The Fed Discusses The Relevancy Of The "Invisible Hand"

Tyler Durden's picture

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

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

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

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.


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)

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Thunder44's picture

Don't you wish you had a invisible hand if you were going pick someones pocket.

TheGoodDoctor's picture

But isn't that the crux really? You never know what caused the bubble until it pops and causes the problems.

G-R-U-N-T's picture

Yeah...Pop Goes the Weasels!!!!

Fraud-Esq's picture

More powerful than the Supreme Court...


"We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand," Greenspan said, according to the transcripts of a March 2004 meeting.

jeff montanye's picture

the greeks had a word for it: hubris.

Nikki's picture

The unbridled hubris of a sociopathic narcissistic economic terrorist.

deadparrot's picture

Translation: If we let private sector professionals with real-world experience into our ivory tower, they will be able to prove to the country that the Fed is a nothing more than a group of the most dangerous people on the planet: idiots with Phds.

G-R-U-N-T's picture

Indeed...The finest so called minds in the country, coming from the most sophisticated, and prestigious universities, and the best they could do is bankrupt our country.

Back where I come from we call people like that "Dumb as a Fence Post!"


Assetman's picture

Sounds like classic groupthink to me.

The last thing the Fed has wanted, past and present, is for outsiders to get involved in an intellectual debate-- that only those in the inner circles actually understand.

What a much of pompous maroons.  Hopefully, this will be the rough phrasing in the annals of history.

BlackBeard's picture

Well, in that case the Fed can jerk me off with that invisible hand.

At least with all this assraping, they'd have the decency to give me a courtesy reach-around.

Mercury's picture

I think you're coming close to a breakthrough economic insight here: The marketplace has the power of the invisible hand but the government (via NY Fed, ZIRP, TBTF etc.) has the power of the invisible reach-around.

Oooh! hey that's not my that you Mr. Marketplace?

Oh my assets! Go easy, I'm trying to save for the fuuuutre....

chumbawamba's picture

Howard, that's definitely a t-shirt ;)

I am Chumbawamba.

TheDuke's picture

I guess what the author is trying to say is "this time is different".

Unfortunately when one questions or ignores the invisible hand it turns into an invisible fist and smacks down all that are non-believers in free and fair enterprise.

Common_Cents22's picture

I see your invisible hand, and raise you a federal govt boot on the neck.


Obama's Interior Sec Ken Salazar:

"Our job is basically to keep the boot on the neck of British Petroleum," Salazar said, who often sports a Stetson and who four months ago stirred the ire of the oil business by saying unlike under his predecessors in the George W. Bush administration, oil companies would no longer be treated like "kings of the world." When he was a senator, he had to apologize after calling Christian conservative leader James Dobson "the antichrist of the world."

Yardfarmer's picture

I also noticed that crude and ridiculous tough guy comment. Mr. Sleazliar has never been known for subtlety of expression or depth of intelligence. When running of the Senate in Colorado, at one of his campaign rallies, he demanded that security remove and arrest an individual silently bearing a sign in support of his opponent Peter Coors. I doubt if his signature chest thumping possesses any relevance or is going to have any effect on this catastrophe especially in light of the fact that BP, whom I believe is under contract with the South Korean government, has a reported $75 million liability cap in that arrangement. Certainly many unseen hands are working behind the scenes in this imbroglio.

LeBalance's picture

I would dearly love to know if this "invisible hand" model has ever been thought applicable.  A free market may have existed at your 12 year olds lemonade stand, but really nowhere else.  This is especially true in the crimnocentric US I find my self in.  Even the "founding fathers" tried to steal King George's enterprise in 1780 and came up short, but the US was never "free or brave", more aptly described as "fee and slave."

The doorway to begin realising a further rabbit hole bungie drop begins by understanding what the device called a "Constitution" is and what "Constitutors" are.

Oh in that sense the "invisible hand" is a useful myth to fog the minds of the "c"itizens.  They think that the smooth functioning of the economy is due to "fairies in the night" and recessions are due to "animal spirits."

I guess it is convenient to distract oneself from the distinct sigmoidal fullness and the heavy breathing on the neck that is our every day life.

Invisible Hand's picture

Am I still relevant? Of course I am! (Don't ask my wife).

