Modern conceptions of the invisible hand

We have seen that the concept of the invisible hand is about how individuals who are pursuing their own interests bring about unintended social consequences and that there is a certain explanatory strategy attached to it. It is useful now to see how modern conceptions of the invisible hand relate to the original concept. In what follows, two different modern interpretations of the invisible hand are identified: the end-state interpretation and the process interpretation. Mainstream economists use the end-state interpretation that does not pay much attention to the explanatory strategy attached to the original invisible hand. Austrian economists use the process interpretation, which is closer to the original concept. Yet they seem to have amplified the meaning and effect of the invisible hand. Let us start with the mainstream interpretation.

1. The end-state interpretation

Generally, in standard economics, the invisible hand is associated with the funda- mental theorems of welfare economics, which basically state that ‘under certain conditions, every competitive equilibrium is a Pareto optimum, and conversely, every Pareto optimum is a competitive equilibrium’ (Chipman 2002: 1). A funda- mental theorem of welfare economics is sometimes characterised as the invisible- hand theorem. It states that when the distribution of income is given, a long-run perfectly competitive equilibrium will yield an optimum allocation of resources, and that every optimum allocation of resources is a long-run perfectly competitive equilibrium (see Blaug 1997: 577–579). Many mainstream economists conceive the invisible hand as an argument about efficiency and equilibrium (see, for ex- ample, Stiglitz 1991; Durlauf 1991; Hahn 1970, 1981; Marris and Mueller 1980, among others.) Indeed, many economists would consider the progress of econom- ics on a line that connects Smith’s invisible hand, the concept of equilibrium, and Arrow and Debreu’s (1954) proof of the existence and optimality of competitive equilibrium. In fact, general equilibrium models in general are considered either as the proof of Smith’s ‘invisible hand’, or as showing the conditions under which this conjecture holds. For example, Tobin (1991: 6) argues that Adam Smith’s invisible hand is a conjecture about the workings of the market system which provides simple intuitions (1991: 12–13), and that this conjecture was proven by Arrow and Debreu. Likewise, Stiglitz (1991) considers the modern theorems of welfare economics as a modern representation of Smith’s invisible hand. The proof of the existence and optimality of equilibrium indeed connects with Smith’s argument that self-regarding actions of individuals would lead to a beneficial out- come for the society. Existence of a Pareto-optimal equilibrium proves the pos- sibility of such a result.25 However, the conditions under which the existence of equilibrium is proven may also be considered as a proof of the limitations of such an argument. Stiglitz (1991) expresses his worries about the empirical adequacy of these proofs. Both he and Tobin (1991) mention that the proofs of the existence of optimal market equilibrium do not take into account issues such as increas- ing returns, externalities, imperfect competition, time, uncertainty, incomplete markets, instabilities, etc. (also see Coase 1992; Maskin 1994). These omissions, according to Tobin, show the limitations of the invisible hand argument.26 Hahn (1981) similarly argues that although equilibrium proofs indicate the logical pos- sibility that an optimal equilibrium exists, because of these limitations (i.e. failure to take into account increasing returns, externalities, etc.) we have to consider the invisible hand argument as a remote reference point in comparison to the real world:

[I]t is logically possible to describe an economy in which millions of agents looking no further than their own interests and responding to the sparse infor- mation system of prices only can nonetheless attain a coherent economic dis- position of resources. Having made that clear let me nonetheless emphasise the phrase ‘logically possible’. Nothing whatever has been said of whether it is possible to describe any actual economy in these terms.

(Hahn 1981: 5)

