Sunday, January 30, 2011

Another Look at Adam Smith and the Market

A correspondent writes to me on some nuanced differences we have on matters relating to aspects of Adam Smith’s “core beliefs” on how markets work. In a recent exchange he ventured into “Invisible hand” territory, which prompted my response below. It is a self-explanatory response:

"I think there is a fair measure of agreement between us (bar one or two relatively smaller points), including the so far non-discussed matter of the modern interpretation of the meaning of Adam Smith’s use of the metaphor on an “invisible hand” (IH metaphor), especially when interpreted to be Adam Smith’s “invisible hand of the market”, ofwhich I have made many detailed criticisms throughout the Lost Legacy Blog since 2005 and in print since 2008.

However, I would like come at this from another angle arising from your presentation of the role played by discrepancies be and market prices in Smith’s Wealth Of Nations, which, seeing as we broadly agree on the consequences of these discrepancies for decisions on output and price levels in a commercial economy, your (startling - to me) statement that “Collective outcomes must be left to the impersonal, and heteronomous, operation of the “invisible hand” of the market.” I could not leave this alone without comment.

You write: “just consider how individuals in a market system—who are, of course, all trying to maximize their individual material gain—decide what to produce, how much to produce, what to buy and sell, how to invest their capital (if they have any), etc. They look at, and compare, relative prices. Prices, one might say, are the signals that guide individuals in deciding how to pursue their self-interest in the market” (my emphasis).

I have often argued (and as often to no avail) that there is nothing invisible in markets – in fact it is their necessary visibility that provides the essential dynamic for their operation. Prices are very visible; they have to be because prices are what influences purchases and competitive responses. Potential buyers do not have to 'guess' the price. Participants, you write, “look at, and compare, relative prices” and “decide what to produce, how much to produce, what to buy and sell,how to invest their capital (if they have any)”.

Now Smith never mentions the IH metaphor in Books I, II, III, and V, of WN, even when he discussed in his core theory detail, and for good reason: there was no role for the IH metaphor in his core theory. All metaphors have “objects”, as Adam Smith taught his students in his “Lectures on Rhetoric and Belles Lettres” ([1762-63] 1983). But the object of this metaphor, in Smith’s use of it, had nothing at all to do with markets.

It was Paul Samuelson who articulated an oral tradition at Chicago in the 1930s and, separately, in Cambridge, England in the 1920s, but he gave it wide prominence in his Economics: an introductory analysis, 1948, p 36 (and in the 19 editions of his popular text right up to 2010), while claiming inaccurately that he spoke of Adam Smith’s theory. Since, the 1950s, modern economists have broadcast this invention and it is now has the mythical status of being “core belief” and it is linked conveniently (and incredibly) to the welfare theorems and to general equilibrium theory.

What then, in addition to the necessary requirement that prices are made visible in markets, does the IH metaphor add to the theory and practice of market dynamics? Markets don’t need some hidden and mysterious (never defined) term in addition to prices to do their work. [And no such term exists in the equations of general equilibrium theory.]

Smith used the metaphor only once in WN (p 445) and only once in TMS (p 184) (and only once in his posthumous Essay on the History of Astronomy, p 49). In none of these case was Smith referring to how markets work. In TMS he referred to feudal landlords having to feed their serfs, slaves and retainers, which enabled them to work for him and, unintentionally, for the propagation of the human species; in WN he referred to some, but not all, merchants whose insecurity about the risks of foreign and colonial trade led them to prefer to invest in the ‘domestick’ market, which added to “annual output and employment” (an example of the simple arithmetic rule that the whole is the sum of its parts), and in HOA he referred to credulous Romans who believed that the invisible god Jupiter fired intervened in human affairs with thunderbolts from his invisible hand at enemies of Rome.

In each case, the object of the metaphor is specified: in TMS, the landlords were ‘led by an invisible hand’, out of the obvious necessity of feeding their serfs, peasants and retainers, if they were to survive to work through the seasons and the winters; in WN, the risk averse merchants were ‘led by an invisible hand’ to invest locally, to avoid the higher risk of the loss of their capital and their destitution that could follow; and in the HOA, Romans were led by ‘the invisible hand of Jupiter’ to fear their god’s fury if they wished to avoid Jupiter’s intervention in their mortal lives (what Smith called their ‘pusillanimous superstition’.

Smith’s use of the popuIar 17th and 18th century IH metaphor described in a “more striking and interesting manner”, (Lectures on Rhetoric, p 29). Smith’s meaning, was in their objects – all the rest was invented to suit ideological ends, using Adam Smith’s name for legitimacy.

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