Guest Post: Grading Free Market Capitalism and “The Invisible Hand”

Free market capitalism is based on the idea that “the invisible hand” of the market will create the best possible outcome for the most people.

But as I noted a couple of weeks ago, the man who came up with idea of the invisible hand did not believe in unrestrained free market capitalism:

Americans have traditionally believed that the “invisible hand of the market” means that capitalism will benefit us all without requiring any oversight. However, as the New York Times notes, the real Adam Smith did not believe in a magically benevolent market which operates for the benefit of all without any checks and balances:

Smith railed against monopolies and the political influence that accompanies economic power

Smith worried about the encroachment of government on economic activity, but his concerns were directed at least as much toward parish councils, church wardens, big corporations, guilds and religious institutions as to the national government; these institutions were part and parcel of 18th-century government…

Smith was sometimes tolerant of government intervention, ”especially when the object is to reduce poverty.” Smith passionately argued, ”When the regulation, therefore, is in support of the workman, it is always just and equitable; but it is sometimes otherwise when in favour of the masters.” He saw a tacit conspiracy on the part of employers ”always and everywhere” to keep wages as low as possible.

Moreover, as I pointed out in September:

One of the leaders of the new science of financial modeling – Rama Cont – points out that Adam Smith was wrong about the “Invisible Hand”.

Specifically, investors in financial markets rationally pursuing individual profit can produce outcomes that are bad for almost everyone.

As an article in City Journal notes:

Simple forecasts can also be mistaken if they fail to account for the actions of market participants themselves: investor strategies can influence prices, which in turn influence future strategies in a feedback loop that can cause considerable instability. Cont recalls the severe stock-market crash of October 1987, which seemed to strike out of the blue, since nothing significant was happening in the real economy. Subsequent research, though, blamed the crash in part on a new investment strategy, “portfolio insurance,” which a large number of fund managers had simultaneously adopted. Based on the famous Black-Scholes options-pricing model, this strategy recommended that fund managers reduce their risks by automatically selling shares whenever their values fell. But the approach didn’t take into account what would happen if many investors followed it simultaneously: a massive sell-off that could send the market plummeting. The 1987 crash was thus not provoked by events in the real economy but by a supposedly smart risk-management strategy—and the current downturn, of course, also derives at least partly from a global craze for a seemingly foolproof financial innovation…

Investors in financial markets rationally pursuing individual profit, then, can produce outcomes that are globally negative. Doesn’t that contradict classical economic theory? “Both theory and empirical facts do tend to show that, on the financial markets, the Invisible Hand does not always lead to welfare-improving general outcomes,” Cont replies.

Does this mean that free market capitalism is dead?

No. And I’m not sure that there is any better alternative.

But capitalism has to grow up and become less naive, relying less on a blind faith in “the invisible hand” and more on an understanding of human nature, including insights from the field of behavioral economics.

It must include sophisticated checks and balances to make sure that the system is not gamed, instead of childish ideas about the “inherent stability” of the market.

And it must make sure that the poker game doesn’t suddenly end when one of the players gets all of the chips.

Of course, with high-frequency trading dominating the market (and see this), frontrunning, permanent bailouts (and see this), government-sponsored credit rating scams and enterprises, the creation and maintenance by the government of banks so big that their very size warps the entire system, socialism for the big boys, and all of the other shenanigans going on, we don’t currently have free market capitalism.

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About George Washington

George Washington is the head writer at Washington’s Blog. A busy professional and former adjunct professor, George’s insatiable curiousity causes him to write on a wide variety of topics, including economics, finance, the environment and politics. For further details, ask Keith Alexander… http://www.washingtonsblog.com

26 comments

  1. Hugh

    “But capitalism has to grow up and become less naive, relying less on a blind faith in “the invisible hand” and more on an understanding of human nature, including insights from the field of behavioral economics”

    Capitalism today is about as naive as an axe murderer. Blind faith is something to tell the rubes to keep them quiet. The only invisible hand is that of market manipulators gaming the system. Our elites are unreformable. With them in place, capitalism is not going to grow up but blow up.

    1. i on the ball patriot

      The “invisible hand” of free markets,
      Is a decoy for market control,
      It masks the “invisible gland” of deception,
      That pounds you in the old butt hole …

      Deception is the strongest political force on the planet.

