Bryan Caplan on Invisible Hands and Selfish Businessmen

Bryan Caplan has a literate, pacy and thoughtful article on the Blog (October 2007): ReasonOnline (‘free minds and free markets’), which all readers should visit here:
It’s called: “The Four Boneheaded Biases of Stupid Voters (and we’re all stupid voters)” and you will get a lot out of it. Also, those of you teaching undergraduates, or employees long out of school, should find it helpful for class discussions.

Among the excellent material there is one paragraph upon which I must comment, as this is Lost Legacy. It involves a simple reference to the ‘invisible hand’, much as most conventional economists present it today. The first two sentences quoted below are absolutely fine. It’s the last one I find problematical and out of place:

“Yet profits are not a handout but a quid pro quo: If you want to get rich, you have to do something people will pay for. Profits give incentives to reduce production costs, move resources from less-valued to more-valued industries, and dream up new products. This is the central lesson of The Wealth of Nations: The “invisible hand” quietly persuades selfish businessmen to serve the public good. For modern economists, these are truisms, yet teachers of economics keep quoting and requoting this passage. Why? Because Adam Smith’s thesis was counterintuitive to his contemporaries, and it remains counterintuitive today.”

Comment
I agree that ‘For modern economists, these are truisms, yet teachers of economics keep quoting and requoting this passage’, which does not explain much, and linking it to Adam Smith and the Wealth Of Nations is an unfortunate error because it perpetuates a 20th-century myth promoted from within by neoclassical economists and now firmly embedded in the profession.

It is interesting that the metaphor of ‘an invisible hand’ is so beyond discussion by our best economists that Bryan Caplan can write the sentence: ‘The “invisible hand” quietly persuades selfish businessmen to serve the public good.’

Has he read what his sentence means: an invisible disembodied hand ‘quietly persuades’? Could he actually explain what this means, with reference to Wealth Of Nations? Is it a general principle of neoclassical economics that disembodied hands persuade ‘selfish business men to serve the common good’ (it certainly isn’t Smithian)? If they do, what exactly is the economic theory behind this persuasion? Or, to put it slightly differently, what does ‘an invisible hand’ explain that economics doesn’t explain without it?

That ‘For modern economists, these are truisms’ is a cause of regret. That they are linked to Adam Smith is doubly unfortunate. First, because it turns a simple metaphor for a phenomenon which Smith explains perfectly clearly before he uses the metaphor, a tolerably known and well-used 17th-18th–century literary device (that can be traced also relatively abundantly back to classical Greek and Roman times), and secondly, it introduces into the working of markets the notion of ‘invisible’ forces working to arrange optimum outcomes, of semi-magical, even divine, origin, when Smith and others made it clear from their analyses that markets evolved in the activities of humans without the assistance of ‘invisible gods’, or their disembodied body parts (see his ‘History of Astronomy' essay).

Wealth Of Nations discusses in great detail the working of markets from first principles (Book I) through to the accumulation of capital (Book II). Among these first principles were the propensity to truck, barter, and exchange; urge to self-betterment; the division of labour; extent of markets; theory of prices (natural and market prices; components of commodity prices); theory of growth; and productive and unproductive of labour.

Nowhere in 375 pages of the analysis and elaboration of these first principles, where he is covering the whole workings of the commercial economy, is there a mention, hint or allusion of an ‘invisible hand’ at work, and certainly nothing is said about ‘selfish businessmen’ being quietly persuaded ‘to serve the public good’.

Indeed, in these two books I have noted that there are 52 instances of where he specifically shows that the self-interests of certain individuals in society leads them to act against the interests of others and of the society they live and operate within. This Blog entry is not the place to list them, but I will do so in a separate entry shortly (they appear in my ms for my new book on Adam Smith).

Apart from any other circumstance, this suggests that Adam Smith did not regard the metaphor of ‘an invisible hand’ to be other than a metaphor for the argument he used on the single occasion when he used it. As a metaphor it was never one of his founding principles, otherwise it would have appeared in abundance in Books I and II; but it didn’t appear even once!

He uses the metaphor only once Wealth Of Nations, in Book IV, chapter ii on page 456. This is extraordinary for what has become a ‘truism’ of Smithian economics. So let’s look closer at the context. Chapter ii is about restraints on imports on goods that can be produced at home. Smith’s main argument is that they are unnecessary and when they are imposed they create a monopoly for domestic producers of the home market for formerly imported goods (higher prices). This diverts capital from where is would otherwise go, with no guarantees that it would be more beneficial than where it would go if allowed the freedom to do so.

Individuals seek the most advantageous employment of their capital, which necessarily is most advantageous for society; whatever their intentions. Individuals prefer their home market over distant markets because home markets have the advantage that his investments do not leave his sight (so to speak); he knows better with whom he transacts than foreigners at a distance; and he is more comfortable with the local legal protections and general justice than he is with foreign justice. This can be summarised as: the individual’s risk aversion is lower for domestic business than it is for foreign business.

By directing his capital locally he adds to domestic capital growth, which results in higher domestic growth than if he diverts some of all of his capital into foreign trade. Driven by his risk aversion, his preferences lead to higher domestic activity, and as the whole is the sum of its parts (by arithmetic), irrespective of his intentions (averting or lowering risk), the outcome is a public benefit in employment and capital turnover, and from free competition with foreign produced imports, prices per unit are lower than monopoly prices from laws preventing or restraining imports (raising real wages of the labouring poor).

After explaining all this, Smith sums up for readers (of which more in a moment) of his critique of mercantile political economy by using a metaphor:

‘By preferring the support of domestick to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce 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 an end which was no part of his intention.’ (WN IV.ii.9: p 456)

So the motives of security (risk aversion) and gain (profits) are frustrated by import restraints (mercantile political economic policy) and the result is higher domestic prices and the need to export capital, for higher compensatory profits to cover the greater risks of making gains in foreign trade.

Wealth Of Nations being a long, closely argued treatise on policy (not a general textbook of principles, such as Sir James Steuart’s Principles of Political Economy, 1767), it was written to persuade legislators and those who influenced them. Those who skipped the ‘technical arguments’ in Books I, II, and the historical argument in Book III, to read the direct critique of mercantile policies as practised by British governments, where certain counter-intuitive arguments against import controls (one of Bryan’s ‘bonehead biases’ and ‘stupid’ to boot) could be too difficult to grasp (but not difficult at all for modern trained economists), Smith slipped in a single metaphor for a complicated argument for those readers struggling with his analysis.

Nobody took much notice of the invisible hand in the 18th-century, few in the 19th century, and few in the early 20th century until the triumph of the neoclassical paradigm (Samuelson in particular, and the Chicago School), which turned it from a specific purpose metaphor in a general metaphor for how markets work, and, indeed, into a general ‘truism’. From this treatment by epigones, Smith’s original meaning was buried. The many occasions in which he refers to non-optimal behaviours (including import restraints!) is forgotten. The invisible hand became a mystical, magical and even divine rationalisation of the conduct of big business, perhaps an apology, for sub-optimal behaviours by corporations.

Am I alone in arguing this case? I hope not.

[If you are not already a readers of Bryan Caplan’s and Arnold Kling’s Econ Log Blog here visit it soon – it is among the best economist's blog on the Net]