Bottom line: A single monkey with a piece of scrap metal can destroy in 1 second the most complex piece of machinary every built.  However, given all the parts of the same machine, a million monkeys could never assemble the machine in a million years.

Single monkey = FED

Million monkeys also = FED

They can break it, but they can't fix it.

The economy in the US worked despite the FED, not because of it.  However, eventually given rope and enough time the FED has managed to hang all of us.

Ain't government wonderful?



jeff montanye's picture

particularly in the last decade, the u.s. economy didn't work very well with or without the fed.  what the essay above seems to ignore is the gross perversion of free markets that the concept of too big to fail introduces.  apparently the smart financiers knew they would be bailed out and the dumb ones (seemingly the majority) never considered they'd need to be.  

the solution isn't an either/or.  if private industry is going to have the power to create money, and apparently they are, both those in daylight and those in the shadow banking system need to be intelligently and honestly supervised regarding, at a minimum, fraud, monopoly, insider trading and maintenance of sufficient reserves/insurance for risks taken.  most importantly, none may be to big to fail.  and when they do fail, the management, stockholders and bondholders are liable first.  long before the taxpayer.

KevinB's picture

what the essay above seems to ignore is the gross perversion of free markets that the concept of too big to fail introduces.

I am sorry, but I must disagree. The last sentence of the report - which is where you usually put your zinger - says they must remove incentives that encourage excessive risk taking by executives. Isn't that precisely what TBTF encapsulates? It's the ultimate bad incentive - heads I win, tails you lose. If you know that you are politically connected (hi Lloyd!), you don't have to fear losing your job (hi Marty! hi Ken!) and, while it causes considerable hardship for the guy on Main Street to lose his bonus for a year, when you've been earning tens of millions for years, it's more an annoyance. Of course, in the squid dominated DC establishment, Leroy had to be circumspect about saying this, lest he lose his own job.

faustian bargain's picture

The Fed has been ubiquitous since its inception, so there's no way of gauging whether the economy has worked well 'with or without it'. It's always been 'with', since 1913. And we've done pretty poorly since then.

Fish Gone Bad's picture

What invisible hand?  All those traders that the Fed hired are doing what exactly?  This is actually pretty obvious, Dorsch said it best, "Imagine for just a moment, that the Dow Jones Industrials has become a key instrument of national economic policy, and that by “actively managing” its direction, the government could impact the wealth of tens of millions of US households, and by extension, influence consumer confidence and spending. By ramping up the growth of the money supply, and slashing interest rates to zero percent, in order to inflate market bubbles, the Fed could in theory, fuel an economic rebound."  Nothing is allowed to fail. 

Implicit simplicit's picture

The invisible hand has a prosthetic index finger with algorithmic sensors guided by misguided brains who think they know what is best.

ghostfaceinvestah's picture

The President of the European Central Bank, Jean-Claude Trichet, told Forbes that global governance is extremely necessary if we want to prevent another financial crisis. In his prepared printed and spoken remarks to the Council on Foreign Relations, Trichet emphasized that politicians, economists, and financiers must work across the Atlantic and collaborate on methods to create an international set of standards

Kreditanstalt's picture

"Another crisis"?  You's OVER?

nmewn's picture

Oh goody...One World Government finally reveals itself...I've been waiting all my life for this...only half snark.

The Final Ponzi...LOL.

How is it that the same people who wrought all this social chaos, financial ruin and mass enslavement to THEIR credit system still get a microphone to even be heard???

Pondering the imponderables.




Kreditanstalt's picture

It's all very convenient to lambaste free markets when you are engaged in a desperate search for someone to take the blame.  Or when the organization for which you work bears some likelihood of someday being held responsible for the mess.  Or when you have lost a measure of your house value/living standards/wealth and need help in playing the needy victim...

But they're running out of other people's money...  

Hansel's picture

No, they're not.  They can print money.  I've seen no indication that this will end.  I have seen many people find some solace in thinking this will end eventually.

Kreditanstalt's picture

True.  But that is liquidity.  Or currency, or credit, or something...NOT real MONEY.  More and more people will be demanding real, unencumbered non-debt-derived MONEY.

Jean Valjean's picture

Bingo.  Money is the key.  The invisible hand has not been functioning since 1971 because we have not been using REAL MONEY to transact and measure profits.

