Fiscal Friday
For today’s Fiscal Friday, I’m sharing more of director Michael Bloom’s notes, this time focusing specifically on where the title The Invisible Hand comes from.
Adam Smith Smith believed that people work naturally toward maximizing their self-interests. The exchange of goods and services facilitates this goal, and market participants engage in those activities most beneficially when regulations and government intervention don’t inhibit them from doing so. The invisible hand of self-interest guides participants into exchange that is mutually beneficial.
For example, by selling productions people want to buy, butchers, brewers, and bakers make money. However, they only get that money if the can meet the needs of their customers effectively—if they other things people want to buy. By doing so, they are financially rewarded and they create wealth for the nation as a whole by being productive citizens. In other words they inadvertently create the best outcome for everyone by looking out for their own self-interest. This is laissez-faire capitalism. He famously wrote: “it is not from the benevolence of the butcher, the brewer, or the baker that we can expect our dinner, but from their regard to their own interest.” *[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.]
Many economists now realize that rational markets aren’t really rational at all because so much of economics is determined by the irrational actions of consumers. The field of the psychology of economics is thus evidence of the irregularities of the market and its participants.
Jeff Madrick, Seven Bad Ideas 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.
Adam’s Fallacy So what is “Adam’s Fallacy”? ... It is the idea that the economic sphere of life constitutes a separate realm “in which the pursuit of self-interest is guided by objective laws to a socially beneficent outcome,” Professor Foley wrote, a realm unlike all the rest of social life, “in which the pursuit of self-interest is morally problematic and has to be weighed against other ends.”
“This separation of an economic sphere,” he wrote, “with its presumed specific principles of organization, from the much messier, less determinate and morally more problematic issues of politics, social conflict and values, is the foundation of political economy and economics as an intellectual discipline.” Professor Foley’s book is simultaneously an introduction to economic theory and a critique of it.
