An Invisible Hand That Claps!

“Chris” writes in Mapwatt Blog HERE:

“Copenhagen was about a bunch of politicians getting together so it looked like they were doing something to slow Climate Change (to be fair, I’m sure most of them really wanted to work it out). But a better strategy for solving Climate Change is one that has been around since America declared its independence in 1776: The Invisible Hand. Adam Smith put forth in The Wealth of Nations that when we act in our own self-interest, society as a whole benefits.

“By preferring the support of domestic 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. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.” [Wealth Of Nations, IV.ii.9: 456]

“So why don’t we start promoting a Clean Energy strategy not as the solution to Climate Change, but as a path to greater prosperity for America? And when America acts in its own self interest to get off fossil fuels, we will also be aiding the climate as a side effect.”

“….As we learned from Adam Smith, society benefits the most when each country acts in its own self-interest, which is what is always going to happen anyway because the International community doesn’t keep politicians in office (and if you don’t believe me, please get off your idealistic high-horse). Instead of trying to convince 190 countries – each with their own culture, industry, and goals – that they all need to agree on a solution (we can’t even get politicians in our OWN country to agree on what to do about Climate Change), let’s show each country that by adopting a Clean Energy strategy and getting off fossil-fuel that the country AND the climate will benefit.”

[And finally:]

“….Once everyone realizes how a Clean Energy (a.k.a. fossil-fuel reduction) strategy benefits their whole country ALONG WITH THE CLIMATE, the invisible hand will start clapping.”

Comment
I don’t with to be picky, but there are a number of holes in Chris’s argument, of which I am sure he realises. Let alone that political systems don’t quite work like that in welcoming an idea that assumes that it hasn’t been thought of many times before, and promises in its simplicity to over-ride the disparate self-interests present in societies, large, like the USA (and China, India, Brazil) and smaller, like the UK, France, Germany, and tiny like the Pacific islands.

The price for co-operation in Copenhagen-like jamborees – 15,000 delegates no less – is billions of dollars per year, probably trillions per decade, and still they can’t get agreement. A marketing man’s appeal to a PR campaign on behalf of self-interest, if it worked, would be a wonder to behold. Except that what appeals to the self-interest of Chris may not be in the self-interest, or even the attention span, of others. Even the idea of the self-interest of a country – however defined – may not be perceived as in the self-interest of other countries, making the idea of the self-interest of the whole world, somewhat vacuous.

Moreover, it would not take long for someone to note – a reader of Lost Legacy, perhaps (the author is too modest to say anything) – that Adam Smith did not quite say what Chris (and many others, top economists too) interprets him as saying.

He starts by quoting one of the paragraphs from Wealth Of Nations, disconnected from the previous 8 paragraphs, which directly connect to paragraph 9. Smith sums up an argument about the distorting affects of foreign trade, especially when part of a monopoly trading scheme as existed in the British colonies of North America, policed by the Royal Navy, which diverted scarce capital to Europe and the Americas, and thus reduced the employment generating and economic growth potential of domestic trade and investment in the Britain.

For a moment, let’s look at the merchants engaged in foreign trade, and not the ones, whose concerns for their security (mentioned above) leads them to invest locally, the metaphor for which action, is Smith’s use of the popular, 18th-century metaphor of “an invisible hand”.

Now both sets of merchants, whether engaged in foreign or in local trade, are guided by their self-interest, which happens to be, and is, different in both cases, but the same in one sense: - they both seek to make profit to enhance their capital “by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain”.

What is the greatest value for the foreign trader? Profit from exercising his foreign trade activities, despite the greater risks from doing so (shipping losses, piracy, foreign problems with local traders, fraud and criminality, and his misjudgements about his trading partners probity, honesty, and capabilities). He enhances the value of his capital by such foreign ventures, but it does not enhance his country’s. His capital could remain in the country he trades with and, in the case of the colonies, could be represented by plantations, mansion properties in town, other ships and stores.

The domestic merchant on the other hand, acting from similar self-interest, personal to him, invests locally and, seeking to enhance the value of his capital stock, he enhances the value of the capital stock of his country, which promotes the interests of his country.

The “invisible hand’s” role in all this is somewhat unexplained by Smith. Does it only work for the patriotic, risk-averse, local merchant? But what about the risk-tolerant foreign trader? It isn’t clear is it? And that’s the problem with using metaphors that are unsuitable beyond the exact situation where they are placed.

