Economics

How Economists’ Distorted Version of Adam Smith’s Invisible Hand Ruined the Economy

As Americans turned away from government, so did the economics profession

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By Jeff Madrick

Remember in 2009 when everyone was dodging blame for the financial crisis? Depending on who you asked, it was the bankers, the federal regulators, Fannie Mae, fraudster mortgage companies, the ratings agencies and the sub-prime borrowers themselves. The favorite claim of excuse makers was that no single group was to blame — it was a cluster-f*** as one journalist friend put it.

If everyone did it, no one could be held accountable. But it wasn’t true. Bankers and regulators were the major creators of the crisis, for their neglect and single-minded self-aggrandizement that often involved bending the rules.

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But let me single out one group that avoided blame and deserved plenty of it: mainstream economists. The deeply held ideas of the nation’s most elite economists from the Right and the Left were direct causes of the crisis, justifying perverse behavior on Wall Street and in Washington, and careless and ignorant behavior at the Federal Open Market Committee of the nation’s central bank, the Federal Reserve.

These ideas did a lot of harm along the way — in particular, they were responsible for slower than necessary economic growth that resulted in higher unemployment and inequality.

But first, consider this one enormous area of theoretical neglect, and you get an idea of the inadequacies of the prevailing body of economic ideas. The Federal Reserve just named a new committee headed by vice chairman Stanly Fischer to research how unstable financial markets may affect the real economy of jobs, production, business investment and profits. If you read the 2008 minutes of the Federal Open Market Committee (released earlier this year), which meets roughly every six weeks to set interest rate and other policies, you’ll see that the policymakers and their staffs had little idea how to account for financial risk. Finance simply wasn’t in their economic models.

In short, the policymakers had no firm concept that the roiled financial markets, which had been in turmoil since 2007, could undo the nation’s Gross Domestic Product. The Fed economists, as able a bunch as there are, did once try to put a guestimate to the effect of the troubled mortgage markets, and they were way off the market. The FOMC didn’t anticipate a serious recession until the December meetings, after the economy fully crashed and credit dried up two months earlier — and even then they underestimated by a long shot how far the nation’s total income would fall. At that point, they thought the unemployment rate would go to, at worst, about eight percent, but it rose to 10 percent.

I think the casual reader may find this hard to believe — not that economists missed the forecast (they generally have an abysmal record at predicting recessions) but that they didn’t even really take financial excesses into account in their models.

This was not just the oversight or prejudice of stuffy FOMC members. It directly reflected the ideas of mainstream macroeconomists at elite universities — the economists typically quoted in the media — from the so-called fresh-water conservatives at schools like the University of Chicago to the salt-water semi-liberals of Yale, Princeton and MIT. (I leave out Harvard, which on balance now has a politically conservative economics department, including Gregory Mankiw, Alberto Alesina, Robert Barro and Martin Feldstein, for example.) As the highly regarded Olivier Blanchard, a left-of-center MIT economist who is now chief economist at the International Monetary Fund, admitted after the collapse, there had simply been no place for financial regulation in macroeconomics up to that point.

This is dismaying but it is important to understand that a fundamental mainstream idea was behind it. Generally, the reaction of the economic mainstream to the inflationary turmoil of the 1970s was to retreat to an ideological interpretation of their fundamental ideas — a doctrinaire reinforcement of laissez-faire economics. As Americans turned away from government, so did the economics profession. In regard to the financial markets, it boiled down to this. Free markets without government interference work too well to become dangerously unstable; therefore, no need to account for how a credit crisis might affect the real economy. It would correct itself too quickly to do damage.

Since the 1980s, this had been a central economic idea, one of several major ones that did great damage. Financial markets were “rational.” If a stock price or mortgage security was overvalued, a smart professional would sell it. Milton Friedman said as much in the early 1950s about letting currencies trade in free financial markets. Speculation would usually lead to stability, not instability.

As with many fundamental ideas, they were often useful initially. Eugene Fama and several other economists at the normally conservative University of Chicago and the usually liberal MIT made persuasive cases that individuals could not “beat the market,” which was composed of countless smart investors incorporating information accurately when assessing how much a stock was worth. That is, even if they invested in a professionally run mutual fund, odds were high simply buying an index fund that mimicked the Standard & Poor’s 500 would do better. Fama won a Nobel Prize for his early work.

