Is Laissez-Faire too Radical for Brazilians? - Bruno Gonçalves Rosi (Mises Daily)

Is Laissez-Faire too Radical for Brazilians?
by Bruno Gonçalves Rosi
Mises Daily, April 19, 2016
http://mises.us1.list-manage.com/track/click?u=bf16b152ccc444bdbbcc229e4&id=09c46afd35&e=bbc3f0dda2

Following some months of political indecision, it seems impossible to reverse the movement toward the impeachment of Brazilian president Dilma Rousseff. Despite expected criticism from her political support group, the impeachment process goes according to Brazilian law and Dilma’s position becomes ever more indefensible as new evidences of corruption surrounding her and her government arise. But as I wrote some months ago, it is not clear that removing the president can lead the country to really pro-market policies. Many of the politicians who voted Rousseff out in the House of Representatives are themselves accused of corruption. This in no way casts doubt on the legality of the impeachment process (as Dilma’s supporters claim), but shows the difficulties Brazil will still have, even without Rousseff in office.

Rousseff and her mentor, Lula da Silva, are the first left-wing presidents in Brazilian history. As Ludwig von Mises noticed long ago (and as empirical evidence has confirmed), interventionist governments cannot help but to grow the state continually. And with a bigger state, the greater are the chances of corruption.

One possible mistake in analyzing the present scenario would be to assume that removing Dilma from office can solve all Brazilian political problems, or even to believe that Dilma and Lula in their political ideology are greatly different from much of Brazilian political history.

Brazil’s Long History of Interventionism
Since its independence from Portugal, Brazil’s tendency has been toward big government. The country’s first head of state (and government), Dom Pedro I, was himself Portuguese and an heir to statist policies implemented in Portugal since the late eighteenth century. Although a liberal in outlook, Dom Pedro I disfavored the more libertarian wing of Brazilian politics at the time and allied with the statists. Brazilian politics in the nineteenth century were mostly dominated by the Conservative Party, which despite its name, was not conservative in a Burkean sense, but mostly statist.

Brazilian politics in the republic (corresponding roughly to most of the twentieth century) were also mostly statist. Until 1930, politics were dominated by a coalition of coffee farmers in São Paulo and Minas Gerais that used the state for economic gain. After that, and until 1945, the country faced the dictatorship of Getúlio Vargas. Vargas and his legacy would still play a major role until 1964, when the country entered a period of military government that lasted until 1985. The new republic that arose from this period showed indecision between continuing the tradition of government interventionism or following the Washington Consensus.

Libertarians Are the Revolutionaries
Conventional politics in Brazil has long opposed groups considered to be either revolutionary or conservative. One might even claim that Lula and Dilma could pass as a great novelty in Brazilian politics, with their proclaimed (revolutionary) democratic socialism. But Lula and Dilma aren’t really all that different form what’s been tried before. Although their socialist approach does have peculiarities that are worth considering, much of the statism in it was already present in the Conservative Party of the empire, the oligarchies of early twentieth century, Varguistas from the 1930s to the 1960s and many of the military governments in the 1960s, 1970s, and 1980s. And most important today, this statism is also present in the opposition to Rousseff that is managing to impeach her.

The true radicals and revolutionaries in Brazil today are the libertarians who are attempting to move Brazil away from its traditional managed economy that always benefited certain elites. Indeed, libertarians in Brazil have suffered politically from being considered too radical.

A Fear of Leaving People Alone
From the 1820s to this day, one thing is constant: the fear of “anarchy.” In the late eighteenth century Adam Smith popularized the concept of “the invisible hand” which was considered too radical for Brazilian ruling elites. They feared that if the country had the level of individual freedom observed in the US, the result would be anarchy. Therefore, more state control was called for. F.A. Hayek later updated the concept as “spontaneous order” and “fatal conceit.” Even more, Rothbard defended market anarchism under a Misean framework. Brazil, on the other hand, pursued “third way” populist developmentalism.  

Many of the opponents voting Rousseff out of office justify their vote saying that she failed to implement policies to control the economy and give welfare to the poor. Although vice-president (and heir apparent) Michel Temer is talking about a (sort of) liberal (i.e., libertarian) political agenda, it is unclear that there is room for truly libertarian policies at this moment.

Historia das Ideias Economicas: Mao Invisivel contra o Laissez-Faire - Jeff Madrick

 

 

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

Jeff Madrick

Jeff Madrick is a former economics columnist for Harper’s and The New York Times, is a regular contributor to The New York Review of Books and the editor of Challenge magazine. He is visiting professor of humanities at The Cooper Union and director of the Bernard L. Schwartz Rediscovering Government Initiative at the Century Foundation.