But, most readers of Wealth Of Nations since the 1950s (it was largely ignored before then) ignore the metaphor’s limited applicability, and generalise from the limited extract to make Adam Smith supposedly say that “an invisible hand” leads all individuals “to promote an end which was no part of his intention”. For here on (roughly beginning in the 1930s at Chicago University) and spreading right across US campuses, until from the 1970s onwards, the metaphor of an “invisible hand”, invariably attributed to Adam Smith, became ubiquitous among modern economists, a mythical status it maintains even today.

Yet all around, in Smith’s time and ours, conflicts of personal self-interest abound. I shall not generalise in detail, but I suggest that this is the flaw in Chris’s well-intentioned advocacy of his solution to what we call “climate change” in common discourse.

Getting from here to there is not going to be achieved by “an invisible hand” – even one that claps!

A Reader is Perplexed by Lost Legacy on the Invisible Hand

[A Reader, Ian B, comments on yesterday's post and his question deserves a fuller treatment than afforded by space on the comments page. It raises issues which may of wider interest. My reply follows.]

Thank you, Ian B, for asking your question and for the polite manner by which you express your perplexity and disagreement.

You will note that the blog is about Adam Smith’s Lost Legacy and has been published since February 2005, during which time I have addressed the “invisible hand” on many – probably on most – occasions.

Economics as a discipline has many problems when dealing with the history of its ideas. Among these we can list several ideas wrongly attributed to Adam Smith, the invisible hand being a prime example.

Few people who quote from Wealth Of Nations, 1776, or his earlier, Moral Sentiments, 1759, have read either of his works and many know very little about him. The minority who have read his works, often attribute to him ideas he never had nor expressed. They go with the flow, like a crowd of latter-day flatterers cheering the proverbial ‘naked emperor’.

The metaphor of the “invisible hand”, used only three times by Adam Smith, once only in each in his two books, and once in his ‘juvenile essay’ on Astronomy, commenced when he was a 21-years old student at Oxford. It was published posthumously in 1795.

The metaphor itself, however, was a popular literary metaphor in both classical times, before the fall of Rome, and from the 17th century through to the 21st century (it appears in one of the “Tarzan" novels). I know of over 40 independent instances of its use, many in books in Adam Smith’s library.

Hence, on the starting-line for a debate on the significance of the “invisible hand” for Adam Smith, we have a popular literary metaphor, his use not commented upon in his lifetime by his readers, and hardly commented upon until the late 19th century by anybody. From mid-20th century until today, floods of references to “Smith’s invisible hand” appear – nowadays daily - and so frequently, that the metaphor and Adam Smith are almost synonymous.

Most comments upon his isolated use of the metaphor impute various meanings to it, for which there is scant evidence that Smith regarded it as imputed(your example is fairly common; but there are many others that are complex, general, and even theological).

In brief then, what do we make of the metaphor of “an invisible hand”? You state that the metaphor is: “simply the (surely reasonable) observation that the economy is self ordering due to the selfish actions of its agents.”

With that view you jump two centuries from Adam Smith’s in Wealth Of Nations. My observation is that whatever the truth of your view, perfectly fine if it is your name only, but it was not Adam Smith’s, and the claim that it was is a “myth”.

You may protest that whatever Smith said or meant is less relevant than the “surely reasonable” observation of many economists that the economy is “self-ordering due to the selfish action of its agents”.

Well, of course, Adam Smith did not consider self-interest to be “selfish”; in fact he went some ways to reject selfishness as an operational motive in economic (and social) transactions. In his earlier work, Moral Sentiments, he explicitly rejected such ideas, as expressed by his earlier “licentious” contemporary, Bernard Mandeville in his “Fable of the Bees” (“Public vice, public virtues”), 1734. (There are several earlier posts on Lost Legacy discussing these particular points.)

I shall move on. You confirm that the metaphor of an “invisible hand”, as understood today, is derived from Adam Smith’s use of it in Wealth Of Nations and you assert that there is “plenty of evidence that confirms Smith's invisible hand - the less regulated the market, the more ordered it is”.

Two problems with your assertion: first Smith never said anything like this in Wealth Of Nations, and second, he found in the case of banking in mid-18th-century Scotland that the absence of certain necessary regulations caused turmoil in the banking sector and required the intervention of law, noting, en passant, that even though this was “a manifest violation of natural liberty” it was necessary because their actions otherwise “endanger[ed] the security of the whole society” (WN II.ii.94: 324).

Let us now look at Smith’s actual use of the “invisible hand” metaphor. First, he used the metaphor only once in Wealth Of Nations; second his use had nothing to do with markets, supply and demand, the absence of regulations, or prices. Those associations for it were invented in the second half of the 20th century by modern economists.