Veblen (1899) raises a similar point against Smith’s conception of economic affairs. He particularly criticises the practice of ‘normalising’ the state of affairs in the real world, that is, the abstract nature of Smith’s argumentation. But, he goes on to argue that modern interpretations of the invisible hand should also be criticised since they work with isolations and abstractions to show that the dispersed self-regarding actions of individual may bring about beneficial conse- quences. Having said that, there is an important difference between the two. In the previous section we have seen that Smith used the invisible hand to represent the connecting principles of society that are supposed to bring about an orderly phenomenon and that the notion is best understood in terms of its relation to unintended consequences at the social level, which are brought about by the ac- tions of individuals who are intending to bring about results at the individual level. His argument against the import restrictions as well as his explanation of the origin of money (see Appendix I) connects the actions of the individuals to the aggregate outcome. He indeed tries to explicate the process through which those unintended social consequences may be generated. The modern conception of the invisible hand, however, does not explicate how individual actions are related to the aggregate outcome.27 Moreover, existence proofs do not mention the process through which the equilibrium is reached. Modern economists’ conception of the invisible hand is, thus, basically an end-state interpretation. Or, as Hahn (1973: 324) argues, ‘general equilibrium is strong on equilibrium and very weak on how it comes about’. It stresses the consequence (i.e. existence of equilibrium), rather than the process that brings about the consequence. Blaug (1997: 60) argues that this end-state interpretation makes no justice to the original metaphor:

But Smith’s faith in the benefits of ‘the invisible hand’ had absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect á la Walras and Pareto; the effort in modern text books to enlist Adam Smith in support of what is now known as the ‘fundamental theorems of welfare economics’ is a historical travesty of major proportions. For one thing, Smith’s conception of competition is [. . .] a process conception, not an end-state conception.

(Blaug 1997: 60, emphasis added)

Similarly, Barry argues that the invisible hand is concerned with the process rather than the end-state:

The notion of the Invisible Hand must be seen as a metaphor that illuminates a continuing process of exchange and competition between individuals which brings about a coordination of plans and purposes. It must not be seen as a picture of an end-state of perfect equilibrium in which all plans have already meshed, since that implies the cessation of human action. The Invisible Hand image refers to an unending process of change and adjustment and not to a perfectly harmonious end-state in which incentives to change have been removed.

(Barry 1985: 138)

Many would agree with Barry and Blaug that the end-state interpretation does not make justice to the original metaphor (e.g. Holcombe 1999, Knudsen 1993: 149–150).29 Although their propositions are correct, this does not mean that the end-state metaphor is not related with Smith’s invisible hand. As we have mentioned above, end-state (equilibrium) models can be considered as tests of the logical soundness of the invisible hand argument. That is, they show/test the conditions under which self-interested actions of individuals would lead to ben- eficial aggregate outcomes. The next chapter demonstrates this point by way of showing the relation between the end-state models of the emergence of a medium of exchange and Menger’s account of the origin of money.

2. The process interpretation

Another popular interpretation of the invisible hand follows Smith by emphasis- ing the need to explicate the processes through which social outcomes are brought about. Under this interpretation, the invisible hand is a metaphor that represents a process that brings about a harmonious social order as an unintended consequence of the dispersed actions of individuals who are pursuing their own interests. This conception of the invisible hand is mainly related to the idea of spontaneous or- der,30 and is generally entertained by Austrian economists.31 Because the concept of ‘spontaneously generated orders’ is generally regarded as the most significant sociological contribution made by the Scottish philosophers (such as Hume, Smith and Ferguson), this interpretation is argued to be closer to Smith’s own thought (see Hamowy 1987; Barry 1982). Roughly, the ‘theory of spontaneous order’ as- serts that social institutions and patterns – which are highly complex – are the unintended consequences of numerous individual actions. The most prominent advocate of the theory of spontaneous order, Hayek (1967a: 72) argues that the task of social science is to explain the unintended consequences of the dispersed actions of individuals.32 Yet he criticises the way in which mainstream economists approach unintended social phenomena.

Hayek complains about the equilibrium approach to economics for it is not about the processes through which equilibrium comes about:

In the usual presentations of equilibrium analysis it is generally made to ap- pear as if the questions of how the equilibrium comes about were solved. But, if we look closer, it soon becomes evident that these apparent demonstra- tions amount to no more than the apparent proof of what is already assumed. The device generally adopted for this purpose is the assumption of a perfect market where every agent event becomes known instantaneously to every member.

(Hayek 1937 [1949]: 45)

This criticism implies another similarity between Smith and Hayek; that Hay- ek’s interpretation of individual knowledge resembles that of Smith’s in certain aspects. He (1937, 1945) argues that the knowledge of society is never available to the individual in its totality because of the peculiarities of individual knowl- edge.

This is the constitutional limitation of man’s knowledge and interests, the fact that he cannot know more than a tiny part of the whole of society and therefore all that can enter into his motives are the immediate effects which his actions will have in a sphere he knows.