  2. The Other George

    American economists have become idiot savants. They know what their economic theories say about what it means to be human, but they pretty much blow off (if they even read) what anthropology, sociology, psychology, most of philosophy, most of history, and a good bit of the natural sciences have to offer. And then they wonder why their models fail.

  3. Marcello

    Now why on earth would the masters of our economy WANT to change “free market capitalism” as it exists today ? They have been made wealthy beyond most everyone’s wildest dreams from it. So what if most of the planet suffers from it. That’s their problem, and besides, security won’t let them past the gated enclaves, so out of sight out of mind.

    Really, it is the people who must stop being naive. The “system” is working perfectly well for the people who constructed it and manage it. If you don’t like it, tough, whad’ya going to do, start a revolution or something ?

  4. Toby

    Economics is the art of obfuscation. There have been others.

    Smith wanted to understand value, price, markets, trade and all the variables that influence them, and was earnest in his attempt. He was also a man of his times, ignorant of many things we now “know”, and consequently came to some conclusions which were solid enough for the time, but need to be re-addressed. E.g., our industrial/technical prowess and its effect on scarcity and abundance presents us with options and challenges Smith could not have imagined. He also had no clue about the income-equality and fairness component of our brains (laid out in The Spirit Level in the form of data and in a recent article in Nature, linked to on Friday in this blog). His take on labour/work necessarily being something no human wants to do, which is then the ultimate source of all economic value, is also out of date. Automation puts huge pressure on that aspect of his theory, as do, in my opinion, things like Wikipedia and other open source software. There are “valuable” rewards for “unwanted” effort other than monetary.

    What we have today is an elaborate web of confusing jargon designed, both deliberately and I suspect unconsciously, to keep the great unwashed out of the temple. It maintains with its secret language of symbols and untested assumptions a particular elite in power/control, and sets us up for an unnecessarily large collapse as that status quo desperately tries to stay in control while clearly losing control. The fearful and stubborn refusal to look at this aspect of society dispassionately is costing lives and causing enormous harm to us all.

  5. John

    Interesting article but I have to wonder whether the “invisible hand” isn’t a lot like the Emperors New Clothes.

  6. Michael Fiorillo

    The existence of a “free market” is about as realistic as Marx’s prediction of the “withering away of the state” under a utopian Communist regime.

    And I say that as someone who thinks that Marx’s analysis of the workings of capitalism remains far superior than most.

  7. dave

    All well and good, but what to do about it.

    If anything I’m more afraid of attempts of government to fix free markets then I am of the flaws in free markets.

  8. scraping_by

    Whether you consider it a bad grasp of PR or a mental and emotional blind spot, the major advocates for ending/limiting the capitalist system are the people who run it.

    In your other post, the GS and JPM plutocrats declare any reality-based compensation as “socialism”. When the subject of financial regulation comes up, the bought Congress cries “socialism”. As medical bankruptcies rise, and more people die from no medical care, the health insurance call any government option “socialized medicine”.

    All in all, it’s the capitalists make socialism sound good.

    If you get beyond this religious belief in private ownership, other forms of ownership (cooperatives, public authorities, governments, etc.)can and have worked just as well.

  9. Patrick

    “Americans have traditionally believed that the “invisible hand of the market” means that capitalism will benefit us all without requiring any oversight.”

    Where do you get these straw men? Who has ever believed this about the free market? These are mostly false constructs spread by folks who are always looking for a pretense to intervene in the marketplace.

    Supporters of a “free market” have always wanted a set of rules to be followed by everyone akin to let us say the rules of chess. What free marketeers despise is changing the rules in the midst of a game creating as politicians continually do–crony capitalism.

    The past interventions over the past year are a prime example.

  10. Jeffrey W.

    I am surprised the few (if any) mention Smith’s Theory of Moral Sentiments, which laid the ethical and psychological basis for his future work. I’ve read that Smith felt the TMS was a more important work versus future writings.

    I’ve also read how the ‘invisible hand’ is frequently taken out of context and Smith may never meant for it to be taken in the manner that it is commonly used.

    Just some observations.

  11. Tom Shillock

    By now, and long before now, the term “free market” and it’s cognates e.g., “free market capitalism” should never be used sans quotes (explicit or implicit) or without qualification because one can always ask “Free of what?” or “Free from what?” It’s too vague to be helpful as a term of analysis which is why it makes such a good term for propaganda and arguments that do not engage each other.