Smith discusses the distortion of the British economy by the diversion of merchants’ capital from the home trade to foreign trade in Europe and with the British colonies in North America. From the British monopoly of all trade with its colonies, and the monopoly influence of the Acts of Navigation (imposed since Cromwell’s time), merchants’ foreign trade could be highly profitable compared to local trade. Likewise, in respect of trade with Europe. However, there were higher risks in such profitable trade: shipping losses, poor investments, local fraud in foreign countries and the colonies, and long delays in turning-over capital for re-use.

Some merchants, but manifestly not all, preferred to invest locally in Britain because, though less profitable, it was more secure for them. It was these merchants that Smith focused on:

“…the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic 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.ii.9: 456).

All merchants are motivated to use their capital most profitably and the only difference between those merchants who engage in foreign trade and those who engage in domestic trade is that the latter do so because of their concerns for their “own security”. We now call this risk aversion. Smith explains that it is their insecurity that leads them to do what they do. In fact, no other explanation is given nor needed.

However, he goes on to point out that their actions have unintentional and unintended consequences, specifically that “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it”, and it this outcome (society is wealthier, measured by the “annual output of the necessaries, conveniences, and amusements of life”, or what we now call GNP) that people are “led by [NOT “as if by”] an invisible hand”.

But he has already identified the subject of the metaphor: their “own security”. And here we can agree: “no such hand actually exists”, but much of the profession, since the 1950s, has come to believe that there is “an invisible hand”, guiding the market, prices, supply and demand, general equilibrium, social harmony and so on, and on most campuses teach their students to believe that the metaphor is a real object, that it exists, when manifestly it doesn’t, at least to Adam Smith.

It is that “part of Smith's invisible hand [which] is mythical” in my view.

I hope I have elucidated the issues which you raise and reduced, if only a little, your “perplexity” upon reading Lost Legacy for the first time.

Thought for the Day 2

‘Security, therefore, is the first and the principal object of prudence. It is averse to expose our health, our fortune, our rank, or reputation, to any sort of hazard. It is rather cautious than enterprising, and more anxious to preserve the advantages which we already possess, than forward to prompt us to the acquisition of still greater advantages. The methods of improving our fortune, which it principally recommends to us, are those which expose to no loss or hazard; real knowledge and skill in our trade or profession, assiduity and industry in the exercise of it, frugality, and even some degree of parsimony, in all our expences.'
(TMS VI.i.6: 213)

Comment
I have made many references to the use by Adam Smith of the metaphor of ‘an invisible hand’ in Wealth Of Nations (1776) and I thought it relevant to quote the above passage from Smith’s Moral Sentiments [1759, ed 6. 1790].

He discusses security and specifically mentions how security is ‘averse’ to exposing ourselves and ‘our health, our fortune, our rank, or reputation to ‘any sort of hazard’.

I was recently criticised by a academically respected referee for using the more modern term, ‘risk averse’, to describe the motivation for why some (but not all) merchants, discussed by Smith in Chapter IV (ii.9: 456) of Wealth Of Nations, preferred to trade and invest locally rather than take the risks of trading or investing abroad, particularly in the American colonies.

The referee considered ‘risk-averse’ as being about the utility functions of players in modern game theory and not applicable to the merchants that Smith identified in his famous ‘invisible-hand’ paragraph.

Despite my reservations, I accepted the referee’s assertion, not being able to lay my hands of the relevant quotation at the moment I needed it. But I found it this morning while looking for something else.

I consider Smith’s comments on the ‘prudence’ of ‘security’ and ‘aversion’ excuse my original mentions of ‘risk aversion’ as the direct cause of these merchants investing locally and thereby, on the arithmetical law that the whole number is the sum of its individual parts, the behaviour of these merchants, which unintentionally made domestic national output and employment larger in total than it otherwise would be, completely explain what motivated them to do so.

The outcome was brought about, and is eminently explained by the causes identified by Adam Smith before he used The Metaphor of 'an invisible hand', thus making The Metaphor redundant as an explantion, and with its redundancy ,all the subsequent chatter that The Metaphor itself was an explanation are shown to be wrong.

The modern myths of invisible and disembodied hands, including the 'Hand of God' and other mysteries, were not part of Adam Smith's original explanation for the phenomenon, the merchant's 'risk-aversion' ('he intends only his own security' (WN IV.ii.9: 456).

The real mystery, in my mind, is why so many respectable and senior fellow economists can read the same passage from Wealth Of Nations and endorse the modern myth.

In these circumstances I feel permitted to use the term 'risk aversion' as being the cause of the merchants' conduct, without implying any connections to elements of modern games theory.

Thoughts on the Banking Crisis, Invisible Hands, and Risk Aversion

It strikes me that the current banking crisis provides a useful illustration of the behaviour which Adam Smith noted in his famous chapter 2 in Book IV in Wealth Of Nations.

