Origins of a Fable

Neil Buchanan writes in Dorf On Law Blog HERE

“Bastard Keynesianism Today”

“The British did not imagine that Adam Smith's fable about the invisible hand could ever be taken so seriously. They (like Keynes) saw the fundamental flaws in even the most sophisticated markets, and they offered a withering critique of the idea that government's role is merely to let rational private actors engage in self-interested action.”

Comment
Buchanan is writing about the Keynesian – Friedman approach to monetary and fiscal policy and I refer you to the whole article in the link above.

My interest was in the paragraph quoted. Depends of course where and when you look.

Certainly in the 1930s there was a stronger reserve among Cambridge, England, economists to what had become 19th-century ‘classical’ economics about the market (Mill, Manchester School, The Economist, and their stories about ‘laissez-faire) and early misattributions to Adam Smith, than was common among Chicago economists, whose enthusiasm for harmonious markets was quite explicit in house.

Interestingly, Samuelson remarked, in a sceptical tone, about the oral tradition at Chicago in the 1930s (he graduated there in 1935 – and moved to Cambridge, Mass. for his post-graduate degrees), that such ideas as the ‘invisible hand’ doctrine had limited explanatory power, especially after “two centuries of experience and thought”. (See: Samuelson’s Economics, 1st edition 1948, page 36 and 12th edition, 1985, page 41.)

Unfortunately, Cambridge, Mass. conquered Cambridge, England, on these matters with the fading of Keynesianism under the triumph of Monetarism from the 70s. Meanwhile, and afterwards, the invisible hand myth conquered the profession with the ruthless energy of the barbarian invasions of Rome in the 5th century.

An Excellent Review of The Failings of Neo-classical Economics

In Reality Base Blog (HERE)a book review by John Gray in the London Review of Books, is reported (25 November):

“Animal spirits and what else is wrong with neoclassical economics”

“A much discussed book this year has been Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller.

He credits Akerlof and Shiller for their evisceration of neoclassical economics for assuming at its core rational behavior of human beings—conceiving them to be a species, homo economicus, that is not us. Gray goes beyond this and points out that even if we all were homo economicus, important parts of the future are always unknowable and cannot be quantified and factored into market decisions as probabilities. A third theme of the review is the hubris of the neoclassical school in assuming that the magic beans they had discovered would work in any environment and that, indeed, no other doctrine would lead to economic abundance. Unaccountably and regrettably, these ideologues appear not to have noticed in the real world the massive contradictions to that view. A few excerpts:

. . . . The trouble with prevailing theories, in Akerlof and Shiller's view, is that they assume human beings are more rational than they actually are. 'This book, which draws on an emerging field called behavioural economics, describes how the economy really works,' they claim. 'It accounts for how it works when people really are human, that is, possessed of all-too-human animal spirits.' . . . .

. . . . If economists have failed to explain repeated crises, it is because they have interpreted economic activity through an unreal model of rational decision-making. Thinking of human behaviour in this way allows them to claim a high degree of precision for their discipline, which is presented as a kind of applied mathematics. But they have left psychology out of their equations.

. . . . The fact that markets are flawed seems novel only in the context of the economic orthodoxy that prevailed between the wars, and in the run-up to the recent crisis. It is wrong to imply, as Akerlof and Shiller do, that the classical economists believed otherwise. 'Just as Adam Smith's invisible hand is the keynote of classical economics,' they write, 'Keynes's animal spirits are the keynote to a different view of the economy – a view that explains the underlying instabilities of capitalism.' Here they are endorsing the caricature of Smith propagated by neoliberal ideologues anxious to confer a distinguished patrimony on an illegitimate intellectual offspring. . . .

If Akerlof and Shiller's grip on the history of economic thought is shaky, they also fail to grasp why Keynes rejected the idea that markets are self-stabilising. . . .

[I]n his canonical General Theory of Employment, Interest and Money (1936) he concluded that there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no 'basis on which to form any calculable probability whatever. We simply do not know!' For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge. . . . .

The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. . . .

. . . . Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out."

Comment
This is more like it. Not having read Akerlof and Shiller’s book, I cannot blindly endorse everything they may have said, but their charge against “Homo economicus”, also made regularly on Lost Legacy, and their objections to mathematical modeling of economics, which precludes humans behaving as they really are, is very welcome.

Nobody actually reading Adam Smith would conclude that humans are, or will become, rational calculating machines, or that economies are closed systems in general equilibrium, and thus predictable, let alone always prone to the working for the public good in a Dr Panglossian “best of all possible worlds”.