  12. Phillip

    Kevin Carson adroitly pointed out in The Iron Fist Behind the Invisible Hand (http://www.mutualist.org/id4.html) it is possible to be pro-free market AND anti-capitalist.

    Jay Greathouse (www.rawmaterialsecon.com) recently pointed out “Capitalism emerged as the dominant means to separate products from their producers subsequent to the general collapse of manorial feudalism during the Great Plague.”

    A balance between raw materials prices, labor and capital is needed. Capital should be a servant not the master.

  13. fortyouncer

    We don’t currently have free market capitalism, true. But are you saying we had it back in 87? Because if we didn’t have it then how is the crash of 87 an example of the failure of free market capitalism?

    “A balance between raw materials prices, labor and capital is needed.” Yes, we can all agree. I am guessing you believe you know how that balance should imposed upon us? Or how about letting people decide using prices, set in a free market.

    It’s easy to bad mouth capitalism, but without offering the alternative, it’s not really saying much.

  14. Jay Greathouse

    @ fortyouncer, viable alternatives to capitalism, “alternatives” far pre-existing capitalism and proved as safer and sustainable over much longer periods of time than since even proto-capitalism existed, have been systematically discovered and destroyed by armies funded by capitalists, to bring “democracy” and “capitalism” to new markets and expanding opportunities for capital (language I am sure you are familiar with) as the hand-in-glove “nation building” that historically arose with capitalism.

    All of this regardless of the desires of the indigenous populations because it not only destroyed their pre-existing non-capitalist (and working very well) societies but also destroyed the resource bases that had supported them since before the dawn of civilization, genocide by definition.

    Any “alternative” that does not rely upon mass global genocidal wars to meet an inherent structural requirement for constant debt expansion would be an improvement. Pick any from history, but then you would need to know history.

    It seems easy to defend capitalism without knowing its history, that is the essence of not saying much.

  15. Phillip

    fortyouncer,

    Pardon my tardy reply. I just now saw your question. The whole issue of balance between sectors was already solved by Carl Wilken, who probably gave more testimony before Congress in the 30s and 40s than any one before or since and resulted in the Steagall Amendment of 1941. See The Nature of Wealth at http://www.economy101.net and other material at National Organization for Raw Materials site http://normeconomics.org/

    Also highly recommended is Charles Walters’ magnum opus Unforgiven: The American Economic System SOLD for Debt and War and Clarence E. Ayres Theory of Economic Progress available free online several places (click on my name for one).

    Sorry I don’t have any 30 second soundbites to answer your question. Understanding takes study and effort.

    If the Secretary of Agriculture would actually follow the Agricultural Adjustment Act of 1938 now codified as 7 USC 601-602. the economy would be well into a real non-debt based recovery within 6 months.

    Steagall Amendment of 1941 (also called Steagall Commodity Credit Act), Pub. L. 77-144, ch. 270, 55 Stat. 498 (1941)

    Signed into law July 1, 1941. [This law] required support for many nonbasic commodities at 85% of parity or higher. In 1942, the minimum rate was increased to 90% of parity and was required to be continued for 2 years after the end of World War II (see parity definition under 1936 act, page 2). The “Steagall commodities” include hogs, eggs, chickens (with certain exceptions), turkeys, milk, butterfat, certain dry peas, certain dry edible beans, soybeans, flaxseed and peanuts for oil, American-Egyptian cotton, potatoes, and sweet potatoes.

    Agricultural Adjustment Act of 1938, Pub. L. 75 430, 52 Stat. 31

    Signed into law February 16, 1938. The law was the first to make price supports mandatory for corn, cotton, and wheat to help maintain a sufficient supply in low production periods along with marketing quotas to keep supply in line with market demand. It also established permissive supports for butter, dates, figs, hops, turpentine, rosin, pecans, prunes, raisins, barley, rye, grain sorghum, wool, winter cover crop seeds, mohair, peanuts, and tobacco for the 1938 40 period. The 1938 Act is considered part of permanent legislation. Provisions of this law are often superseded by more current legislation. However, if the current legislation expires and new legislation is not enacted, the law reverts back to the 1938 Act (along with the Agricultural Act of 1949).

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