Friday, March 21, 2014

Refusing Adam Smith’s “Invisible Hand”

An essay for the class I am taking.


Adam Smith’s The Wealth of Nations is sometimes seen, especially in recent decades, as a description of natural or divine forces at play in society akin to Newton’s description of gravity or Darwin’s of evolution.  His theories in An Inquiry into the Nature and Causes of the Wealth of Nations come equipped even with a divine “explanation”:  “an invisible hand.”  It’s a phrase that he used only once in The Wealth of Nation, and which originated in his first book The Theory of Moral Sentiments. But it is an idea that animates—and sweetens—his description of how national economies function.  The idea, as it is often portrayed, is that no matter how much humans muck around with the economy, displaying their greed and incompetence, everything will always end up righting itself and some kind of balance will return to markets.  As history has progressed there are reasons enough to credit Smith with a great deal of insight, but to respect the limitations of this theory.
Smith lays out a basic description that an economy is founded on the principles of buyers and sellers.  In any given transaction, there is a person or group selling a product that another person or group wishes to purchase.  He believes we all benefit by increasing the number of these exchanges.   Generally, he is interpreted as advocating that we should do anything we can to support the expansion of these transactions. The more, the merrier. His well-known statement that “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest” alludes to both sides of the transaction (119).  Both parties need to benefit from the transaction:  the buyer receives the goods that he or she needs or desires, and the seller receives some sort of profit, which he or she will use to satisfy his or her own needs or desires.  If only the buyer benefits, then the seller will cease selling.  If only the seller benefits, the buyer will not be able to continue participating. 
Smith also describes how three essential factors function:  land, labor, and capital.  First, there are the owners of land, buildings, factories, and equipment.  These can be rented to others.  Next, there are those whose work creates the product.  The more specialized that labor, he argues, the more product that can be produced at lower costs.  Third, there are those who have capital—either in cash or in equipment, or as Smith calls it, “circulating” or “fixed” capital.  All these factors inevitably contribute to the “natural price” of a commodity, or, simply, the cost to produce the product.  This “natural” price” should include a little profit for the contributors of the land, labor, and capital.  The problem occurs—but Smith would not call it a problem—because each of the parties involved—the owners and providers of the land, labor, and capital—are in competition with each other and with other providers of the same product.  Everyone is trying to maximize his or her own income and to minimize his or her own outlay.  Similarly, consumers are in competition with each other to purchase various products.  In this way, prices for commodities can vary if one is attempting to buy or sell food products during a drought or excessively rainy season, if one is offering black (mourning) cloth during a war or period of pestilence, if someone has secretly developed a new technology that reduces labor, or created a product that supersedes or eliminates the need for previous products. 
At every moment, the economy has opportunities to be thrown out of balance, for good or ill, for one or more constituencies—buyers, sellers, land owners, workers, capitalists.  If commodities become scarce profits go up, owners hire more laborers with higher wages to increase output.  If the market is glutted with commodities with low or no profit margins, cut labor.  Still, through that mysterious force of the “invisible hand,”  benefits flow to one or all in the long run.  Or, cynically, one might believe that it is those who benefit who believe that the benevolent “invisible hand” has been active.  I wonder if the poor, unemployed, and others who have not benefited from a particularly violent economic shift believe that the ‘invisible hand” has rebalanced their lives.   
One of the effects of Adam Smith and later theorists like Karl Marx coming to understand economic markets so well is that, of course, others would come to understand them equally well.  Especially, people in business.  And those business people were not interested in understanding the economy for policy or political or ethical reasons (no, Theory of Moral Sentiments, here); rather, they were looking for the best way to make a profit, or to game the system. One can think of the business tactics of Andrew Carnegie and John D. Rockefeller, for instance.  A recent academic example is Harvard professor Michael E. Porter’s ideas as developed in 1979’s “How Competitive Forces Shape Strategy” and his subsequent books.  “[C]ompetition in an industry is rooted in its underlying economics, and competitive forces exist that go well beyond establishing combatants in a particular industry.  