Adam Smith and the Invisible Hand
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By Rafi Amir-ud-Din and Asad Zaman
[Editor’s note: This and similar material can be found on the WEA Pedagogy Blog.]
Textbooks, like Mankiw, state that the four claims listed below are at the centre of modern economics. In a paper [Rafi Amir-ud-Din and Asad Zaman “Failures of the ‘Invisible Hand’” Forum for Social Economics Vol. 45, Iss. 1, 2016 pp 41-60.], we aim to show that all four of these claims are wrong.
- Participants in market economies are motivated by self-interest. (SI) – In fact, cooperation, service, recognition and status in community, and reciprocity are very strong motivators of human behaviour.
- Decentralized market economies work very well, and maximize the welfare of society as a whole. (FM: free markets). As illustrated by the Global Financial Crisis, unregulated markets lead with regularity to disasters and crises.
- The reason for excellent functioning of decentralized market economies is that all participants are motivated by self-interest. This self-interest works better than love and kindness in terms of promoting social welfare. (GG: greed is good). This is absolutely false, and the opposite of the truth – love and kindness work much better at promoting social welfare.
- The principles listed above were summarized in the concept of the “Invisible Hand” by Adam Smith. (AS). Adam Smith can be blamed for many wrong ideas, but this is not one of them. In fact, free market economists attribute this theory to Adam Smith to create legitimacy for their ideas.
Here is an extract from the paper regarding point (4) above. This shows the huge difference between what is attributed to Adam Smith in the name of Invisible Hand, and the actual writings of Adam Smith:
Section 6: Recent Vintage of the Invisible Hand
The main goal of this section is to show that the modern interpretation of the IH is relatively recent. The idea that Mankiw (together with other modern economists) attributes to Smith is not actually present in Smith’s writings. In fact, modern writers borrow the authority of Adam Smith to provide weight to a very dubious idea of recent coinage.
We first note that modern interpretation of the “IH” is radically different from any interpretation of this concept that existed before the second half of the twentieth century. There is a growing body of literature (e.g., Grampp, 2000; Minowitz, 2004) which insists that the metaphor used by Smith was never meant to be anything more than a metaphor, and that the meanings inferred from Smith’s idea of IH by the modern economists support only their own interpretation of economic policies. Kennedy (2009) shows that three leading modern economists laud the IH as the “profoundest” and “most influential” contribution of Adam Smith. Nonetheless, their interpretation of the term and its significance is not supported either by Adam Smith or by readers of Adam Smith until the late nineteenth century.
In a corpus of over a million words, the terms IH appears only twice in the economic writings of Adam Smith. It is used only once in the Wealth of Nations in very limited and narrow context. Rothschild (1994) analyses the controversy surrounding the meaning of IH and concludes that what Smith meant by this metaphor was only a “mildly ironic joke.” Blaug (2007) also shows that Adam Smith cannot be blamed for these ideas. He cites other references which state that:
Some economists regarded the Arrow-Debreu results [on the existence of general equilibrium] and the fundamental theorems of welfare economics as the modern expression of Smith’s invisible hand … But Smith would be surprised at what is attributed to him today … On careful reading Smith does not say that selfish behavior is praiseworthy, is bound to pay, or necessarily promotes the best interests of society … The passage containing the invisible hand metaphor is not about general equilibrium theory: its purpose is to explain why merchants would continue to buy British products even if tariffs were removed.
Ashraf, Camerer, and Loewenstein (2005) make a detailed analysis of Smith’s pioneering work The Theory of Moral Sentiments to conclude that “For Adam Smith, a mixture of concern about fairness . . . and altruism played an essential role in market interactions, allowing trust, repeated transactions and material gains to occur.” In sharp contrast to the modern economists’ unwarranted understanding of the IH metaphor as a sanction for selfish behavior, Smith explains that justice is in fact only a rational behavior. Fear of retribution is likely to deter the people from committing injustice. He says: “Nature has implanted in the human breast, that consciousness of ill-desert, those terrors of merited punishment which attend upon its violation, as the great safe-guards of the association of mankind, to protect the weak, to curb the violent, and to chastise the guilty.” See Smith (1759, p. ii, iii, 125). Realizing the crucial role of justice, especially in ensuring just behavior, he believes that justice is the “main pillar that upholds the whole edifice. If it is removed, the great, the immense fabric of human society … must in a moment crumble to atoms.” Fairness and justice have only recently attracted the attention of economists as providing justifications for many observed human behaviors in conflict with standard utility maximization theories, see Karacuka and Zaman (2012) for a brief survey.
