Neither they
nor their greatest successors created economic edifices out of theory;
instead, they created theory out of the concrete edifices they observed.
Unlike, say, Newton’s or Einstein’s theories, which offered predictions
based on immutable laws of nature (within defined limits, granted),
economic theories did not predict the Industrial Revolution or
the fabulous wealth of today’s rich nations. John Maynard Keynes was a
brilliant but mostly conventional economist until the devastating Great
Depression; when the facts on the ground changed, he said, he had to
change his ideas.
Adam Smith did not begin The Wealth of Nations
with the Invisible Hand. The general cause of increasing wealth is
productivity, he wrote in his first chapter, the growing quantity of
goods and services that can be produced per hour of work. More income
was produced per worker as productivity increased. The persistent
increase in productivity, accumulating over years, decades, generations,
and centuries, is the cause of the economic benefits we enjoy today.
This was accomplished through what Smith called the “division of labor.”
Smith started with the aforementioned pin factory, a
classic example of rising productivity, both simple and highly
illustrative. Smith may have called the manufacturing of pins
“trifling,” but the availability of cheap pins was important to the
burgeoning textile industry. Smith explained that one man could make one
pin a day, perhaps twenty. But when manufacturers learned to divide
and specialize the work, productivity exploded. Smith reported
that there were up to eighteen separate operations—“ one man draws out
the wire, another straights it, a third cuts it, a fourth
points it”—and by dividing the labor, twenty men with specialized
skills could now make an astonishing forty-eight thousand pins in a
day. This huge multiplication of output was achieved even as the cost
of labor remained low. Here, in a nutshell, was the miracle of
modern wealth. But it was the Invisible Hand that directed business to
make such investments as demand created opportunity; it was the guidance
system, so to speak.
This primitive example of growing productivity is crystal
clear. Smith went on to show how it characterized industry after
industry. More than a century later, the division of labor became the
basis of mass production, which made use of elaborate machines that, by
and large, worked on the same principle of breaking tasks down to their
simplest level. Henry Ford took this to the extreme, paring down the
multiple tasks involved in building a car to a degree that no one had
imagined possible.
When Ford started out, a car with an internal
combustion engine typically cost around $5,000. He eventually got the
price down to a few hundred dollars, having figured out a way to make so
many more cars with little change in labor time or costs. There have
been countless examples in industrial history of this reduction in
price. By the end of the 1920s, about three-fifths of American families
had a car—compared to a little over one-fifth a decade earlier—and a
huge number owned washing machines, radios, and telephones. The increase
in television ownership in the 1950s was even more explosive—and even
with TVs being relatively more expensive, adjusted for inflation, than
the computer would later be. But since the 1980s, the price of a
personal computer has dropped substantially, and now about
three-quarters of Americans own one.
Division of labor was the central principle, but other
factors were exploited to increase productivity. New sources of power
made a significant difference by reducing labor time: wind and water
at first, well before Smith’s day, then coal, oil, and, finally, the
generators that produced the electricity (and, to a much lesser
degree, nuclear fission) that powered the increasingly complex
machines that produced more and more goods faster and faster with less
and less labor. Another major factor was the rising speed of the
transportation of raw materials, parts, and finished goods to
producers and markets—first over the waterways, then by train, and soon
on trucks and huge oceangoing vessels. The steam engine was key to these
developments, but so were navigational techniques. Transportation costs
were sharply reduced, which also radically enhanced the mobility of
labor. Soon communication became faster, further boosting productivity.
The telegraph was critical to American economic development in the
mid-1800s, as was the telephone by the end of the century. Lower costs
of parts made it possible to produce countless newly invented products
over the decades.
The size of the market was every bit as critical as
output—and maybe more so—and has usually been overlooked by
contemporary economists. The division of labor and other
productivity improvements could only be made if the market was large
enough. Smith knew this, giving the third chapter of The Wealth of Nations the
title “That the Division of Labor Is Limited by the Extent of
the Market.” What good would it be to make forty-eight thousand
pins rather than two hundred if there was no need for those pins,
even if the price dropped drastically? Markets had to expand beyond
the village to the region, the nation, and the world. This was
another reason that more efficient and low-cost transportation was so
necessary to the advance of productivity.