But the economics profession became more extreme in their support of the power of free markets, and what had been known as the efficient markets theory went off the rails. Economists like Fama began to claim there were no speculative bubbles. Regulations to limit them, like credit restraints, would only interfere with the efficient workings of the markets. Others like Michael Jensen, a Harvard Business School disciple of Fama’s, argued as did Fama that stock prices rationally reflected the future value of a company. To get CEOs to manage companies better, just give them stock options. They will get rich as the company’s stock price rose due to their abilities.

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It turned out, however, that stock prices weren’t all that rational at all. They were subject to fashions, as Robert Shiller, the Nobelist from Yale showed. It also turned out that, as Lucian Bebchuck at Harvard Law School has shown, there is little relationship between CEO compensation and a company’s performance.

Some purely bad ideas were resurrected, such as Say’s Law. It argued in part that any savings in a nation would be productively invested. But what we know is that just isn’t true if there is no buying power for goods and services. Austerity economics was one damaging result, not merely at the University of Chicago but among researchers at, for example, Harvard, led by Alberto Alesina, and to a large extent Kenneth Rogoff, and some economists at the Brookings Institution. But deficits became the bogeyman.

The wide-ranging turn to laissez-faire doctrine reached across the economy, but here is how it contributed directly to poor and unequal incomes. After the inflationary 1970s, the nearly sole objective of government policy should be to keep inflation low. Again, there was a fundamental idea here. Inflation upset the rational workings of free markets by introducing uncertainty. With low inflation, economies would be efficient and prosperous.

But inflation targeting, led by the Federal Reserve, resulted in higher unemployment rates than necessary and slower growth in wages for most workers. There was a deliberate effort to keep wages from rising rapidly to avoid a squeeze on profit margins that would force business to raise wages. The unemployment rate was higher than what government economists thought a natural rate should be most of the time since the 1970s.

The founding idea of modern economics is Adam Smith’s invisible hand, and this great idea, badly over-simplified, was the foundation of many bad ideas of the last generation. The invisible hand tells us how an economy free of government regulations may work, not how it does work. Competitors will push prices down to maximize consumer buying, pure and simple. Government need not regulate these competitors. Increasingly, the profession took a dogmatic view. Financial deregulation, a low minimum wage, reduce government invest — these were all results of a purist interpretation of the invisible hand.

The great nineteenth century economist, John Stuart Mill, writing well after Adam Smith, was skeptical that competition alone was the great regulator as Smith insisted it was in his invisible hand. He said that economics was by nature “hypothetical.” Its laws were not engraved in stone. If you looked around, wrote Mill, “custom,” which he used to describe many non-economic aspects of culture and behavior, was equally important. “It would be a great misconception of the actual course of human affairs to suppose that competition exercises in fact this unlimited sway.”

The ideas that governed the mainstream economics profession since the 1980s were turned into rules when they were at best only hypotheses. Rules are easier to deal with; ambiguity and uncertainty are shunted aside. But the world is not so simple, and good policy is scarce when a profession once dedicated to brilliant thinking and extemporaneous judgment to fit changing times turns to formula and ultimately cliché.

2016 August 26

Originally published here.


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  • Kind of – yes – and it really is much deeper than that.

    The fact that markets must give a zero value to universal abundance is actually now a very big issue.

    It didn’t matter when most things were genuinely scarce.

    It really does matter now that we can actually meet the reasonable needs of every person on the planet through fully automated systems.

    Right now, fully automating systems delivers benefits to very few.

    That is criminally insane!!!

    We do actually need to go further, much further!

