Saturday, February 27, 2010
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.
As Paul Krugman writes:
Adam Smith ... may have been the father of free-market economics, but he argued that bank regulation was as necessary as fire codes on urban buildings, and called for a ban on high-risk, high-interest lending, the 18th-century version of subprime.
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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If free market capitalism is dead, it was preceded by the death of nuance.
ReplyDeleteIf stifling over-regulation is bad, then total deregulation including laws against fraud must be good, right? I mean that's what Smith meant by the invisible hand- total anarchy, right?
If Keynes advised government spending during downturns, he must have also supported pro-cyclical government spending, and exponentially increasing government spending, in perpetuity right?
When Friedman endorsed market determined interest rates, he really meant a Central Bank led race to ZIRP, worldwide.
Certainly capitalism can only be 19th century workers' hell and socialism can only mean Soviet Communism.
And how does one player get all the chips? Through government intervention. Our entire banking system is based on fractional reserve banking and the Fed. Both are huge give-aways to bankers.
ReplyDeleteFinance is replete with examples of government intrusion on the free market. Just look at the ratings cartel that was given away in 1975.
http://globaleconomicanalysis.blogspot.com/2007/09/time-to-break-up-credit-rating-cartel.html
Legal monopoly.
If you want to see who can do things better, the government or private enterprise, even in some of the most fundamental things like building roads, I highly recommend checking out Thomas DiLorenzo:
http://mises.org/journals/scholar/internal.pdf
This is shorter, and incomplete, but it should give the idea:
http://books.google.com/books?id=_YaS18_3nlQC&pg=PA84&lpg=PA84&dq=dilorenzo+turnpikes&source=bl&ots=OtimM0hzai&sig=JvR1qavl3uw75UFzeOS6PgZrbLE&hl=en&ei=i-qJS727F5S1tgeZ0a2bDw&sa=X&oi=book_result&ct=result&resnum=1&ved=0CAYQ6AEwAA#v=onepage&q=&f=false
The invisible hand can't work if the government ties it.
Trouble is, the guiding hand gets corrupted. A longer story, one that shows the University of Chicago, or at least my favorite parts of it, remain Shiningly relevant.
ReplyDeleteA true free market has natural checks and balances built right into it. If a company sells products and services at a price too high or is found out to be misleading consumers, they will go out of business.
ReplyDeleteThere is no better regulation than consumers voting with their dollars.
Government regulation is an oxymoron that always leads to an enslaved society.
1) "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."
ReplyDelete2) "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."
3) "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."
The above are three quoted paragraphs from the article.
Most contemporary-modern writers empirically assume any problem can be gnawed at with a synthesis of several ideas to produce an enlightenment of understanding. They fail to be critical enough of their own processes to recognize, it is all this empirical gnawing at the problems, that creates the surety to take the next step, which ALWAYS creates an even bigger problem.
That is the nature of our current cultural depression, which too many want to interpret as an economic phenomenon, when it is not -exclusively or even in the greater of its part.
In paragraph one- we find a restatement of empirical resolve couched in terms of our current conundrum, concerning mustering the faith to try, try again- to correct a problem that cannot be corrected using the archaic terms and methods of the past. This approach will only make matters, again, exponentially worse, if it has any effect at all. (Note the bail out strategy, which was deduced using this exact-same approach.)
Paragraph two, is a restatement of Adam Smith's invention, similarly couched in the terms and methods current to the now historic predicament of his time. (Note, Smith arguing "When the regulation, therefore, is in support of the workman, it is always just and equitable." I am sorry -but Carnegie and others rightly pointed out -if you pay the workman well he will be a poor worker, prone to drunkenness. Others noted, well-cared-for workers will breed endlessly, creating the seeds of their own labor-value destruction, -also ruining the environment in which they live.)
I included paragraph three because its statement concerning the current conundrum has all the ingredients for measurably taking a path that would allow for the escaping of the empirically obsessive-compulsive behavior of modern-contemporary thought, even if it then goes on to ignore the truth that stares everyone in the face.
"Doesn’t that contradict classical economic theory?"
Yes, Folks.
It is all the endless empirically derived theories themselves that are the dominoes that repeatedly fall over and over again, in an endlessly obsessive-compulsive empirical behavior -that has found us again at the bottom of a very deep ravine arguing about what has happened, and what the next obsessive-compulsive empirical move should be...
Now stop.
There is a new knowledge set called Categorical Knowledge, that approaches truth entirely differently.
Categorical Knowledge allows for creating rules that should NEVER be violated.
Here are two of those rules. 1) All bureaucracies are categorically immoral. And 2) All credit is categorically immoral.
Follow categorical rules, if you want to end the obsessive-compulsive empirical behavior that is so vexing humanity.
Life is good. Science is a load of crap.
This particular issue is one of the reasons attainder was prohibited. It could take many forms, but all of them were laws targeted at any group, for one group's benefit, or penalty.
ReplyDeleteThe greatest nature of the Republican form of government (quite distinct, separate, and different from that political party) was the fact that no law could be made that did not equally have its benefits and penalties upon the whole of society. All laws must be general in applicability, and must affect congress, their friends, and the whole of society equally. (federalist 57).