The process that created the incentives to increase
productivity and guide production and prices was itself driven by
self-interest, Smith argued. He observed that it is merely a human
“propensity” to want to barter and that the way to get what one wants is
by giving others what they want.
How much to produce? At what price to sell? Is this really
for the overall good? Shouldn’t somebody decide? This is the process of
the Invisible Hand. “By directing that industry in such a manner as its
produce may be of the greatest value,” Smith wrote, “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 not part of his intention.”
The fact that Smith used the term “Invisible Hand” only once in The Wealth of Nations has, as noted, misled some scholars into thinking that he did not really care about or even fully believe in it.
Yet the chapter in which he described it without
explicitly mentioning it—“ Of the Natural and Market Price of
Commodities”—is the most important in the book. First of all, Smith
assumed there was a “natural” price for every good, one ambiguously
based on the long-term costs of producing the product. “When the
quantity of any commodity which is brought to market falls short of the
effectual demand,” he wrote, “a competition will immediately begin
[among those who want to buy it], and the market price will rise.” In
other words, as demand increases, the price rises until it reaches
the point at which the entire quantity produced is consumed. If
supply increases, the opposite occurs. As he wrote, “When the
quantity brought to market exceeds the effectual demand . . . some
part must be sold to those who are [only] willing to pay less, and
the low price which they give for it must reduce the price of the
whole.” Thus, more people can own the product at the lower price.
Supply and demand shift to strike a balance at a specific
price, which is called the equilibrium point. If there is too much of
a commodity or, similarly, too much labor or land, the employer will cut
jobs or wages or the landowner will reduce the price or amount of
salable land until the wage or the price reaches its so-called natural
level. If there is greater demand, the employer will hire more workers
or the landowner will prepare more land for use. Natural price and
effectual demand are ambiguous ideas, but they were key, if unexplained,
assumptions for Smith. Later economists would spend a lot of time
trying to make these ideas more explicit. But they essentially accepted
the assumptions without ever to this day devising a complete explanation
of how price and demand are determined. Price always gravitates to its
natural level, Smith said, so that demand is fully met and the resources
of a nation are fully used. Economists assume as much today.
Smith acknowledged potential obstructions to the ideal
functioning of markets. Producers can try to keep secret a rise
in demand, thus avoiding competition. Lack of widespread
information about prices and the availability of goods is an
inherent problem. Similarly, anyone with a monopoly can keep the
market understocked or prices too high. A tariff to keep exports out
keeps prices too high to satisfy effectual demand.
Smith did not fully explore some other problems. Simply
said, he believed market participants must know what they want and
what they are willing to pay. Barring such (rather formidable)
obstacles, the process is automatic. Government will only hinder it with
taxes, product standards, and price regulations.
In his chapter on natural and market price, then, is
Smith’s almost complete description of the Invisible Hand. So
accepted and seemingly obvious is his theory that it is hard to believe
that Smith did not conceive of the supply and demand curves that
all first-year economics students learn. Alfred Marshall, the
talented British economist, drew these about a century later.
In addition to the problems just cited, there is another
major gap in the explanation of how the Invisible Hand functions. The
main claim is that price sends a message to buyers and sellers on
how they can adjust their consumption and production. But the
countless buyers and sellers must communicate with each other,
after all—in effect, bargain. This is no easy task.
Smith’s proposal that there is a natural price for a
product is sketchy, to say the least. There is no convincing explanation
of where this natural price comes from. Smith presumed that there
exists for goods and services a price known by custom and practice and
that the price goes down and more people buy as new and cheaper
supply comes on the market. Within this set of narrow possibilities,
the Invisible Hand can spread the benefits of productivity and
induce businesses to invest more, expand capacity, increase
production, and reduce labor costs. They may also hire more workers and
even raise wages.