  • X-7

    Props. Tough, clean, well delivered.
    Dig this: ” … consider this one enormous area of theoretical neglect, and you get an idea of the inadequacies of the prevailing body of economic ideas.”
    Might this interest thee? Adding an additional theoretical neglect: Mainstream economists’ lack of understanding of code, including monetary code, in a physics / evolution / complexity context.
    (Bertrand Russell’s first commandment: “Do not feel absolutely certain of anything.” How I handle uncertainty & mainstream economists: I’m not saying I’m right; I’m saying I’m less wrong than you.)
    Partial orientation attached.
    Fuller treatment: Culture, Complexity & Code2 http://ow.ly/4mJQ2r
    Best, Bryan Atkins

  • Sue Holmberg

    Jeff, great piece. It’s important to point out that this issue is beyond “elite” economists and departments. These limitations describe 99.9% of economics departments in the U.S. And the department that is getting so much attention now for cogent analyses and research, UMass, Amherst, was considered radically “out there” for decades.

  • John M Legge

    Jeff, please take a few hours to read Adam Smith by Gavin Kennedy http://www.palgrave.com/br/book/9781403999481
    You correctly point out the many errors made by mainstream economists. Don’t join them by misrepresenting Smith.

  • Larry

    You are 100% correct
    #howmonwyworks

  • planckbrandt

    There are scholars offering fresh perspectives that bring in other factors besides regulation and re-regulation. Scholars and researchers, some from inside mainstream economics, and others from outside are pointing to money creation as debt as a significant issue in the volatility, inequality, and power concentration.

    One is Steve Keen who argues that money creation is missing from economic models, yet if we look at speculative bubbles, we can see bank creation of money for mortgages or for margin accounts, and now “prime brokerage services” in the combustion. He has been challenging Krugman to acknowledge the role of money creation in the mess. Another is Richard Werner who has tested the 3 dominant money creation theories of economics and shows which one is most accurate depiction of what really happens. He marvels that in 100 years, no such experiments were done and economics have been free to choose which “school” they wish to belong to, even if 2 of the 3 “schools” are more or less ivory tower navel gazing.

    Money creation can of course be regulated and re-regulated, but it begs the question why should it be created by private banks in the first place when the yoyo credit expansion contraction and exponentially compounding interest on paper process is so deadly and destructive. They can argue all they want about this yoyo’s existence or effects till the cows come home. Setting those terms of debate as the main argument avoids the basic existential question underlying the system itself of why should banks create our money? And, to take it one step further and to be crystal clear, why should a few controlling stake shareholder family groups and beneficial owners of banks profit from permanent rent on our money supply that they have been licensed by the US congress to create? And, when the constitution grants that the US Treasury itself can coin our money for us interest free?

    Writers like Bernard Lietaer who comes out of a central banking career presents that alternative that we don’t need bank created money at all for most economic activities. We need mutual credit systems like the Wir in Switzerland which replaces the need for businesses and people to borrow CHF at interest from private banks in order to trade amongst themselves. The Wir has prevented tremendous recessions by providing an alternative way to keep exchanging even when banks can’t lend anymore in crisis and CHF disappears from the Main Street productive economy like the USD and Euro are right now. At times, Wir transaction volume has equaled 20% of Swiss GDP. That means quite a severe depression was avoided when the banks got themselves into another crisis situation. This is another real democracy feature of the Swiss constitution over ours. Wir is little known in the Anglo-American sphere where banks dominate, but it represents an operational alternative to bank credit that could re-energize local economies, put many more of us back to work, and put us back in charge of deciding where we want to create value or not in our society.

    Margrit Kennedy shows how even in a regulated banking system like Germany, the vast majority of interest accruing on money created as debt by the banking system goes from the Bottom 90% to the Top 10%. This is an inherent quality of a money form created as bank debt by a small closed and close knit industry, surrounded by a few other specialized ones like law, public accounting, shadow banking, money management, insurance, real estate, management consulting, etc. This issue cannot be changed with regulation if the comparison between Germany and the Anglo-American world is made. It is an issue that remains increasingly conspicuously off the agenda of anybody trained by this economics profession and of course interviewing them all day for stories (Mr. Madrick included). Gillian Tett wrote about this issue of journos not being schooled about money properly in her great article Silos and Silences from 2010.

    John Lanchester in the London Review of Books recently wrote about the potential for blockchain to replace bank “credit” money (“bank credit” is the form of our money by the way for anybody who never thought about it before. We have a “bank credit” money system and we could have something else.). Lanchester paints a picture of a virtual central ledger keeping mutual credit accounts for all us out there for work we do for each other on the Internet. That vision looks more like the granary clay tablet accounts of Ancient Mesopotamia or Egypt than the Italian Renaissance bankers’ paper ledgers of debits and credits on deposits and loans, which is the genesis of our current horrible money system for anybody wondering.

