This is the first in a series of blogs that aims to connect founding ideas in economics to life in our modern world. A good place to start is with Adam Smith (1723-1790), and takes that core idea of his that has grown into an identity-confirming mantra for economists plying their trade in governments and companies around the globe: the logic of the invisible hand.
Smith, more than any other of the early economic philosophers, was a proponent of the capacity of self-interest to deliver an efficient social outcome through processes that are unseen by the outside observer. The point often missed by modern students of economics—who, after all, are bombarded with data and analytical techniques in virtually every class—is that these processes truly are unseen. Invisible. Not measured in standard economic data sets, and arguably difficult to measure even if one had an unlimited budget. The efficiency of the free market system relies utterly on these processes, so it is worth thinking hard about what they actually are, and where in our modern world they might be imperilled.
Let’s start first with the supply side of the market, and go back to the original birthplace of the phrase ‘invisible hand’. Smith writes in An Inquiry into the Nature and Causes of the Wealth of Nations (IV.2.8-IV.2.9) :
‘But it is only for the sake of profit that any man employs a capital in the support of industry; and he will always, therefore, endeavour to employ it in the support of that industry of which the produce is likely to be of the greatest value, or to exchange for the greatest quantity either of money or of other goods.
But 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.’
Translating this into more modern language and applying some editorial discretion, we have:
‘Anyone with resources makes his decision about how to invest them based on how profitable that investment will be, without regard for its effects on others. All investors in the economy behave like this, meaning that every available opportunity to create higher value in the economy will be taken by somebody. This leads to the situation in which the country as a whole produces as much as possible, though no individual intended this beneficial overall outcome.’
Smith does limit his consideration here to the case that all investors choose to invest domestically rather than abroad, and assumes that this choice is motivated by purely selfish reasons; but for the purposes of this exercise, we can safely ignore these nuances.
What Smith does not make explicit, and what is often omitted from retellings of this idea, is the process by which investors form expectations about profit. This process underpins their investment decisions and hence it is one of the unseen pillars of the entire economy.
How does this process work? Any trade (ie investment) is chosen on the basis of expectations about profit, that themselves are formed on the basis of the price at which the investor anticipates he will later be able to sell the asset he buys today. These sale-price expectations are based in turn on untold numbers of market signals to which the investor is exposed – everything from official consumer confidence estimates, to how busy the donut shop was yesterday, to whether his boss looked relaxed this morning. The investor’s perennial processing of all of these signals, every moment of every day, is unmeasured and largely infeasible to measure, yet it is crucial in delivering correct, wealth-maximizing, self-interested decisions that propel the economy forward. This conception of how the economy delivers value lies at the base of a myriad of drumbeats one hears repeated by modern economists worldwide: the vital importance of preserving free and accurate information flows; the optimality of delegation rather than centralization in the sense of letting people ‘at the coal face’, those who can with least effort and most accuracy observe the market signals relevant to particular investment alternatives make investment decisions; and the importance of free access to investment in all markets, so that investment alternatives must openly compete with one another in an evolutionary struggle to prove which is profitable enough to merit investment. We do not typically, as economists, measure all of this information gathering and processing that leads into expectations, meaning that the invisible hand is, to this very day, still invisible!
We can also surmise that there is a way to break Smith’s logic. There may be situations where expectations are systematically wrong, having become unlinked from ‘exchange value’ in the economy. An unlinking of profit expectations from ‘exchange value’ means that people pay for goods whose use for making future profits is less than anticipated, leading to inefficient allocation of their resources and, to the extent that other investors are afflicted as well, inefficient allocation of the resources of the broader economy. Where might such fissures arise? One classic example is a market bubble, where unanticipated collapses in the perceived value of activities supported by particular markets cause initial profit estimates to be inaccurate. This means large losses for investors in the short run, after which estimates and exchange values are then brought back in line through people’s processing of the very obvious market signal that lots of investors just lost their shirts. Another example of such an unlinking is the case when excess rents are made available through imperfect monitoring or unsettled property rights. For example, a market intermediary who benefits from lack of information on the part of two market players that he brings together has the opportunity to mislead one or both parties about the true value of the proposed transaction, and hence to encourage transactions that may be profitable for him personally but do not in fact lead to greater value for the transactors. To the extent that the information problems that support his position are entrenched, perhaps for geographic or technical reasons, this social vein continues to be exposed and the intermediary can continue to leech profits from it that are essentially unlinked from the value of the trades he makes possible. This is why IT departments are notoriously disliked, and more generally why one is suspicious of one’s agent in any principal-agent problem.
Finally, let me indulge in a personal anecdote to consider in light of Smith’s invisible hand, what is possibly the most famous bug-bear of the free market economist: big companies wielding market power. How does their existence threaten the power of the invisible hand? Take the classic Australian example of Woolworths and Coles, the two oligopolists that control the lion’s share of the Australian supermarket sector. When I visit my local supermarket (not naming names), I often find that the flour shelf is replete with rows upon rows of white flour, and the shelf above the wholemeal flour label is empty. Extrapolating from this observation, one may surmise that the store owner’s purchase of one additional bag of white flour would be a less profitable investment than his purchase of one additional bag of wholemeal flour, because the latter will sell more quickly, thereby generating a higher return, that is, revenue per square metre of retail space for the investment. If this is correct (which assumes no irregularities in the upstream supply chain for the two different types of flour), then why does the supermarket not react to that market signal? Essentially it does not react because it is not forced to by competitors who do see the opportunity and will act upon it.
The bosses of these supermarket companies and the managers of particular stores have little incentive to improve their performance in the market, as they already make a comfortable profit and they know that their customers are to some extent beholden to them. Shoppers usually have only one or two local supermarket choices anyway, often a Coles and a Woolworths, and making special trips to specialty stores for certain products is an extra cost that many people figure is not worth paying just to reliably get those products. So, many customers just put up with little inconveniences like this and keep giving their business to Coles and Woolworths, which creates a continued possibility of rent extraction for the supermarket chains and their weak reaction to the market signal is not punished. In this way, the absence of evolutionary competition of investment alternatives creates a market malignancy that ultimately supports the inefficient use of resources in the economy. (PS: For the Australian consumer wanting to make a difference, try shopping at Aldi.)
In the next blog in this series, we’ll move to the other side of the table and consider how demand-side behaviours too can be subject to the workings of a benevolent invisible hand.