The Fed Discusses The Relevancy Of The "Invisible Hand"

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With America on the fast-track to a centrally planned economy, courtesy of a surging budget deficit and a debt load that would make Greece blush (at the current rate of debt accumulation, US debt will surpass 100% of GDP by mid-2011) it is imperative to reassess the macroeconomic framework of America from a simplistic Econ 101 perspective, as the US economy of the past 50 years (or even of two years ago) is no longer the prevalent model. This reevaluation should necessarily consider the thoughts of Smith, Pareto, and Hayek, as to whether these are even relevant any longer, now that both the government will be running the majority of the country (at least those sectors that are Too Big To Not Be bailed Out), and a corrupt DC will be regulating the multi-trillion financial industry with the dexterity of gloved Parkinson-afflicted kickboxer. Incidentally, none other than current Fed visiting scholar Stephen LeRoy, a professor emeritus at UC Santa Barbara, has put together a coherent investigation into just how relevant the whole premise of the Adam Smith "invisible hand" (not to be confused with the FRBNY "invisible hand" appearing every night in the futures market at around 2 am) is in our day and age. While somewhat theoretical, economic purists and particularly Austrians may enjoy this brief essay.

Is the “Invisible Hand” Still Relevant?

By Stephen LeRoy

The single most important
proposition in economic theory, first stated by Adam Smith, is that
competitive markets do a good job allocating resources. Vilfredo
Pareto’s later formulation was more precise than Smith’s, and also
highlighted the dependence of Smith’s proposition on assumptions that
may not be satisfied in the real world. The financial crisis has
spurred a debate about the proper balance between markets and
government and prompted some scholars to question whether the
conditions assumed by Smith and Pareto are accurate for modern
economies.

The single most important proposition in economic theory is that, by
and large, competitive markets that are relatively, but generally not
completely, free of government guidance do a better job allocating
resources than occurs when governments play a dominant role. This
proposition was first clearly formulated by Adam Smith in his classic Wealth of Nations.
Except for some extreme supporters of free markets, today the
preference for private markets is not an absolute. Almost everyone
acknowledges that some functions, such as contract enforcement, cannot
readily be delegated to market participants. The question is when and
to what extent—not whether—private markets fail and therefore must be
supplanted or regulated by government.

The answer to that
question is something of a moving target, with views of the public and
policymakers tending to ebb and flow. In much of the latter part of the
20th century, support for Smith’s pro-private-market verdict gained
favor, as reflected in the partial deregulation of financial and
nonfinancial markets in the 1980s and subsequent decades. The financial
and economic debacle of the past few years, however, has led many to
revisit this question, particularly in Europe, but also in the United
States and elsewhere. To many, financial markets in the last several
years appeared dysfunctional to an extent that was never imagined
possible earlier. Did Adam Smith get it wrong about private markets?

This Economic Letter
discusses two versions of the argument in favor of private markets:
that of Adam Smith in the 18th century and that formulated in the 19th
century by the Italian sociologist and economist Vilfredo Pareto. The
discussion in this Letter points to the key assumptions in
the arguments. Differing views on the degree of applicability of those
assumptions underlie a good deal of the debate over the appropriate
balance between relying on markets versus government intervention. Also
important are views on the effectiveness of government involvement.

Competitive markets work: Adam Smith

In 17th and 18th century England prior to Smith it was taken for
granted that economic and political leadership came from the king, not
from private citizens. If the king wanted to initiate some large
economic project, such as expanding trade with the colonies, he would
encourage formation of a company to conduct that project, such as the
East India Company. The king would grant that company a monopoly,
usually in exchange for payment. Smith thought that these monopoly
grants were a bad idea, and that instead private companies should be
free to compete. He called on the king to discharge himself from a duty
“in the attempting to perform which he must always be exposed to
innumerable delusions, and for the proper performance of which no human
wisdom or knowledge could ever be sufficient; the duty of
superintending the industry of private people, and of directing it
toward the employments most suitable to the interests of the society.”
(Smith 1776 Book IV, Chapter 9)

Thus, Smith’s conclusion was that private markets worked better if
they were free from government supervision, and for him it was just
about that simple. Smith’s idea received its biggest challenge when the
Soviet Union achieved world power status following World War II. In the
1960s, reported gross national product grew at much higher rates in the
Soviet Union than in the United States or western Europe. Such
authorities as the Central Intelligence Agency estimated that, before
long, Soviet gross national product per capita would exceed that in the
United States. To many, it looked as though centrally planned economies
could achieve higher growth rates than market economies.

Economists who saw themselves as followers of Smith took issue. To
them, it was simply not possible for centrally planned economies to
achieve higher standards of living than market economies. As Smith put
it, government could not be expected successfully to superintend the
industry of private people. Too much information was required, and it
was too difficult to structure the incentives. G. Warren Nutter, an
economist at the University of Virginia, conducted a detailed study of
the Soviet economy, arguing that the CIA’s estimates of Soviet output
were much too high (Nutter 1962). At the time, those findings were not
taken seriously. But, by the 1980s, we knew that Nutter had been
correct. If anything, the Soviet Union was falling further and further
behind. By 1990, this process came to its logical conclusion: the
Soviet empire disintegrated. Score a point for Adam Smith.

Competitive markets work: Vilfredo Pareto

By
the 19th century, economists had largely abandoned the informal and
literary style of Smith in favor of the more precise—if less
engaging—style of today’s economics. Increasingly, economists came to
appreciate the role of formal mathematical model-building in enforcing
logical consistency and clarity of exposition, although that
development did not get into high gear until the 20th century. Under
the leadership of Pareto and others, Adam Smith’s argument in favor of
private competitive markets underwent a major reformulation.