A bookseller, for example, might sell a book for $19.95
and see how many takers he gets, thus testing the market. But what if
a $14.99 price would attract many more buyers, resulting in a
greater total profit for the bookseller? A competitor might then sell a
similar book as cheaply, and so the experimentation that led to an
equilibrium price would continue. Léon Walras, the influential
French economist who in the late 1800s used mathematics to expand
the Invisible Hand as a model for the entire economy, did not have
an answer to how the process would work in real life, either.
Walras presumed that there was an economy-wide “auctioneer” who
gathered all prices of goods and sold them to those willing to pay.
That assumption about the process by which the Invisible Hand
matches buyers and sellers has not been improved upon by
contemporary economists. How the equilibrium point is reached remains
a mystery.
This central ambiguity matters a lot. Prices can in fact
be shoved around by powerful forces: big business, strong unions, and
ubiquitous monopolies, or at least oligopolies with market power.
In financial markets, prices can be manipulated by collusion or
secret trading or access to inside information. In labor markets,
wages can be affected by the ability of businesses to fire workers
without cause or by stern government policies that restrain growth
and keep unemployment high.
Belief in the Invisible Hand allows economists to
minimize these concerns. The battle against unions, for example, is
driven by a claim that the Invisible Hand guides business and labor to
set fair wages. Union organizers believe that they are not set fairly
and that workers need collective bargaining to level the playing
field. Alan Greenspan, as Federal Reserve chairman, believed that
bargaining power mattered. High unemployment, he realized, could keep
workers insecure and therefore less willing to bargain hard for their
jobs, giving business more power over wages than the Invisible Hand
would dictate. One measure of insecurity is the rate at which workers
are willing to quit their jobs. If the quit rate is high, workers are
secure and might ask for higher wages, putting pressure on business to
raise prices and stimulating inflation; if the quit rate is low,
workers don’t have the security to bargain hard. (Of course, unions
sometimes have too much power, too, driving wages too high.) Greenspan
kept a close eye on this and seemed to encourage worker insecurity.
Faith in the Invisible Hand led to the once-general belief
that a higher minimum wage results in lost jobs. It presumes that the
wage paid reflects the worth of the workers and that any wage
increase resulting from a minimum wage law represents an overpayment
to workers, reduces profits, and also reduces the hiring of new
workers. But in fact often the wage can be too low because of a
business’s power or generally restrictive government policies that keep
unemployment high. In that case, a hike in the minimum wage would be
healthy economically, restoring demand for goods and services, and would
not cause jobs to be lost. At the turn of the nineteenth century, the
American economist John Bates Clark made one of the first claims that,
economy-wide, wages reflect the worth of labor. As we shall see, there
is little serious empirical work to justify this conclusion, and recent
studies—what I call dirty economics—have shown that increases in the
minimum wage result in very few lost jobs, if any. Empirical analysis is
at last changing economists’ minds.
Another concern regarding the labor and other markets is
often referred to as asymmetric information. The classic example is
the used-car salesman who has more information about the car than the
buyer has, much of which is kept secret. As Smith feared, a
market cannot work under these circumstances. Buyers cannot make proper
bids without knowing what they are buying. This concern extends to
markets in health care, insurance, and mortgages—and arguably to most
other markets as well. It is not only the poor subprime mortgage buyer,
for example, who will make errors, but almost all homebuyers who enter
into such transactions only two or three times in their lives. How can
they possibly be knowledgeable and informed? Even sophisticated pension
fund managers clearly did not have enough information about the complex
mortgage securities fashioned by Wall Street to make sensible
decisions in the years leading up to the 2008 crisis. Countless pension
funds and individual investors and the Department of Justice have
been suing major banks like JPMorgan Chase and Goldman Sachs
over alleged deceptive practices, and in several cases
multibillion-dollar settlements have been reached. One Goldman Sachs
banker—if only one—has gone to jail for selling the complex products
without informing his buyers. A pure interpretation of the Invisible
Hand suggests such easy fraudulent behavior should not be possible.
