The Dead-End of General Equilibrium in Practice

Dr Madsen Pirie of the Adam Smith Institute writes Here
which is part of his series on “Philosophical Observations on Economics.”:

“There is no equilibrium position in economic activity”

“Economists used to talk, and some still do, of the equilibrium position at which supply meets demand. Demand generally decreases as price rises, while more suppliers will tend to enter the market as prices rise. The equilibrium price is supposed to the price at which the supply exactly matches the demand. People use this (and other) 'equilibrium' notions to derive equations which aim to describe how an economy behaves.

The problem is that equilibria are entirely theoretical abstractions and do not occur in real economies. The real economy is characterized by motion. There never is a point at which supply meets demand. Demand changes from moment to moment, and so does supply. There are countless economic actions taking place every moment as potential consumers change their positions on whether they are in the market for particular items, and potential producers decide whether or not to put more produce on sale. Even further back, producers are deciding whether to commit resources now to augment production in a few months time, in anticipation of what demand might be.”

[Follow the link for the rest of the article]

To which I offered a comment:

“Congratulations, Dr Pirie. You have observed reality and not accepted that we can model it accurately with equations seeking to 'prove' equilibrium in markets. Beyond first year economics, equilibrium notions are misleading. The pursuit of scientific credentials from the 1870s - while rooting them by assertion in ancestral Smithian economics - has led to illusions of predictability and imaginary theorems, more poetic than real.

Smith never made predictions (except that the former colonies in North America would become the most powerful economy in the world by the 1870s) because given the multiple distortions and wrong-headed mercantile political economy myths in his day he knew enough about human interactions to know how easy it was to be wrong about the present.”

[Disclosure: I am a Fellow of the Adam Smith Society.]

Markets and Panglossian Invisible Hands

Scott Cooney, author of Build a Green Small Business: Profitable Ways to Become an Ecopreneur (McGraw-Hill) writes a slanted piece in Triple Pundit (‘people, planet, profit’) HERE: “Paul Hawken on the State of the Markets”:

“To those that argue the efficient market hypothesis, based on Adam Smith’s theory that the ‘invisible hand’ of the markets will right our course and get us on a path to clean energy, Hawken responded that not only has this not occurred, but that the theories of the free market are even arguable at best. “Markets prove most of the people wrong, most of the time,” he said. Otherwise, they wouldn’t function. It’s a bit like Vegas.”

Comment
Scott’s article primarily is about environmental change, of which I have no comment, and while I have no particular sympathy with the “efficient market hypothesis”, or the rest of the apparatus of the omaginary mathematical markets without humans – a successor to the imaginary market beliefs of something vague called “Providence” inhabited by invisible gods and other superstitions – I am fairly certain, as I can be, that Adam Smith had little to do with any of them.

He certainly did not associate the invisible-hand metaphor with “markets”.

By observation, people make mistakes. Some people are sometimes “wrong” – have to be, otherwise how would a market work if everybody made the “right” decision, perfectly adjusting their efforts with infinite velocity to ever changing signal?

Adam Smith recognized these actualities in noting that ‘projectors’ who make mistakes and lose their capital (or anybody else’s) are in the same unproductive role of the prodigals. Losers of their capital do not reproduce their costs plus a profit, that is, they are unproductive.

Paul Hawken makes his case against markets by misquoting Adam Smith and attributing to him views out of context, which he did not hold. Paul believes certain of Smith's epigones, who justify their fantasy world of mythical general equilibrium outside of any known society of human beings, by trying to give their fantasies authority by linking them to the wholly innocent Adam Smith. They might as well call in Dr Pangloss for support.

[Apologies for not supplying references here, but my Adam Smith library (Glasgow edition of the Works and Correspondence of Adam Smith, Oxford University Press) is in another place - temporarily].

Excellent Writing But Still Mythical

Atanu Dey writes a highly readable and lively piece on “Why education matters” HERE

“I am sure that there is no secret cabal of powerful people with evil glints in their eyes plotting to keep Indians illiterate. But individual behavior motivated by private incentives - micro behavior - have consequences at the social level - macro outcomes - that are not intended by individuals. The most famous example of this is Adam Smith's "invisible hand" - the market mechanism that grinds out the socially beneficial outcome even though an individual is only interested in his or her own welfare. So also, there could be what we can call the "invisible fist" of the government which can pummel the life out of a society even though no single government official is doing anything more than making his or her life comfortable.”