That markets are better, in an acceptable sense, than their alternatives is a modest requirement, as the experience of Soviet central planning and the accompanying tyranny, is adequate testimony. But that is where we start from, not where we end.

The hubris of a belief in a predictable world, and events in it, is a serious flaw in the modern “science” of economics. Smith, like the later Keynes, did not endorse the myths of predictability – hence there are few, perhaps only one or two, specific predictions in Wealth Of Nations - one being that the former British colonies in North America would be wealthier (measured by the “annual output of the necessaries, conveniences, and amusements of life” within a century of 1776).

Nor was the 20th-century re-invention of the metaphor of "an invisible hand" as a comforting assurance that whatever the moral failings, or externality-induced misery, that was inflicted by individual "merchants and manufacturers" (to which we can add some governments some of the time, and a few governments all of the time), on the rest of society, was somehow a social benefit.

It wasn't, and economics as a "science" can only delude its practitioners into believing such nonsense by denuding its "models" of human beings. This charge cannot be made against Adam Smith.

Time Travel to the Heady 1960s

I attended a meeting addressed by Robert Skidelski last evening (6.00pm - 7.15pm – left before last questions). He is a very clear speaker and fluent in Keynes and ‘Keynesian’ macro-economics – so much so it was like sitting in a graduate economics class in the late-60s.

His analysis of the current crisis focussed on “uncertainties in modern economies” and the fallacies of rational expectation and market efficiency theory (the latter which he asserted was the followed by “all” economists). His ascription to “all” was challenged by Professor David Simpson in the early question session, to which Professor Skidelksi responded that those few economists who disagreed with it were from minor universities, had undistinguished publication records, mainly in “uncited” and "non-peer reviewed” journals (an impolite caricature that certainly did not fit Professor Simpson – Harvard, etc.).

I enjoyed much of Skidelski’s talk on regulation (what, and by whom, though?), which when he went, under questioning from various economists in the large audience, onto Bancor, for narrower and managed exchange rate stabilities, and various old-familiar “remedies” to currency depreciations, speculation and other problems of the 50s-70s, plus "fiscal policies",suggested that Skidelski had not moved on to 2009.

He did not mention Adam Smith, who was not an equilibrium economist, nor stuck with the imaginary ‘Homo economicus’ and a laissez-faire economy of the late 19th century that led to the mathematisation of what essentially cannot be treated that way – economic behaviour is peopled by, er, people. They do not behave as well-behaved functions.

Keynes knew this too (“An End to Laissez—Faire”); apparently, Skidelski conflates modern economics with praise-worthy, but as yet unearned, credentials, while enjoying his re-born role as the authoritative voice of Keynes.

I came away disappointed, as did my economist wife; both of us children of 1960s economic degrees.

It was back to filling of boxes for our house move (see recent Announcements).

Self-Interest and Copyright

William Patry writes the Blog, Moral Panics and Copyright Wars (‘a blog about copyright discourse’) which is about his book of the same name, published by Oxford University Press’ HERE:

“Adam Smith and the invisible hand of copyright” (22 August):

“Adam Smith’s theory was that “individuals were led in the pursuit of their own self-interest by an invisible hand to pursue the nation’s interest, but also that this pursuit of self-interest was a far more reliable way to ensure that the public interest would be served than any alternative,” especially government intervention. Joseph Stiglitz, however, rejoined that “the invisible hand often seemed invisible because it was not there.” (Page 98). John Maynard Keynes also rejected this view:

It is not a correct deduction from the Principles of Economics that
enlightened self-interest always operates in the public interest. Nor is
it true that self-interest generally is enlightened; more often individuals
acting separately to promote their own ends are too ignorant or too
weak to attain even these. (See pages 98-100 of the book).”

Comment
Copyright is the 'price' exacted by authors (and publishers) for potentially acting in the public interest (creating and publishing works which the public purchases from the publishers, a small portion of which goes to the authors).

Whether individual products are really in the public interest are separate issues – the bulk of books do not sell out their first printing; do not make a profit; often do not cover their costs; and sometimes do not cover their author’s advances (though some, such as David Hume’s, 1739-40 Treatise, ‘which dropped from the press stillborn’, but become a major contribution of philosophy and are still in print in the 21st century).

No alternative system of mobilising the efforts of authors, covering the financial risks of the publishers and, in the wider sense, serving the public interest, has been devised so far.

