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Saturday, 20 November 2010

MIA: The Invisible Hand

Fantasy Finance

Here’s a thought. What if all of modern finance is an elaborate hoax, a fantasy perpetrated on an unsuspecting world by an unscrupulous coalition of evil power brokers, determined to ensure that free market agendas are secured in their own interests?

Exaggeration this certainly is, but it contains the nub of an idea that’s been around for over a century. This is that modern finance is built on foundations that aren’t really secure. Laissez faire may be many things but it isn’t necessarily fair, and this isn’t an inevitable consequence of economics but a decision made by people. Perhaps the invisible hand is invisible because it doesn’t exist.

Natural Selection

To the extent that we can trace the history we know that much of the modern formulation of market economics arises from Adam Smith; and we know that Smith’s theories bear an uncanny similarity to those of Charles Darwin. As it happened Darwin’s theory of natural selection arose after Smith’s and, indeed, was drawn partially from it.

Natural selection has always attracted people looking to find justification of the current social order or to squeeze some excluded party into it. The basic idea is that if you can show that inequalities arise “naturally” from behaviour that is somehow ordained by biology then these aren’t really inequalities at all. So, the poor are poor because they’re genetically weaker than the rich. There are, of course, more extreme arguments than this.

Status Quo

The basic structure of these debates is always framed in the same way: some person or group are either trying to justify the status quo or trying to modify it. Almost invariably the arguments are spurious because human behaviour is plastic to an extreme and we can choose, for instance, whether to allow people with great wealth to keep it or try to force them to redistribute it. These aren’t issues of biological determinism but of moral choice and political conviction.

We’ve seen instances in the past of how Darwinian selection has been used to attempt to justify various economic positions, like the idea in Economic Parasites that poor countries are poor because their people are stupid, rather than because they’re poor to start with and can't afford to protect themselves from disease. That being the case, it’s not too large a jump to surmise that if Adam Smith’s invisible hand is analogous to nature red in tooth and claw then his ideas might be used for the same purpose; and with the same disregard for the difference between biological, or in this case, economic, inevitability and social choice.

Survival of the Fittest

Well, the idea begets the thought. “Survival of the fittest” was a phrase coined not by Charles Darwin but by Herbert Spencer, whose social determinism extended the realm of natural selection into social and economic behaviour. Spencer’s ideas informed many American economists. Take William Graham Sumner for instance:
“Let it be understood that we cannot get outside this alternative: liberty, inequality, survival of the fittest: non-liberty, equality, survival of the unfittest”.
Sumner was writing at the back end of the nineteenth century, just as the industrialisation of America was taking place, as the likes of Vanderbilt, Carnegie and Rockfeller were taking control of the economy. Social Darwinisim was an ideal tool to justify the predatory capitalism of the robber barons and to argue against anti-trust laws or unionisation.

Of course the economy isn’t some naturally occurring thing, it’s an artefact of human construction. No one today would accept that eugenics is justified by theories of social evolution so it’s odd to find arguments in favour of unrestrained capitalism based on the same underlying ideas. These are moral decisions, not scientific ones.

The End of Lassez-Faire

Roll forward to 1926 and we find John Maynard Keynes arguing that just such unrestrained capitalism was risking the world’s economic wellbeing. In The End of Laissez-Faire he traced the history of economics and draws out the similarities between economics and natural selection:
“The parallelism between economic laissez-faire and Darwinianism, already briefly noted, is now seen, as Herbert Spencer was foremost to recognise, to be very close indeed. Darwin invoked sexual love, acting through sexual selection, as an adjutant to natural selection by competition, to direct evolution along lines which should be desirable as well as effective, so the individualist invokes the love of money, acting through the pursuit of profit, as an adjutant to natural selection, to bring about the production on the greatest possible scale of what is most strongly desired as measured by exchange value.”
However, Keynes then skewered the idea that this analogy was anything more than a useful metaphor:
“The beauty and the simplicity of such a theory are so great that it is easy to forget that it follows not from the actual facts, but from an incomplete hypothesis introduced for the sake of simplicity. Apart from other objections to be mentioned later, the conclusion that individuals acting independently for their own advantage will produce the greatest aggregate of wealth, depends on a variety of unreal assumptions to the effect that the processes of production and consumption are in no way organic, that there exists a sufficient foreknowledge of conditions and requirements, and that there are adequate opportunities of obtaining this foreknowledge.”
Heroes or Demons

So, the basic idea that individual self-interest drives wealth creation is open to question and there's no causal link between evolution and the Invisible Hand, it's a simplification developed to aid understanding. Keynes suggested why this metaphor had taken hold – because it was in the interests of those in power to make it so:
“Individualism and laissez-faire could not, in spite of their deep roots in the political and moral philosophies of the late eighteenth and early nineteenth centuries, have secured their lasting hold over the conduct of public affairs, if it had not been for their conformity with the needs and wishes of the business world of the day. They gave full scope to our erstwhile heroes, the great business men.”
Now of course the mention of Keynes’ name is enough to send some into an apoplectic rage but you don’t have to agree with his policy prescriptions to trace the line of his thinking here, as he gropes his way towards an idea not dissimilar to that of Knightian uncertainty. To find a new way of managing economies you need to start by recognising that the old way isn’t an inevitable consequence of existence, but an elaborate fantasy constructed to justify the status quo.


There are more modern economic thinkers who reckon that this was implicit in Adam Smith’s original formulation of the subject – as we saw in Arbitraging Embeddedness – but that’s to take a very narrow view of what Smith was describing; it’s only with the luxury of hindsight we can take such a lofty perspective. In fact Smith’s original idea was built on co-operation as much as competition – the concepts of sympathy and empathy we discussed in Adam Smith’s Monkey Business: ideas foreign to the original conception of natural selection and social determinism.

In the end laissez-faire capitalism is not the natural state of economics, any more than liberal democracies are the natural state of politics. These may be the best possible systems in a flawed world, but they’re the result of decisions made by humans, not the inevitable outcome of some mystical process. Indeed, as money didn't evolve but was invented, how could it really be any different?

Related articles: Darwin's Stockmarkets, A Keynesian Theory of Mind, Adam Smith's Monkey Business


  1. To find a new way of managing economies you need to start by recognising that the old way isn’t an inevitable consequence of existence, but an elaborate fantasy constructed to justify the status quo.

    My take is that the old way is neither an inevitable consequence of existence nor an elaborate fantasy constructed to justify the status quo. My view is that the old way of managing economies is a MISTAKE, one that causes more and more trouble as the economies being managed become richer ones and the mismanagements thus become ever more costly.

    People learn over time. We will move beyond the old understanding as we learn better how the world works. This blog (for example) advances that effort. We are all involved in a great Learning Enterprise.

    It is an exciting thing to be a part of this, to see all the wonder of a learning experience unfold before our eyes.


  2. It is not surprising finance takes the central role in neoliberalism, the dominant macroeconomic theory. And both have effectively ruined the global economy and lives of millions