Customers, suppliers, potential entrants, and substitute products are all competitors that may be more or less prominent or active depending on the industry” (2).   Porter established the process of analyzing “Five Forces” when developing a business strategy.  It seems to me that he basically applies Smith’s macro–analysis to a business strategy that advocated avoiding all situations in which “natural pricing” occurs.  In other words, one’s business strategy should always be to deflect the “invisible hand.”  A business’s best competitive stance is to make certain the economy, or at least one’s own sector of it, should never come to balance.  Profits occur when there is an imbalanced market place.  So as Smith accepts (and even applauds), Porter implies that a business’s goal is never to promote or sustain the public good, but to exploit opportunities for maximum profit by accessing one’s strength over and vulnerability to five forces: supplier power, buyer power, (the number and strength of) other existing competitors,  threat of substitution, and the threat of a new competitors.
It seems to me that his conclusion is simply a statement of how important it is that a business not fall victim to the constant urge of the economy to balance itself:
            The key to growth—even survival—is to stake out a position that is less vulnerable to attack from head-to-head opponents, whether established or new, and less vulnerable to erosion from the direction of buyers, suppliers, and substitute goods.  Establishing such a position can take many forms—solidifying relationships with favorable customers, differentiating the product either substantively or psychologically through marketing, integrating forward or backward, establishing technological leadership.  (10)
            But, of course, the world in which Adam Smith wrote no longer exists.  Industries and corporations are larger, markets are more extensive and even more global, banks more powerful, financial products more complicated than ever.  Still, Adam Smith and his ideas remain influential.  Nobel Prize winning economist Paul Krugman acknowledges, “The birth of economics as a discipline is usually credited to Adam Smith, who published The Wealth of Nations in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market” (1).  Then in 1929, we suffered the stock market crash, which ushered in The Great Depression and faith in the markets was shattered.  Yet over the course of over sixty years of prosperity, the pain of The Great Depression was forgotten.  “[E]conomists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.”  And
“[t]hey turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.” (1)
            So even though I have enjoyed reading Adam Smith and feel that I have discovered a rational explanation of how the economy functions, I have two issues that have nagged me as I studied his work.  First is that I simply don’t trust capitalists and corporations to act in moral ways.  I believe that many, if not most, are out to game the system in some way.  Perhaps it is to lock up suppliers of key components or technologies so that competitors cannot enter the market.  Perhaps they will focus on global profits to the neglect of local employment.  Perhaps, larger wealthier companies will purchase smaller vulnerable companies with advanced products and refuse to bring those new competitive products to market.  Adam Smith might say that certainly these things can happen, but that over time, some competitor will break the lock on suppliers, offer jobs locally, or discover and release competitive technology.  Sure, I can agree, but that leads to my second issue.
            Macro-economics of this kind just simply does not take into account all the small and personal instances of harm.  Some economists, for instance, believe that The Great Recession of 2008 and beyond was simply a typical kind of market correction that they interpret Adam Smith acknowledges and accepts.  As Krugman points out, the effects of that recession include:  “U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940 (6).  It might be stimulating to be a rational Smithian economist who flies high overhead computing these numbers, but down on the ground in the individual lives losing six million jobs, the effect is devastating. Like Krugman and other economists who are critical of the warmed-up and simplified versions of Smithian economics, I believe that markets need to be regulated and that there will be occasions for real and urgent government interventions.  As Krugman concludes:  “When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly” (8).  Or sometimes, an “invisible hand” needs a nice, old-fashioned slap on the wrist.




Works Cited
Krugman, Paul.  “How Did Economists Get It So Wrong.”  New York Times Magazine.
2 September 2009.  Accessed on-line: 21 March 2014 <http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=0>
Porter, Michael E.  “How Competitive Forces Shape Strategy.”  Harvard Business
            Review.  Reprint.  July-August 1997.  1-10.  Harvard Business Review
March-April 1979.  Accessed on-line: 21 March 2014
Smith, Adam.  The Wealth of Nations, Books I-III.  Ed. Andrew Skinner.  New York:

            Penguin Books.  1999.

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