The Invisible Hand also depends on market participants
knowing and understanding their self-interest well and therefore
making rational decisions about buying and selling products.
Behavioral economics has uncovered many examples of buyers being
unable to make such rational decisions, a factor economists once
minimized. An obvious example is herd behavior in buying stocks,
in which buyers are lured into paying high prices because so many others
are. The opposite, also damaging, is irrational risk aversion, with
investors refusing to buy even when the odds of gains are good. Another
example is susceptibility to misleading advertising. Still another is
fashion itself, evident in surges in demand for new products like the
iPhone or traditional ones like an Hermès Birkin bag. One can argue that
there is some satisfaction in being a part of fashion, of course, but
not if it leads to buying bad products or stocks whose prices will
inevitably fall precipitously.
The seeming power of the Invisible Hand, however,
enables many economists to neglect or set aside these concerns. Milton
Friedman forcefully argued that competition will correct most wrongs.
Fraudulent products or manipulated financial services will create
opportunities for honest competitors, overpricing will create
opportunities for sellers to reduce prices, and herd behavior leading to
overspeculation will be counteracted by sellers who know better. There
is no need for labor unions to offset the power of business, as John
Kenneth Galbraith had claimed in his concept of “countervailing power”;
unions will only keep wages too high by interfering with the Invisible
Hand.
The Invisible Hand is a source of clean economics in a
dirty world. Great castles can be built on the Invisible Hand, but a
rising tide will wash them away. This is what happened in 2008.
Among the most important limitations of the Invisible Hand
are economies of scale. The Invisible Hand presumes that it will
eventually cost more to produce a good, not less. The supply curve rises
to meet the demand curve. But the greatest productivity increases in
the Industrial Revolution were arrived at as the volume of sales
increased; this is what enabled Henry Ford and others to cut prices. The
more you make, the lower the unit cost. The supply curve could actually
fall when more units were demanded at lower prices, and it often did.
Economies of scale are a major component of wealth creation and of the
history of economies. Smith’s pin factory was a version of this.
The grandest leap of faith among economists, however,
concerns more than how the Invisible Hand works in a single market. A
general equilibrium was reached for all markets and the economy as
a whole. This conclusion, arrived at by economists like Léon Walras, is
remarkably convenient, but the assumptions required to make such a claim
are extreme.
The many obstacles to the workings of the Invisible
Hand amount to an overwhelming criticism. The Invisible Hand is
an approximation, usually not applicable in the real world
without significant modification. Dependence on it leads to major
policy errors, most of them having to do with restraining
government intervention. We assume away monopolies, business power, lack
of access to information, the likelihood of financial bubbles,
economies of scale.
The proof is in the pudding. Predictions about economies
based on this generalized theory have often been proved wrong. The
most important of these is that economies should be stable because
they self-adjust to reach general equilibrium. Yet we have had
countless deep recessions and financial bubbles and crashes since the
start of the Industrial Revolution. The eighteenth century was rife
with them, but so have been the past thirty years of the modern
laissez-faire era. Simplistic, convenient belief in the Invisible Hand
led to mindless financial deregulation beginning in the 1970s and
an astonishingly misplaced faith—one that ignored asset bubbles
and income inequality, among other things—that the Great
Moderation would maximize prosperity. This is why the devout
believer Milton Friedman could state in 2005 that the economy was
stable; he couldn’t imagine that it wasn’t, and he never looked under
the hood of Wall Street securities to see what was really going on.
If rightly read, Smith’s theory proposes the opposite of
laissez-faire political practice, suggesting that there is a need for a
visible hand of government. It describes both why markets work and
why they fail, as well as how much guidance from an outside force
is needed to keep them on track. The Invisible Hand is a
brilliant idealization of markets that shows how limited
laissez-faire theory is in reality.
From the Book: SEVEN BAD IDEAS
by Jeff Madrick Copyright © 2014 by Jeff Madrick Published by
arrangement with Vintage Books, an imprint of The Knopf
Doubleday Publishing Group, a division of Penguin Random House LLC.
2106 April 15