(Hayek 1946a [1949]: 14)

According to Hayek (1946a [1949]: 45) the end-state interpretation of the invis- ible hand (that of neo-classical economists) is ‘an assertion of a tendency toward equilibrium’ yet it does not tell us how this equilibrium is reached. To show this, one has to show how the knowledge and expectations of individuals are changed and how these individuals are able to coordinate given their partial information about the market.35 He states that the process through which market order (or equilibrium36) is reached cannot be understood by assuming that every individual knows everything. To be able to understand the process ‘we must look at the price system as such a mechanism for communication information’ (Hayek 1945 [1949]: 87).37 According to Hayek, when agents act spontaneously by pursuing their own interests (i.e. at the individual level) more information is utilised in the market and coordination among individuals is rendered more easy in comparison to market where individuals intent to bring about social consequences.

Competition is essentially a process of the formation of opinion: by spreading information, it creates that unity and coherence of the economic system. [. . .] It is thus a process which involves a continuous change in the data and whose significance must therefore be completely missed by any theory which treats these data as constant.

(Hayek 1946b [1949]: 106)

What Hayek means by ‘data’ here is the information upon which agents act. According to him, by assuming that individuals are hyper-rational, traditional equilibrium analysis in economics misses the point that every individual has lim- ited knowledge about the economy as a whole and about the motives of other individuals. The ‘data’ changes as the agents act, and the analyses of the process of economic activity has to take this into account. He (1937 [1949]: 38) argues that neoclassical economics abstracts from the fact that the consequences of one individual’s actions are dependent on other individuals’ actions, and that the overall consequence depends on the interactions of individuals who have limited knowledge and rationality. The aforementioned similarities (between Smith and Hayek) indeed point to the argument that if those connecting principles of society that link the dispersed actions of the individuals to the social consequences are to be explicated, one has to take two things into account: the interaction of individu- als who have limited knowledge and the process through which they coordinate their activities. These issues are not dealt with in traditional static equilibrium models of economics. In Chapter 8 we will see that some of the contemporary economists try to deal with these issues by using the tools of game theory.

Another important idea that is common to Austrian economists and Smith is the explanatory strategy by which unintended social consequences are explained.

Hayek emphasises the element of conjecture and conceptual construction in ex- plaining spontaneously generated orders (see, for example, Hayek 1967a: 72). Hayek echoes Smith with the idea that explanation can only be made starting from the regularities of human action.38 He also echoes Smith in that his explanatory strategy is similar to that of ‘conjectural history’, the explanatory strategy that is attributed to Smith by Dugald Stewart. In his Biographical Memoir of Adam Smith, Stewart argues that historians sometimes find themselves in situations where they cannot find or use direct evidence, and proposed that

[I]f we can shew, from the known principles of human nature, how all its various parts might gradually have arisen, the mind is not only to a certain degree satisfied, but a check is given to that indolent philosophy, which refers to a miracle, whatever appearances, both in the nature and moral worlds, it is unable to explain.

(Stewart 1793 [1858]: 34, emphasis added)

To this type of investigation Stewart gave the title of ‘conjectural history’. Stewart particularly refers to Smith’s (1762 [1985]) Considerations concerning the first formation of languages as an example of conjectural history. In Considerations, Smith conjectures about the way in which language may have developed, and provides an invisible-hand type of explanation of its emergence. He indeed tries to show the ‘conditions under which language might evolve naturally (i.e., without human or divine contrivance)’ (Land 1977: 677).39 By way of departing from what he sees to be the facts about human beings and natural languages he constructs a story where language develops naturally. Smith’s argument against import restric- tions, and his explanation of the origin of money (see Appendix I) contain such conjectural elements.