Comment
Atanu Dey writes well and complains that 33 per cent of Indian adults are illiterate. An alarming statistic for any country and doubly so for the world’s largest democracy.

His clever construction of the possible reason why government action fails to address the illiteracy problem by drawing a parallel with the invented notion of an “invisible hand” in the economy, wrongly attributed to Adam Smith by modern economists is well stated. But good writing is still vulnerable to the evidence.

Because Adam Smith didn’t write anything about the “invisible hand” being a “market mechanism” that “grinds out the socially beneficial outcome even though an individual is only interested in his or her own welfare” - see numerous posts in Lost Legacy that expose this myth – it was at root a myth created by well-meaning modern economists as part of anti-Soviet planning propaganda during the Cold War (and over enthusiastic mathematicians carried away with their 'proof' of general equilibrium applying to the real world).

Their motives were laudable – Stalin’s Soviet planning was backed by repressive civil violence and threatened to cause World War III (and IV and V, etc.,). But by their apparent endorsement of unrestrained behaviours their own unintended consequences created a mythical monster that self-interest, elided by epigones in selfishness, worked out, Panglossian-like, for the “best of all possible worlds”, covering over a plethora of externalities that damaged the interests of the rest of society (pollution, environmental destruction, monopoly pricing, protectionism, and local wars arising from them.

By associating Adam Smith with the invented myths, they traduced his reputation too. Most economists actually believe that Smith was the author of the myth. He wasn’t.

Yet many climb on the bandwagon that the current recession ‘exposes’ the ‘failures’ of following Adam Smith’s policies, in particular ‘laissez-faire’ (which he never supported – nor mentioned even once), ‘lack of regulation’ (when in fact he specifically advocated the exact opposite where it came to bank policies “which might endanger the whole security of the society”; see WN II.ii.94: 324) and the mythical “invisible hand”, mere metaphor for an entirely different set of circumstances).

Spare Us From the Invisible Hand

Patrick Kilbride writes in Chamber Post HERE:

“Free People, Free Minds, Free Markets”

‘In the 18th-century, Adam Smith left us with the indelible image of markets producing desirable social outcomes through the work of an "invisible hand." ’

Comment
In an otherwise neat argument for both liberty and free markets, Patrick Kilbride spoils his case with modern nonsense about Adam Smith and his use of the metaphor of “an invisible hand”.

Smith did not use the metaphor when explaining either how markets work generally (Books I and II, Wealth Of Nations) or how some, but not all, merchant traders preferred to invest locally following their concerns about the higher risks of investing abroad or in shipping (Book IV.ii, Wealth Of Nations).

In fact, a close reading of the only place in Wealth Of Nations where he used the metaphor of an invisible hand, shows that he first explains in detail the circumstances leading some, but not all, merchant traders to behave as they did (paragraphs 1 to 8, chapter 2, Book IV), and only then deploys the metaphor for the consequences of their specific behaviour (“intending their own security”), conforming to the arithmetic rule that the whole (the national annual output of wealth, including local employment) is the sum of its parts – the more merchant traders who are risk averse, despite the high profits from foreign and colonial trade, the greater the total annual wealth, including domestic employment.

Modern economists have invented a whole new meaning to Smith’s singular use of the metaphor, giving it the characteristics of a “law” of markets, though it was never stated as such by Adam Smith.

The modern invented meaning is commonly taught in first year economics courses and textbooks, and such is the effect of it on modern economists, it is extremely difficult to dislodge it – they seldom actually read Wealth Of Nations or even the relevant paragraphs (1 thru 8) and, by relying on a truncated extract from paragraph 9 only, they remain solidly convinced that Adam Smith explicitly stated what their tutors told them he wrote.

This gives succour to hostile critics of markets who throw the “invisible hand” back at them (“invisible fist” or, as seen recently, “invisible middle finger”, and such like). But there is no actual “invisible hand”, it does not exist and never did. The metaphor is just that, a metaphor, and one that was popular in literature, sermons, and poems in the 17th and 18th centuries – I have a list of 59 examples of its uses, besides Smith’s.

Mathematicians called it into being when “proving” that general equilibrium in an imaginary market, loaded with assumptions that removed all semblances of real world economies, was a theoretical possibility (Debreu, Arrow). Others (Samuelson, Freidman) and among them propagandists against Soviet communist planning, used the metaphor to good effect – Stalin needed the gulags to enforce planning, but free markets had an “invisible hand” that did its work without menace.

