Adam Smith theory of invisible hand

July 8, 2015
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One of the best-kept secrets in economics is that there is no case for the invisible hand. After more than a century trying to prove the opposite, economic theorists investigating the matter finally concluded in the 1970s that there is no reason to believe markets are led, as if by an invisible hand, to an optimal equilibrium — or any equilibrium at all. But the message never got through to their supposedly practical colleagues who so eagerly push advice about almost anything. Most never even heard what the theorists said, or else resolutely ignored it.

Of course, the dynamic but turbulent history of capitalism belies any invisible hand. The financial crisis that erupted in 2008 and the debt crises threatening Europe are just the latest evidence. Having lived in Mexico in the wake of its 1994 crisis and studied its politics, I just saw the absence of any invisible hand as a practical fact. What shocked me, when I later delved into economic theory, was to discover that, at least on this matter, theory supports practical evidence.

Adam Smith suggested the invisible hand in an otherwise obscure passage in his Inquiry Into the Nature and Causes of the Wealth of Nations in 1776. He mentioned it only once in the book, while he repeatedly noted situations where “natural liberty” does not work. Let banks charge much more than 5% interest, and they will lend to “prodigals and projectors, ” precipitating bubbles and crashes. Let “people of the same trade” meet, and their conversation turns to “some contrivance to raise prices.” Let market competition continue to drive the division of labor, and it produces workers as “stupid and ignorant as it is possible for a human creature to become.”

In the 1870s, academic economists began seriously trying to build “general equilibrium” models to prove the existence of the invisible hand. They hoped to show that market trading among individuals, pursuing self-interest, and firms, maximizing profit, would lead an economy to a stable and optimal equilibrium.

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