Besides setting the rules of copyright in laws, the state has a minimal role in deciding what may be written and published by laws on defamation, libel, plagiarism, inappropriate language and subject, the administration of which is subject to a legal process, not the executive (in non-totalitarian societies).

Where I may disagree with William is the above repetition of errors about Adam Smith’s views on self-interest, such as the false characterisation that Smith asserted: “individuals were led in the pursuit of their own self-interest by an invisible hand to pursue the nation’s interest”.

This was a specific, not a general, assertion by Adam Smith in a single instance in his 900-page, Wealth Of Nations (Book IV) in the case of some, but not all, merchants investing locally and in aggregate thereby increasing the annual output of “necessaries, conveniences, and amusements of life”.

This was occasioned by some, but not all, merchants being risk-averse about investing in foreign trade, as he states quite clearly in chapter ii, of Book IV. Their ‘risk-aversion’ led them to do so, which Smith capped with a well-know 17th-18th century metaphor of “an invisible hand” to give a more “striking” representation of the link between their risk-aversion and a nation’s interest. (Metaphors are not real!).

It was not a universal rule, though it has been made into one by modern economists, few of whom ever read Wealth Of Nations, and is passed around by repetition since the mid-1940s.

The idea that Smith’s understanding of self-interest led him to assert the easily refutable notion that a mystical entity intervenes in the economy to lead self-interest individuals to benefit the national interest is a insult to his scholarship.

He never said such a thing.

Indeed, in Books I and II of Wealth Of Nations he gives over 60 examples of self-interested actions in which individuals act in a manner contrary to the national (even local) interest.

Consider his suspicious opinions of the behaviours (many of which he documented) throughout Wealth Of Nations, including in Book IV, before and after the single instance of his use of the metaphor of “an invisible hand”, of “merchants and manufacturers”, “legislators” and those who influenced them, and national governments, and then explain these widespread behaviours, based on the self-interests of the individuals concerned, with the alleged statement attributed to Adam Smith that, somehow, individuals end up achieving something manifestly at odds with what they actually achieve.

Smith’s ideas about self-interest were not “nuanced”; they were starkly clear and did not include the attribution modern economists give to him. I concur with Keynes and Stiglitz in their quoted assessments.

Update:

William writes that he was quoting Stiglitz on Adam Smith's reference to the invisible hand.

That is not as clear the way the Blog is written, but I accept that William is innocent and Stiglitz is the guilty party.

Either way, the assertion that Smith wrote the ideas I criticise in my post remains an error of attribution by modern economists.

Real Wealth

From Airllelon’s Investing and Trading Blog, complete with video links to U-tube-style pieces by the author (HERE) I find this piece:

"Week in Review: The Death of Keynes Mercantilism?"

"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country" - Adam Smith

For decades now, Keynes has been held as the pinnacle of "capitalist" thought, and the latest in the evolution of what started with Adam Smith.

There's only one tiny problem with that little concept.

Keynes was no capitalist. Keynes ideas are a direct descendant of everything that Adam Smith opposed. Keynes ideas are a descendant of Mercantilism. Capitalism isn't dying, because Capitalism hasn't been practised. Keynes Mercantilistic thoughts and theories are what are dying.

Keynes firmly supported concepts found in Mercantlism. Which is that government should work in partnership with private companies.

In a Capitalistic society, there can be no lobbyists.

In a Capitalistic society, governments do not work as partners with private industry.

In a Capitalistic society, private industries do not seek capital from the government when they are doing poorly."

Comment
To quote a phrase, “there’s only one tiny problem with that little concept”. The author of the piece goes on to recommending to readers that they buy silver, not gold, because silver is doing better at present, which is partly exactly what Smith considered was a central fallacy of ‘mercantile political economy’!

Gold, silver, and cash money are not wealth in Smith’s eyes. They are illusionary wealth by being stored claims on the real wealth. They do not create wealth in themselves. Hording gold or silver will not add to the wealth of nations.

Wealth according to Adam Smith was the ‘annual output of the necessities, conveniences, and amusements of life’, or the real goods and services of consumption, and working capital.

Revenues from engaging in productive work can be spent on final consumption or re-invested in future productive employment; the balance between these ends determines whether growth in the next period’s annual output of real wealth occurs.