I have quoted this chapter many times here when discussing Smith’s use if the 18th century popular literary metaphor of ‘an invisible hand’, which modern economists since the 1950s elevated into a ‘theory’, ‘concept’, ‘principle’ and even a ‘paradigm’ of how markets work.

Of course, it was nothing of the sort; it became a convenient piece of semi-mystical ideology to propagandise on behalf of leaving large corporate entities to do whatever they found convenient to their interests.

Looking at the political issues around the ‘credit crunch’, the complaint is often presented as the banks being unwilling to make loans to willing borrowers, presumably of good quality, or even to each other. Much angst is suffered asking to why this should be so, given the billions of pounds they have been ‘given’ by various governments.

The answer is partly concealed in the cause of the problem. I refer to the risk-aversion of the banks. They have taken onto their books billions of pounds worth of ‘toxic assets’, most of which neither they nor those who carry them as ‘assets’ are sure exactly as to their true worth. Lending to people with undisclosed – because unknown – liabilities is no way to run a profitable or any other kind of bank.

Borrowers from the general public may receive a trickle of loans, but these are nowhere sufficient to ‘kick-start’ the sluggish economy, and without bank credit flowing more freely, the economy becomes increasingly sluggish.

Borrowers from within the banking sector, even those supported by government loans, guarantees, and assurances, are unlikely to engage in normal ‘inter-bank lending’, while nobody is willing to disclose even to other banks because they may not know themselves the extent of their ‘toxic’ debts, nor their true level of toxicity. This fully explains the current impasse in bank lending.

Hence, the frustration of hapless government ministers, whose complicity in the creation of the mess is as big a secret as are the extent of toxic problem.

But let’s be clear. It is the risk-aversion of the players in the banking crisis that leads them to behave in this manner. They prefer to hold onto what real assets they have rather than commit their business to the uncertain fortunes of lending to both other banks and the wider business community.

Ironically, government borrowing creates an opportunity to buy bonds and earn some interest, though at lower rates than they were used to. But that won’t end the crisis. But banks carry debts owed to them by foreign banks, and what they fear about the risk of their bank lending in Britain is made much worse when considering the security of their loans abroad, where uncertainties caused by doubt and ignorance of the true state of affairs with foreign banks makes them ever more insecurity.

What is true for British banks is also true for foreign banks, all of which was made worse by the swift decision of the Prime Minister and the Chancellor, just when the crisis broke, to seize and confiscate the funds of the Iceland banks in London. Other foreign banks, seeing this treatment, were positively encouraged to disengage their banks situated in the UK. Likewise, British banks’ insecurity about lending abroad is another disincentive to lend.

Adam Smith shows in Wealth Of Nations an analogous situation when noting that some, but not all, domestic merchants preferred to invest their capital locally rather than join those merchants who sought higher profits from trading with the British colonies in North America.

The risk premium, plus long experience of some merchants in the Atlantic trade, was covered by the higher profits they could obtain while their monopoly trade, under the protection of the British Navigation Acts – originally an idea under Cromwell’s remit - and which were enforced by the Royal Navy and every British seaport at home and abroad.

But those merchants, who were risk-averse towards overseas trade, found that local investment, nearby where they operated, though less profitable, were also much less risky. Local courts were serviced by neighbours they knew and laws were clearly defined. These considerations led them to invest locally, which directly benefited the British economy and produced a higher national output of the ‘necessaries, conveniences, and amusements of life’, with a higher amount of employment than would otherwise have occurred. [The whole is the sum of its parts.]

Smith used the metaphor of ‘an invisible hand’ to explain how they were ‘led’ to do this, which has since taken on a life of its own, as if such an entity actually existed; some attribute the ‘invisible hand’ to the hand of God (presumably the hand of the Judaic-Christian God only) and some to ‘Providence’, maybe even to the ‘Intelligent Designer’ too.

The cold fact remains, the action of those, but not all, merchants who preferred to invest locally, was driven by their risk-aversion, and not by anything mystical at all. Likewise, today’s bankers, who hang on to their money rather than lend it out, are driven by their risk-aversion, and nothing else.

There is no invisible hand at work in the Banks. It’s a judgment about comparative risks made by those who run the banks. Change the personnel, but the risk-aversion remains while the causes of it remain on their books.

Meanwhile, the plethora of so-called ‘doing the right things’, in a stream of endless and empty sound bites, creates a complex web of suspicions, fuelled by failures, to have any real effect, and makes it more and more difficult, and unlikely, that the crisis will end for a long and longer time.