REFERENCES:
Ashraf, N., Camerer, C. F., & Loewenstein, G. (2005). Adam Smith, behavioral economist. Journal of Economic Perspectives, 19, 131–145
Blaug, M. (2007). The fundamental theorems of modern welfare economics, historically contemplated. History of Political Economy, 39, 185–207
Grampp, W. D. (2000). What did Smith mean by the invisible hand? Journal of Political Economy, 108, 441–465
Kennedy, G. (2009). Adam Smith and the invisible hand: From metaphor to myth. Econ Journal Watch, 6, 239–263
Minowitz, P. (2004). Adam smith’s invisible hands. Econ Journal Watch, 1, 381–412
Rothschild, E. (1994). Adam Smith and the invisible hand. The American Economic Review, 84, 319–322
A one hour video of a seminar presentation on Failures of the Invisible Hand can be found here.
From: pp.5-6 of WEA Commentaries 7(3), June 2017
http://www.worldeconomicsassociation.org/files/Issue7-3.pdf
Thanks, good piece! The Ayn Rand crowd have vilely misquoted Adam Smith for their own misbegotten purposes – and have unfortunately been heeded by too many economists and an unquestioning media. [!]
Years of study have convinced me that Adam Smith can only be understood by locating him within the Natural Law tradition. 18th-century providentialism was a flowering of that tradition common to the entire intelligentsia of Europe and North America. Though it has antecedents in the Greek philosophers, full-blown Natural Law first appears in the work of Cicero and Virgil. Their vision was fused with Christian theology first by Boethius and Augustine, and then later by the medieval schoolmen, notably Thomas Aquinas, and the School of Salamanca, especially Suarez. Brought to northern and western Europe, and moreover from Catholic to Protestant culture, by Grotius, Pufendorf and Leibniz, Natural Law became the underlying assumption for all work in the natural and social sciences, as evidenced in Newton, Locke and Hobbes. That was the basis on which 18th-century providentialism emerged. What all these versions had in common was the belief that nature, including human nature, was created by God and exhibited his plan for the world and for man. Smith used the phrase, the invisible hand, on three occasions in his writings, not twice – the article omits the ‘invisible hand of Jupiter’ in the History of Astronomy. But the texts of his entire literary legacy are saturated in the notion, and cannot be correctly interpreted without attending to it. Adam Smith held that the universe was a machine tended by a deity, which produced one output, the greatest possible quantity of happiness at all times. Nature exhibits the working of the infinite mind of God, while conscious, deliberate, human activity expresses the finite and fallible mind of man. At all times we do best by following the guiding hand of the deity, that is, by following nature, including our own nature, so spontaneous processes are to be preferred to activism. That this is what Smith’s audience would have understood him to mean is evidenced by the way writers such as George Washington and Dugald Stewart picked up and used the phrase, the invisible hand. Modern versions of Natural Law have subsequently been adopted by some Austrian writers, such as Hayek, Rothbard, and Huerta de Soto, for obvious reasons.
Andy, I am hardly an expert in this, but I see in today’s militant Islam the kind of emotional commitment which I believe permeated much of Scotland at the time of Smith. Thus, most present Americans & Europeans have little idea of how a DIVINE hand could indeed make markets work, even if the human participants kept making horrendous mistakes. Perhaps this is why some economists treat neo-liberalism as above analysis, that is, it is a successor to Smith’s DIVINE hand, but without explicit reference to a Deity.
There is a saying to the effect that Adam Smith got the IH metaphor directly from the Bernard de Mandeville’s “Fable of the Bees” (1705).
C-R, that is likely the case, as Mandeville created a sensation with its publication in 1714. After all, thrift was considered a virtue. Naturally there is an economic difference small & large expenditures, just as there is between saving a little & saving “too much”, but the public seemed interested in platitudes, then & often now.
Our mind is not prepared to understand complex feed-back loops involved in market dynamics with division of labor. Computer simulations can. They show that it is the synergy unleashed through cooperation between different specialists produces the positive marker dynamics.
See: Agent based simulations visualize Adam Smith’s Invisible Hand by solving Friedrich Hayek’s Economic Calculus. Arxiv 1509.04264
Not being an economist, I find reading The Wealth of Nations to be a less than thrilling way to spend my time, so I have read some now and then over the last 5 years or so, but I did find some things that stick out and seem to be worth more attention than they usually get.
First, A Smith was not an economist. He was a historian, and he set out to try to explain a 300-400 year long anomaly he had noted in the price of corn (or wheat, or both): short term(year to year) price variation but long term price stability (century by century over 400 years).
He hit on the market mechanism as a way to explain this pattern, and the explanation worked pretty good except for at least two fatal flaws that expose the free market as a false fiction. AS identified 7 necessary conditions (a term in formal logic meaning that if a necessary condition does not happen, then the result (a free market) does not exist. An aside: government regulation is one of the necessary conditions for a free market. Without government regulations, there can be no free market, but the two necessary conditions that render Smith’s idea of a free market a fantasy that never existed and never will exist are:
1] perfect knowledge of products by both buyer and seller, and
2] long term price stability. Smith’s reliance on prices over only 300 years was too small a sample of time to support his conclusion. Shortly after Smith hypothesized the free market based on long term price stability, the industrial revolution blew long term price stability, even for corn and wheat, out of existence.