Pareto’s version of the argument is usually taken to be a refinement
of Smith’s. But, for the present purpose, it’s best to emphasize the
differences rather than the similarities. First, Pareto provided a more
precise definition than Smith of efficient resource allocation. An
allocation is “Pareto efficient” if it is impossible to reallocate
goods to make everyone better off. Or, to put it another way, you
cannot make someone better off without making someone else worse off.
This idea captures part of what we usually mean by “good performance,”
but not all of it. For example, attaining a reasonably equal income
distribution is often taken to be part of what we mean by good
performance, but an equal income distribution is not an implication of
Pareto efficiency. Indeed, public policies designed to reduce the
degree of income inequality can involve redistribution of income,
making some better off and others worse off. (See Yellen 2006 for a
discussion of income inequality.)

Pareto reached the remarkable conclusion that competitive markets
generate Pareto-efficient allocations. In competitive markets, prices
measure scarcity and desirability, so the profit motive leads market
participants to make efficient use of productive resources. The English
economist F.Y. Edgeworth made a similar argument at about the same time
as Pareto. Economists Kenneth Arrow and Gérard Debreu presented precise
formulations of the Pareto-Edgeworth result in the 1950s and 1960s.

A mathematical proof that competitive allocations are Pareto
efficient required a characterization of a competitive economy that is
more precise than anything Smith had provided. For Pareto, unlike
Smith, it was not enough that the economy be free of government
intervention. The essential characteristic for Pareto was that a
buyer’s payment and a seller’s receipts from any transaction be in
strict proportion to the quantity transacted. In other words,
individuals cannot affect prices. This assumption is satisfied, to a
close approximation, by the classical competitive markets, such as
those for corn, wheat, and other agricultural commodities. The
assumption rules out monopoly and monopsony, in which individual
sellers and buyers are large enough to be able to manipulate prices by
altering quantities supplied or demanded. When monopolists and
monopsonists can distort prices in this way, allocations will not be
Pareto efficient.

Pareto’s efficiency result was first formulated in mathematical
models of economies that were static and deterministic—that is, models
in which time and uncertainty were not explicitly represented. In the
20th century, economists realized that the validity of the
Pareto-efficiency result does not depend on these extreme restrictions.
Arrow and Debreu showed that allocations will be Pareto efficient even
in economies in which time and uncertainty are explicitly represented.
They showed that, in any economy, there is an irreducible minimum level
of risk that somebody has to bear. In a competitive economy with
well-functioning financial markets, this risk will be borne by those
who are most risk tolerant and who therefore require the least
compensation in terms of higher expected return for bearing the risk.
This is exactly as one would expect—risk-tolerant participants use
financial markets to insure the risk averse. These aspects of
equilibrium are discussed in standard texts on financial economics
(such as LeRoy and Werner 2001).

However, demonstrating these results mathematically depends on
assuming symmetric information—that is, assuming that everyone has
unrestricted access to the same information. Such an assumption is less
unrealistic than excluding uncertainty altogether, but it is still a
strong restriction. The advent of game theory in recent decades has
made it possible to relax the unattractive assumption of symmetric
information. But Pareto efficiency often does not survive in settings
that allow for asymmetric information. Based on mathematical economic
theory, then, it appears that the argument that private markets produce
good economic outcomes is open to serious question.

Nonmathematical economists such as Friedrich Hayek proposed an
argument for the superiority of market systems that did not depend on
Pareto efficiency. In fact, Hayek’s argument was the exact opposite of
that of Arrow and Debreu. For him, it was the existence of asymmetric
information that provided the strongest rationale in favor of
market-based economic systems. Hayek emphasized that prices incorporate
valuable information about desirability and scarcity, and the profit
motive induces producers and consumers to respond to this information
by economizing on expensive goods. He expressed the view that economies
in which prices are not used to communicate information—planned
economies, such as that of the Soviet Union—could not possibly induce
suppliers to produce efficiently. This is essentially the same as the
argument against socialism discussed above.

Reevaluating the balance between markets and the government

The
financial crisis that we have just experienced puts the question about
the appropriate balance between reliance on markets and government
intervention on center stage. Those who believe that unregulated
markets generally work well express the view that misconceived
interference by the government was the major cause of the crisis. In
contrast, those who take a more critical view about the functioning of
private markets believe that the crisis stemmed mainly from the
destructive consequences of factors such as information asymmetries in
financial markets and distortions to incentives that encouraged
excessive risk-taking. The problem was not government involvement per
se, but rather government’s failure to place checks on destructive
market practices.

This latter view dominates most of the recent proposals for
financial reform. And, while the particulars of financial reform are
still to be determined, it appears that current sentiment is less
supportive of Adam Smith’s verdict on the efficiency of markets than
was the case prior to the financial crisis. At the same time, it seems
clear that neither extreme view of the causes of the financial crisis
is accurate. Reforms based only on one of these views to the exclusion
of the other will not lead to a set of changes that will guarantee
improvement of the performance of financial markets and prevent
recurrence of financial crisis. The problems are complex, and sweeping
changes in the regulatory structure could do more harm than good. A
better strategy may be to identify specific problems in the financial
system and introduce regulatory changes that address these clearly
defined weaknesses, such as executive compensation practices that
encourage excessive risk-taking.

Stephen LeRoy is a professor emeritus at the University of California, Santa Barbara, and a
visiting scholar at the Federal Reserve Bank of San Francisco.


References

LeRoy, Stephen, and Jan Werner. 2001. Principles of Financial Economics. Cambridge: Cambridge University Press.

Nutter, G. Warren. 1962. The Growth of Industrial Production in the Soviet Union. Princeton, NJ: Princeton University Press.

Smith, Adam. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations.

Yellen, Janet. 2006. “Economic Inequality in the United States.”FRBSF Economic Letter 2006-33-34 (December 1)