In addition, this prohibited the people from voting away any rights of any others, as it would also affect them. (federalist 51). The states themselves are bound to this Republican form of government, wherein no group could receive the advantage of law, by penalizing others to their benefit.
The only way monopoly can arise is by these actions of government, targeted legislation, and unequal law.
But what do I know? I'm just an idiot.
General Washington, I do not think you grasp the full extent of government/corporate collusion in manipulating the economy. One key point that even many top mainstream economists on our side like Paul Craig Roberts do not understand are the socially manipulative effects of fiat money creation by a Central Bank. We need to limit government so that there is nothing for the corporations to loot with.
ReplyDeleteHere we are learning today that unless something is done quickly, something over one million will run out of unemployment benefits and, in many cases, I'm sure, food as well. Yet we have post after post instructing us in the libertarian catechism that the only steps that government can take to intervene in the economy will be destructive! What stands behind this rather peculiar notion is one even more peculiar: That the state is a kind of moral agent, that it is intrinsically "evil" and that only "evil" can come from its activities. This contruct lies at the very core of libertarianism and is as flawed as it is outrageous. Structures such as the state can only be neutral morally as only human beings possess moral agency and can be said to be evil. To assert otherwise is to express only the most abysmal ignorance of moral theology. Would a libertarian assert that a gun is anything but morally neutral? Hardly. How, then, to justify this atrocious contradiction when it comes to the state? Perhaps we'll learn when libertarians revive their beloved Confederacy or elect Ron Paul who might as his first act as President offer membership in the Flat Earth Society free of charge to any citizen. Now that's "liberty" for you, eh?
ReplyDeleteAndrei Vyshinsky
The "inherent stability" of the market is a reliance on human innovation to take advantage of any big mess. In most transactions money is neither created nor destroyed, simply transferred.
ReplyDeleteThe "invisible hand" idea has always bothered me on many levels. I've actually heard it argued that if there was no government welfare, poor people would be better off because the rich in this country would be more motivated towards philanthropy and the poor would be more motivated towards hard work. Anyone with real world experience knows this is a bogus argument.
Beyond that aspect of it, the job of the "invisible hand" seems to be shuffling money from the poor to the rich.
Hi, thank you very much. good job.
ReplyDeleteInvisible Hand? Are you referring to the Rothchilds...
ReplyDeleteThe American Monetary Institute proposes the following alternative:
ReplyDeleteIncorporate the Federal Reserve System into the U.S. Treasury where all new money would be created by government as money, not interest-bearing debt; and be spent into circulation to promote the general welfare. The monetary system would be monitored to be neither inflationary nor deflationary.
Second, halt the bank’s privilege to create money by ending the fractional reserve system in a gentle and elegant way. All the past monetized private credit would be converted into U.S. government money. Banks would then act as intermediaries accepting savings deposits and loaning them out to borrowers. They would do what people think they do now. This Act nationalizes the money system, not the banking system.
http://www.monetary.org/need_for_monetary_reform.html
" 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. "
ReplyDeleteThis statement is Totally inacurate and misleading : capitalism/free markets are designed to enhance Profit at Any cost to the conssumer/people generaly . Just look around you and the News , capitalism is an open door for profettering , abuse and Selfishness .
The Money Masters have the right approach to our common problem.
ReplyDeletethemoneymasters.com
They recommend the following a Two Step Plan to National Reform and Recovery.
"1. Direct the Treasury Department to issue U.S. Notes (like Lincoln's Greenbacks) to pay off the National debt.
2. Increases the reserve ratio private banks are required to maintain from 10% to 100%, thereby terminating their ability to create money, while
simultaneously absorbing the funds created to retire the national debt.
These two relatively simple steps, which Congress has the power to enact, would extinguish the national debt, without inflation or deflation, and end the unjust practice of private banks creating money as (i.e., fractional reserve banking). Paying off the national dept would wipe out the $4oo+billion annual interest payments and thereby balance the budget. This Act would stabilize the economy and end the boom-bust economic cycles caused by fractional reserve banking."
Support the Monetary Reform Act - write your Congressman today!
We don't live in a Free Market economy so can't prove that Free Markets don't work by citing current issues. You can't have a free market when money supply/interest rates are controlled by the Fed.
ReplyDeleteWe have government welfare so you can't say that the rich would not donate more to charity (without welfare) by stating that "Anyone with real world experience knows this is a bogus argument."
We have to actually try something out before we can say that it doesn't work. Considering our whole system is based on fiat money and it's tanking maybe we should try something new.
Perhaps going to a completely free market system "could" turn into a world where governments buckle under pressure from huge multi-national corporations and every official is bought off...hmmm that sounds strangely similar to the world in which we live. Maybe it won't be as bad as a lot of people think? Maybe it would be good? Personally I'd rather take my chances with something that "could" happen as opposed to something that "is" happening.
Finance is not Capitalism. Finance is a service that helps facilitate Capitalism, but when Finance goes rogue it kills Capitalism by destroying the system that Capitalists need to keep score..
ReplyDeleteA true free market has natural checks and balances built right into it. If a company sells products and services at a price too high or is found out to be misleading consumers, they will go out of business.
ReplyDeleteSo, how can we know if we are being misled if there are no product labeling regulations?
How can we avoid "too high" prices if there are monopolies or cartels?
Regulations don't stifle economies, people do.