Yet it is also true that the Scottish philosophers were against ‘boundless con- jectures’. For example, Ferguson (1767: 7–12) criticises the ‘state of nature’ theo- rists, such as Jean-Jacques Rousseau and Thomas Hobbes, by pointing out that their approach is conjectural (see Berry 1997: 23). He criticises the practice of explaining the ‘progress of society from a supposed state of animal sensibility’ and argues that we should not work with such an analogy.40 For him (1767: 12) the explanation of the progress of society should start from the ‘laws of human nature’. Thus, the ‘instinctive propensities’ and ‘set of dispositions’ of man should be used in developing such a theory (Ferguson 1767: 16). Yet Ferguson is also aware that historical records about earlier stages of the society are rare. He only suggests that our theories should be consistent with the ‘facts’ we know about hu- man nature. Whether we agree with his argument about human nature, or not, his suggestion is clear: our theories have to be constrained by and be coherent with the known facts about our object of inquiry. This is, in fact, what Stewart means by conjectural history:

In examining the history of mankind, as well as in examining the phenomena of material world, when we can not trace the process by which an event has been produced, it is often of importance to be able to show how it may have been produced by natural causes.

(Stewart 1793 [1858]: 34, emphasis in original)

Conjectural history, then, emphasises the element of rational reconstruction that has to be consistent with the facts we know about the subject matter. It shows a social phenomenon ‘may have been produced’ by ‘natural causes’. We have seen that Smith suggests explanation of unfamiliar phenomena with reference to familiar facts. In fact, in WN and TMS, Smith provides us conjectural con- structions of real-world phenomena which are based on what Smith considers to be familiar facts concerning individuals. Also, Smith’s accounts of the origin of money and language are conjectures which are based on familiar individual mechanisms. Hayek, as well as Stewart, sees such activity as an essential compo- nent of conjectural history.

Conjectural history in this sense is the reconstruction of a hypothetical kind of process which may never have been observed but which, if it had taken place, would have produced phenomena of the kind we observe.

(Hayek, 1967a: 75)

What is common to Hayek, Menger and Smith is their interest in the processes through which unintended consequences may emerge, but the proposed processes do not have to be the actual ones in every occasion, for we usually have limited information about the actual process (e.g. about particular details of the phenom- enon, or about the actual intentions and motives of the individuals). By means of starting from what is thought to be the basic principles or facts about the object of inquiry, rational reconstruction, conjectural history (or a theoretical explana- tion) may inform us about the connecting principles of society or of the social phenomenon we wish to examine. The element of conjecture is a necessary part of theoretical analysis for they argue that we can neither know the exact interests and intentions of the individuals, nor the peculiarities of their situation.

Austrian interpretation of the invisible hand seems to be a faithful interpreta- tion of the original metaphor. Yet it should be noted here that Smith’s use of the invisible hand does not emphasise the explanation of an overall social order as an unintended consequence of human action. It is, rather, concerned with ex- planation of certain type of phenomena such as the consequences of the actions of merchants, or the rich. Smith explains the origin of money and language as unintended consequences of human action but he does not lay much emphasis on the explanation of overall social order as an unintended consequence of hu- man action. Explaining the overall social order as an unintended consequence of human action would require an explanation with multiple layers of unintended phenomena and intentions therein. Such an explanation would run into difficulties because of the complexity of the social realm, which embodies both intention- ally designed and unintentionally brought about institutions.42 It seems to be fair to say that Austrian interpretation of the invisible hand magnifies the original concept by considering the overall social order as a beneficial unintended social consequence of the dispersed actions of individuals. In Chapter 8 we will consider game-theoretical models of coordination which follow the process interpretation of the invisible hand without endorsing the Austrian emphasis on overall harmo- nious social order.

Thus far, we have discussed two different interpretations of Smith’s ‘invisible hand’ – that is, the end-state interpretation and the process interpretation – by contrasting the two. But, we should not forget the fact that they are coming from the same source, and that they are alternative ways of justifying Smith’s invisible hand. The static equilibrium interpretation tries to show that it is indeed possible (under certain conditions) to reach an equilibrium, an orderly state, where every individual acts self-regardingly, and that they may be better off by doing so. Or, the end-state interpretations of the invisible hand focus on the conditions under which unintended social outcomes are compatible with self-interested individual action. The process interpretation, on the other hand, tries to show through which mechanisms this opportunity may be rendered more probable. The relation be- tween these two different justifications43 of the invisible hand is discussed further in Chapter 6 by means of discussing the contemporary contributions to Menger’s explanation of the origin of money. But before doing this we should examine the notion of invisible-hand explanations.

Source: Aydinonat N. Emrah (2008), The Invisible Hand in Economics: How Economists Explain Unintended Social Consequences, Routledge; 1st edition.

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