    Doug Rushkoff wrote in his it seems already forgotten little known book Life, Inc. all about this so called Renaissance under the influence of these Italians like the Medici. His book is a brilliant story about not only the totalizing effects of our current system on our individual, group, and social behavior, but also can open up our minds about alternatives to it.

    David Graeber in his great book Debt: 5,000 Years suggested that the reason we don’t have agonizing philosophical treatises in clay from Egypt and Sumer may be precisely because a mutual credit system where everybody could get credit for whatever he or she was capable of producing of value actually made for a more equal society that didn’t generate moral and ethical angst and existential questions. Ancient Greece, the first place where coinage infiltrated natural human exchanges, was of course the first place all these social strata troubles started to make themselves known. Then of course Ancient Rome and Medieval Europe were all monetized societies, eventually sending the conquistadores off to steal precious metals since interest on paper ledgers denominated in them was compounding exponentially even when the metal stocks more or less stayed the same.

    There is a lot to consider here that we are not going to get from our economics training. We need to look for the writers who are not promoted on TV or are even marginalized to begin to see alternatives. Like Lewis Powell prescribed in his famous Chamber of Commerce memo and like we all now know about our country, economic elites own our media and also lend money to it and so keep it on a leash. They are not going to let this story get out without a big resistance and reaction. Just look at the variety of conflict stories we have between ourselves now in our country five years after a spontaneous Occupy Wall Street fingered debt and banks (like Margit Kennedy) at the root cause of our problems. Those days are long gone. So many bad incidents and trends have been broadcast in the meantime, creating chain-reactions and negative feedback loops (and good incidents and trends of course not broadcast and not creating chain-reactions and positive feedback loops). Hmmm.

    BTW. The FMOC should be also held accountable for not knowing Minsky
    cold. There really is no excuse except foundation funding for economics
    departments, journals, and prizes as prescribed by Lewis Powell. Like James Galbraith said in congressional testimony in May 2010, the profession is entirely corrupt. But, Lewis Powell and the push to remove public funding of education in the Reagan years and replace it with private money should be examined as a big part of this economics department problem. There was an article published on a blog years ago about how many academic economists get research grants from the Fed to keep them on the reservation (plantation may be a better term to use for that).

  • pluviosilla
    • Unlearning Economics

      Not all theories have equal standing.

  • It seems quite clear to me that the economics profession didn’t just make a wrong turn in the 1970s. It made that turn in the 1930s when it rejected Keynes analysis of what Robertson dubbed “the long-period problem of saving.” That’s what set the stage for the pivot in the 1970s. See: http://www.rweconomics.com/htm/LPLFLPPS.htm

  • How do tens of millions of people manage to trade goods and services with reasonable efficiency at all? Wouldn’t the result have to be a big mixed up mess? Adam Smith’s invisible hand was essentially an argument for emergence of self-organizational processes in economics, in systems that simply cannot be controlled from some central power. Why can’t they be so controlled? Too much information. And from the viewpoint of statists, things are much worse now than back in Smith’s day. Because economics involves far, far, far more information now than it did back then.
    No essay on Evonomics that I’ve read deals with Smith’s fundamental observation of the necessity of decentralized decision-making processes due to too much information. And thus, the essayists ignore what they say they very much esteem, the insights of evolutionary processes, which are emergent, uncontrolled by any central authority (God?), and therefore self-organizing. I hope at least some essayists start doing better work here.

    • Derryl Hermanutz

      When Adam Smith wrote of butchers and bakers and candlestick makers, farmers and crafters and traders, factories where a few guys used a machine to make pins: he was thinking of a village economy, not a global economy.

      Physical gold was the money, and gold was produced as a commodity no different than tin pails or slabs of bacon. The economy “produced” its own money supply. Gold miners “traded” gold for tin pails and slabs of bacon. Smith was describing a barter economy with commodities functioning as the medium of exchange: as the ‘money’.