Editors of Time, Newsweek, Wall Street Journal, Financial Times and assorted media journalists loved the “invisible hand”, Nobel Prize winners sang it praises, and the epigones believed in its miraculous powers with the passionate certainties of Jihadists.

Worse, the invisible hand became an alibi of last resort, flaunted all round as if it existed. When it “failed”, the invisible hand was dumped among wails and the gnashing of teeth in wholesale “confessionals” (Alan Greenspan).

Markets suddenly became naked – they always were naked, but the veil of the invisible hand obscured their nakedness. It never was the answer to everything that could go awry in the normal condition of disequilibrium in all economies, much of it excited to crises by public policy interventions by legislators and those who influenced them.

Smith was right about them and the damage they could inflict – fortunately “there is a lot of ruin” in an economy, as he might have put it in another context...

A Good Book Ruined by Misunderstanding Adam Smith

Richard Bronk, 1998, Progress and the Invisible Hand, London, Little, Brown and Company:

“For the ‘invisible hand’ of the market is seen to lead to the most efficient satisfaction of the wants of different market participants, and in this sense to maximise the social good, merely by harnessing the selfish desires of individuals to further their own ends.” (p 7)

“The invisible hand is a metaphor for the free market’s ability to spontaneously to reconcile and balance the requirements of competing individuals pursuing their own self-interest is such a way that self-interested behaviour can unintentionally promote the interests of society as a whole.” ( p 92)

“In the years that followed publication of The Wealth Of Nations, the conditions which Smith had stipulated (in particular, the need for perfect competition) – and the implicit moral context which he, as an Enlightenment moral philosopher, which he had assumed – were not as well remembered as his central message of the power of the invisible hand. It was this image which entered Western consciousness and helped to underpin faith in human progress.” (p 95)

“In this limited-efficiency sense, modern economists have succeeded in proving Adam Smith’s first intuition with regard to the invisible hand, that a perfectly free market can ensure that the pursuit of individual self-interest or preference satisfaction, as expressed through the market-exchange mechanism, will increase the benefits of society taken as a whole.” (p 107)

Comment
The above quotations are representative of how Smith’s use of the metaphor on “an invisible hand” has elided from its original use by Smith from a summation in a “striking manner” – which is the role of metaphors – in a case where merchant traders choose between exporting their capital abroad and investing in their locality from considering the risks of each choice and their relative profitability (wholly explained in Book IV of Wealth Of Nations, chapter2, paragraphs 1-9: 456), into a general principle of how markets operate, how supply and demand sets prices, and how society benefits from competition (incidentally covered in Books I and II without any mention of "invisible hands"!)

Richard Bronk pays no attention whatsoever to the stark difference between Adam Smith’s use of the popular, 18th-century metaphor and how modern economists, roughly from the 1940s, transformed its role (from metaphor into a 'concept', a 'principle', and a 'theory') and generalised its effects into general equilibrium theory, both verbal as a 'miracle of markets' and as a mathematical "proof" of the miracle. One consequence of Bronk’s ahistorical treatment of Smith’s role in the transformation, is that he attributes to Smith modern ideas of which he was wholly innocent.

Smith favoured competitive markets over monopolies (he was not opposed to state intervention on principle, where the role was to protect the consumer, e.g., banking regulation; quality of bullion; quality of cloths, and such like). He knew nothing about "perfect competition" - an idea from the inter-war years - and regarded "harmony" as a goal, not a destimation.

Bronk writes “In the years that followed publication of The Wealth Of Nations” - first edition 1776, Smith’s last edition 1790. Even taking the last edition date, practically no interest was taken in Smith’s use of the metaphor at all. Dugald Stewart mentioned the paragraph from Book IV, in a footnote to his Lectures in Political Economy, in 1808 (later re-published in his Collected Works, 9 volumes, 1856), but hardly anybody mentioned the metaphor again until a few mentions in the late 19th century - Malthus, Ricardo, Marx for example, did not focus on it.

