Tuesday, June 12, 2007

Adam Smith's Invisible Hand


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. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
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 value of 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. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

Adam Smith
The Wealth of Nations
One of the common misconceptions with regard to economics is that it is a man-made construct that we have created to serve us. One of the insights I had when studying economics is that nothing could be further from the truth. The law of supply and demand, of diminishing returns, and of comparative advantage are as fundamental as Newton's 3 laws. The reason is quite simply that the human race is faced with fundamental constraints - the most important being of time and of resources.


As both time and resources are limited, they have value. We use resources or we use time to maximize our benefit. How and with what efficacy we use these is what the study of economics is about. And like any really elegant scientific theory, from very simple principles come some impressive implications.

This is not to say that there is universal consensus. There are many economists, such as Jeffry Sachs and now Alan Bender who believe that some limits to globalization should exist. But these are all arguments of degree not of fundamentals. There are almost no economists worth anything who would question the fundamentals of economics.

So pervasive are these laws that even when every effort is made to suppress them such as in communism, they come back to bite. It wasn't the West that bankrupted the Soviet Union, it was the market. I personally have seen the destruction of an African country because they attempted to put a brake on free markets. The only thing that happened is that a flourishing black market opened up, prices shot through the roof, corruption became rampant.

There are those who believe that violence and corruption are endemic to the free market system. After all without any "guiding hand" from government, who would check on people's honesty? In fact, the opposite is true. Anyone who has lived in India at the time of the licence Raj can attest to the corruption of government officials. Even the US, which has one of the most open systems in the world, politicians routinely earmark massive budgets to pork-barrel projects. Give a politician or bureaucrat too much power and that power will be abused. In a market system, it is much harder to acquire such power because there are some natural checks and balances in place.

Markets rule. Businesses answer to their customers. Businesses need capital to invest in new projects and so they answer to shareholders or to banks. You can fool the markets for some of the time but you can't fool the markets all of the time. Cases such as Enron are more a confirmation of this idea than a refutation because the markets did catch up with them (and a few other companies) and hurt them badly. Shareholders soon caught onto the fact that the company was sitting on a house of cards. The Asian financial crisis of the 90s was the result of inadequate checks on loans to businesses, which precipitated a massive flight of investor capital. The markets keep people honest not because people are honest or well meaning but because if they weren't, after some time, they will be discovered and will find that either they lose their customers or that investors will shun them, leaving them without funding. Studies (Antunovich et al (2000)) have shown that companies with very strong corporate governance and oversight grow 50% faster than their less well governed competitors over a 5 year period.

Markets thrive on transparency. They wilt when there is too much corruption. This is a clear pattern around the world. As one Nigerian politician said - "In Indonesia, politicians pocket 10% and return 90%, whereas in Nigeria, they pocket 90% and return 10%". There is a strong correlation between the degree of a country's well being and the amount of corruption there is. Corruption eats up capital that could otherwise be put to good use. If you pay $100 to some corrupt official, that is $100 that could have been used to invest in useful machinery for a factory, which would have had a greater rate of return than what the politician would have used it on (such as luxury cars which actually depreciate over time).

Going a little further, there is also a correlation between the level of contentment and freedom in a country and the strength of its markets. A free and open market generates jobs which keeps people occupied, it destroys privilege by rewarding the talented and punishing the lazy. In India, the very system that was meant to help the poor hurt them instead because only the well off could afford the bribes and favours needed to get things done. The collapse of European aristocracy and the rise of the middle class was due to the growing strength of the businessman in Europe. The rise of the middle class could have been one of the early motivators for modern democracy.

On the other hand, suppression or distortion of markets leads to stagnation, decadence and social instability. Nowhere is this more clear than in the Arab World. Saudi Arabia has one of the most restrictive market systems in the world. They have benefited hugely from their oil wealth (and American investment) but Saudi Arabia has no free market and the consequences are clear. There is a 20% unemployment rate in Saudi Arabia. Saudi Arabia is one of the biggest welfare states in the world because they thought they could premise a successful system on patronage. A high unemployment rate for young men is one of the leading sources of social instability. Witness the burgeoning neo-Nazi movement in the states of former East Germany, or the rise of islamo-fascism in Saudi Arabia. As Benjamin Netanyahu said in a recent interview with the Wall Street Journal:


I think that one element that should be expedited as rapidly as possible is the democratization of markets. I think that expanding economic freedom is just as important--in some cases more important--in moderating societies than accelerated moves to political freedoms without the proper democratic institutions.

Trading is natural to human nature. We start trading from the youngest age. We constantly trade with our partners, our children and our friends. Relationships could not survive without the sense that we are getting something in exchange for us giving something. Our ideas of fairness, stemming from our trading instinct, are so fundamental that even the criminal world exacts harsh penalties for cheating. We cannot get away from the market, tame it or do anything else to control it, any more than we could pacify Newton's Three Laws. This is why Adam Smith's invisible hand will never lose it's potency.

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