      In our world virtually all money is created by banks as deposit account credit to purchase loan account and bond debt. We don’t “produce money”. But we buy-sell virtually everything that is produced, and we pay and are paid money. Aside from government bodn debt, most bank credit is created to finance borrowers’ (debtors’) purchases of already-existing assets like real estate. No “value” is produced, when you sell your house in 2006 for $600,000, that you bought in 1975 for $30,000. It’s pure asset price inflation, enabled by bank credit creation.

      A buy-sell “for money” economy works nothing like a barter goods-for-other-goods “trading” economy. In his 1986 book, Stabilizing an Unstable Economy, Hyman Minsky called the dominant neoclassical school of (barter) economics, “the economics of capitalism without capitalists, capital assets, and financial markets.”

      In a village economy there is not “too much information”. Everybody knows everybody else. There are only 2 butchers in the village, and everybody knows the prices each one is charging, and the quality of their meats. It is in the butchers’ interest to sell good quality meats at “competitive” prices, because if one doesn’t, the villagers will buy from the “good” butcher. Smith’s “market discipline” was as much moral discipline as economic discipline.

      Smith’s “self-regulating” free market village economy was populated by small business owner-operators, not by nation-size transnational industrial and commercial corporations. The business revenue was the owner’s personal income. The business costs werre the owner’s personal costs. The butchers’ personal income was directly affected by their “market behavior”. A corporation can lose a billion dollars one year, and the CEO still gets a 10 million dollar “bonus”. There can be no “market discipline” of economic actors, unless they personally pay the price of their mistakes, and personally enjoy the income from their “virtuous” economic behavior.

      Read Smith’s book. Smith invented his village free market economy as a utopian antidote to Britain’s actual 1776 economy: state-corporate mercantilism. The only purpose of corporations, Smith wrote, is to acquire monopolies to preserve the profits that real market competition would most surely reduce. Monarchs granted commercial monopolies to transnational merchant corporations like the British East India Company whose foreign “markets” were opened up and secured by the British Royal Navy.

      In, War is a Racket (1935), Two Star Marine General Smedley Butler wrote, “I served in all commissioned ranks from a second lieutenant to a Major General. And during that time, I spent most of my time being a high-class muscle man for Big Business, for Wall Street, and for the bankers. In short, I was a racketeer for capitalism.”

      Mainstream macroeconomics to this day preaches the imaginary workings of a free market village economy where we produce the money by digging up gold and growing more carrots than we eat. Transnational corporations whose annual revenues are greater than the annual GDP of all but the biggest countries, are treated like Smith’s village butchers competing for customers and being “disciplined” by loss of personal income for their missteps. Many macro models have no money, no credit-debt, and no banks, “in them”. Just farmers and crafters producing more economic value than they consume, and trading their surplus supply with each other in the village marketplace.

      This is the braintrust that “didn’t see it coming”: the biggest credit-inflated price bubble and Crash in the history of humanity.

      The travesty isn’t even that they were looking at economic models of an alternate reality.

      The travesty is that anybody still takes anything they say as “informed opinion”.

  • Chris Dougherty

    Milton Friedman was an idiot. Pure and simple. This embrace of austerity economics with out of control, free flow financial trading only contributes to “hot” money speculation and little investment in infrastructure, economics and other items to capture liquidity within an economy. Friedman has been dead for ten years and his theories died a long time before that. Time to kick them to the curb and move into a different direction. This is a huge political problem because the Republicans are still all in on this stupidity and the Democrats have failed to come up with a real sustainable alternative like they did in the early ’30’s.

  • Rory Short

    The real economy, i.e. the exchange of real goods and services, is the most stable aspect of the economy. The source of instability lies in the fiat money supply. If the money supply was automatically linked to real exchanges the money supply would become as stable as the real economy. What is needed is a money system which only produces new money when an individual needs some newly issued money to complete a purchase. New money is NOT issued for any other purpose. The new money is issued as non-interest paying new money debt to the individual concerned. The new money debt is settled as and when the individual concerned earns money. There is a money system enforced cap on the amount of new money debt that an individual can carry at any point in time. This means that monetary Inflation would be minimised and directly controllable.