Burnbright's picture

They aren't running out of "money", but they are running out of "value". As printing continues the incentive to actually produce something of value decreases.

So no I don't think it will go on for ever.

Fraud-Esq's picture

So long as there is no substantial debate about appointments to the Fed, this will continue. Glass Steagall was also slowly eaten away by regulatory changes inside the Fed too, not only legislative. A few "5-4" decisions with Volcker in the minority up against Greenspan. Nothing had broad debate. De-politicizing the Fed and monetary policy is the coup of coups. After 2008, it is still a nonissue, more-less, in mainstream media. Legislation rarely gets the whole job done. You have to get in these people's faces and demand accountability, especially when they hide their proceedings. We need supreme court style selection and consent. It ain't happening. They're hiding behind their economic degrees and bank support when it all really about...who's making money, how and who's side they're on. There is no rule Fed board member have to come from the banking industry just like Supreme court don't have to be judges.    

drbill's picture

Once again, the "free market" has failed and we need government to correct the tendencies of the "free market" to self-destruct.

What's truly sad is that most people (and a sizable percentage of economists) actually go for this line of reasoning.

I guess that's why I believe the current system ultimately must collapse.

Assetman's picture

Good points, drbill.

I'm still amazed there was a regulatory structure in place over the past 2 decades, and although imperfect, the regulators (esp. the SEC, DOJ and Fed) did very little to enforce what was already in place.

Free markets didn't work because fraud was widely accepted as everyday business practice-- and it was something that could have been detected and enforced.

So do we REALLY think MORE regulation (though much of what has been inlcuded, esp the amendments, make sense) will really be the magic pill? 

I don't think so.


Burnbright's picture

That is exactly right, you can lead a horse to water but you can't make em drink. What good does it do to increase taxes and regulations when simply following the law (i.e. the constitution) would have prevented all this from happening in the first place?

GeoffreyT's picture

It annoys me immensely that academics never start their examinations in the right place (as my mentor once quipped: there is six weeks' worth of actual theory in economics - the rest is embroidery).

When considering the latest financial disruptions, the central counterfactual in the "regulation versus free-markets" argument should NOT be whether the problem could have been avoided by changes in the degree of oversight of financial market participants.

The central counterfactual should be whether the situation would have been avoided if the short term price of money (the interest rate) was determined by a market or by a politically-appointed group of frothy old crabbers led by a failed investment consultant (Alan "Wrong Way" Greenspan, whose forecasting performance is immortalised in an image on my site: had Greenspan not fastened himself to the public teat he would have starved to death).


If Mises and Hayek were correct about the information problem in economic calculation (and they were correct), then why the fuckety fucking fuck do we still insist on letting central planners decide the most important price in a modern western economy (the price at the short end of the yield curve)?


If you don't start at the right point, you wind up asking the wrong questions. The political-parasite class relies on this type of misdirection to mislead the polity into accepting greater degrees of regulation at levels ABOVE the root causes of core problems.

To refresh Diderot (to account for the collapse of kingdoms and priesthoods): man will be free when the last politician is bludgeoned to death with the severed arm of the last police sniper.

Caedite Eos.





LeBalance's picture

are we clowns to you?  are we here to amuse you? can't you fff'n see us? didn't we make ourselves fff'n obvious?  don't we have our (ahems) so far up your (aha) that you know who we are?  c'mon, three guesses and the first two don't count.

dumpster's picture

man will be free when the last politician is bludgeoned to death with the severed arm of the last police sniper.

the hand having been severed  from the arm as it placed a  brown paper sack in front of a crowd of politicians

Hulk's picture

Dumpster, where the hell did that come from???

dumpster's picture

 paraphrase Diderot...

Burnbright's picture

I understand that you were joking but there are some people who won't. Not trying to be rude...just sayin.

Hulk's picture

Thanks Dumpster. Diderot new to me , so I will need to do some reading...

nmewn's picture

"man will be free when the last politician is bludgeoned to death with the severed arm of the last police sniper."

If I can condense that to coffee mug size to sell to suburban college trained anarchists I intend to make a fortune ;-)


Mitchman's picture

Go for it!  I'll buy the first dozen mugs.  Every libertarian in the US will buy one.