For Bronk to assert that Smith’s other ideas “were not as well remembered as his central message of the power of the invisible hand” is breathtaking in its “ahistorical” hyperbole. Practically nothing was said about the “invisible hand”, even in the 1880s, compared to Smith’s alleged views on laissez-faire, his “ alleged labour theory of value”, and his polemics against “tarrifs”, “mercantile political economy”, and his alleged “small government” policies.

Much of this attention dominated accounts of Smith’s economics through to the early 1930s, when the Chicago, oral tradition began to take an interest in the “invisible hand” by applying its mystical powers from risk-averse merchants to markets as a whole (remember that the challenge, such as it was, in the Great Depression began to circulate from a critique of markets compared to the “new”, albeit doomed, central planning in Communist Russia), and, from the late 1940s, the invisible hand, partly transformed into a theory, emerged in print, most famously in Paul Samuelson’s textbook, Economics, (1st edition 1948; still going strong in its 18th edition). The depression was over, but the Cold War was on.

The new, invented invisible hand, began to appear in all textbooks, and slowly at first, then in torrents in journal articles, across the media, into the rhetoric of politicians and "experts", and lastly among the general public.

Bronk wrote post the mathematical “proof” of general equilibrium (Debreu and Arrow) and, from then on, the modern invented role of “invisible hands” has never looked back. Bronk blames the modern “invisible hand”, repeatedly misattributed to Adam Smith, for its “sins, as modern economics popularises it among governments in their trenchant beliefs in unlimited progress.

His book was written as the 1999s were recovering from the 1997-98 recessions (it reads quite up-to-date in the current recession of 2007-09!). I am surprised a new, revised, edition has not been published. If it were, I bet it would not add anything about the causes of the current crisis, nor change anything about the statements attributed to Adam Smith’s culpability in failures of modern macro-management. Indeed, Bronk could quote from similar tales in support of his own that have appeared almost daily in the media, and on many Blogs, blaming the “invisible hand” for its inadequacies as a positive force.

I have no complaints about Bronk’s criticism of modern economic management (or lack of it) – in fact, I enjoyed quite a lot of his analyses (he is good, clear writer). If he disassociated Adam Smith from the modern myth of the “invisible hand”, I would have much to say in Bronk’s favour.

Research Project to Challenge Modern Economists on Their Invisible Hand Explanations

I returned to more serious research today for my larger project on the invisible hand. This work has gone slowly up to now because, as I have mentioned, I am waiting for Warren Samuel’s paper to be published (now set for later this year in a collection edited by Jeffrey Young and is to be published by Cambridge University Press). I considered it prudent not to go too far ahead in case Warren’s promising treatment made my own redundant, or, in the unlikely event that Warren was off target in some fundamental way, my own paper may have required considerable re-work.

Research develops its own pace, sometimes like walking through treacle into dead-ends, tinged with boredom, and at other times flies along under an exciting momentum from the pieces falling into place, opening new insights, re-constructed ideas, and closing the gaps in understanding.

Having dealt with Adam Smith’s meaning of “an invisible hand” in two papers for the Econ Journal Watch (May and September), I am now working more intensely on phase 2, so to speak, (and have been since 2008) which analyses how and why the invisible hand metaphor was taken up, mainly in the middle decades of the 20th century, by modern economists, in part to make an ideological case for markets (sometimes tinged with theological claims and assertions) over the challenges from both creeping state capitalism and Soviet-style central planning. The other part, included genuine enthusiasm among economists from the 30s to the 70s from their pursuing lines of research into general equilibrium theory.

The problem, which I have been focussed on since my preliminary work from 2003, for my book, Adam Smith’s Lost Legacy (2005), is why modern main-stream economists embedded their theories of “invisible hand” in capitalist markets and, simultaneously, attributed to Adam Smith the role of progenitor of their work.

I have been unable to read into Smith’s works anything remotely like these modern attributions – the fact that they do not qualify for such roles on the basis of what he wrote remains, for me, in stark contrast to what senior colleagues in the discipline claim to have found.

This next project is my attempt to answer this dichotomy from what distinguished economists assert they have read in Moral Sentiments and Wealth Of Nations (and his essay on the History of Astronomy) by coming at the problem from the other direction:

What exactly do modern economists claim for their “invisible hand”, where did these views originate (Chicago, MIT, LSE, and so on, and what evidence is there for such a role in their models of modern economies (general equilibrium, growth theories, welfare economics, business cycles, and recent history)?

I shall report from the research front occasionally on Lost Legacy and share my progress with readers.