Too much prodigality in consumption and too little in re-investment is not good for an economy, or the people in it. Hoarding metallic ‘symbols’, such as gold and silver is a psychological comfort to individuals but does nothing for the economy. Printing more money is not a substitute for generating the means to produce real wealth when it is disconnected from the real economy; too much printing leads to inflation, not more real wealth (see Zimbabwe).

Strong boxes, protected vaults, brim full of gold and silver, are sterile unless part of the great wheel of circulation that puts to work real resources, primarily labour, capital, and work in progress.

Adam Smith did not write about ‘capitalistic’ society – that came later in the mid-19th century. Long before the commercial entities in the 19th-20th-21st centuries sought governmental help for whatever mess they were in, powerful entities in ancient times sought relief of various kinds from their states, usually in the form of retribution against former clients and competitors, punitive expeditions, revenge missions, armed interventions and lucrative supply contracts. Emperors, kings and ‘strong’ leaders, also sought help from traders – sometimes as excuses to intervene with neighbours in pursuit of plunder and tribute, and colonies and empires.

What is needed by those who write about the ‘perils’ of modern capitalism and modern states is a little more historical knowledge beyond what they apparently misunderstand to be the unique behaviour of the current age. Unless they are only interested in selling their 'solutions'...

Adam Smith and Keynes

Susan Lee writes on a ‘A Keynsian Halloween’ in Forbes.com, 24 October HERE:

“Keynes' central (and disputable) insight was that markets were not self-correcting during economic downturns. He rejected Adam Smith's idea that businesses, when they found they were holding too much inventory, would drop their prices. Lower prices would then entice consumers back into the market and the economy would perk up again.

Instead, Keynes argued that downturns could become protracted. When faced with too much inventory, businesses would cut back production and lay off workers. Since the unemployed wouldn't have money to spend, the economy could stagnate at low levels of production and employment.”

Comment
A bit unfair to Adam Smith, who was not in a position to speak of what all businesses would do, as might be inferred from what we know of a modern market economy. Dearth and feasts in his day came from agriculture and not the relatively small commercial sector, itself separated into local impacts only.
Notions of ‘managing an economy’ were two centuries later.

Even with this qualification, Susan Lee’s contrast between Smith and Keynes (surely ‘Keynesian’ and not ‘Keynsian’?) is not quite right. Smith spoke of what a seller would do in a local market – too many apples on the barrow would lead to a fall in price per apple.

Even if that local example of a seller’s reaction to a lack of buyers was extended to the entire country, it would still lead to a drop in prices. To suggest it wouldn’t is to deny experience.

Whether this would revive the economy or not is not an issue addressed by Adam Smith, though it might be addressed by post-Smithian economists who, across the board, claimed Smith authored their versions of economics popular from Mill, Marshall, and the neo-classicals, when clearly he didn’t, as a reading of Wealth Of Nations shows.

When Smith discussed ‘the natural and market Price of Commodies’ (WN.I.vii.pp 72-81), he followed his argument through as market prices fell. Landlords would withdraw their land as rent income fell; as wage income fell, labourers would look for other work; and employers would withdraw from that line of activity as prfots fell (WN I.vii.13: pp 74-5), and eventually market prices would adjust to their ‘natural rate’.

Smith discusses at length the effects on price of changes in ‘effectual demand’; he does not discuss general slumps in demand across all commodities; but for what he does discuss, his ideas are broadly correct. By the early 20th century, Keynes moved the discussion well beyond the simple effectual local demand ideas of Smith.

Indeed, late 19th century economists generalized Smith’s arguments pertaining to local market conditions into strong assertions about ‘laissez-faire’ as if they were Smith’s views (he never mentioned laissez-faire) and adopted the policy of leaving markets to solve the trade cycle, as if this was Smith’s view. The epigones were responsible for this turn of events.

Keynes, brought up, so to speak, with this so-called Smithian package, struck out in a different direction (‘The End of Laissez-faire’, 1926) and went on in the General Theory (1936) to prescribe solutions as he saw them for a stricken economy and not just a reaction by a market-stall holder of too many apples left over near closing time in a street market.

Hence, Susan Lee ascribes to Smith a view that he did not articulate about a condition he did not face and credits to Keynes a criticism he had no business making in regard to Adam Smith, but he did have grounds for his criticism if directed at contemporary 20th century economists. She should have written:

‘He rejected the contemporary idea popular among his contemproaries that businesses, when they found they were holding too much inventory, would drop their prices.’

As in so many other areas of economic commentary by columnists and professional economists, including Nobel Prize winners, they attack an innocent man for the doctrinal sins of his successors.