By William K. Black, Quito: April 26, 2015
One of our many distinguished readers of New Economic Perspectives is the economist Michael Meeropol. Mike contacted me after reading my columns about Mankiw pushing the Trans-Pacific Partnership (TPP) to alert me to another way in which Mankiw, who purports to be relying on Adam Smith, actually willfully misinterprets Smith through what Mike refers to as “pedagogical malpractice.” I thank him for bringing it to my attention.
Mike laid this out in an article in 2004. Reading Mike’s entire superb article is, of course, the best solution. For those with less time I have quoted extensively from the most relevant portion of his article, which includes a lengthy footnote. Mike’s major point can be summarized briefly: Smith believed fervently in emphasizing domestic manufacturing and agricultural production, domestic trade, and domestic investment as the essential means of building a Nation’s wealth. Mike’s article builds on the work of Joseph Persky. I’ve deleted two footnotes from his text.
“In an effort to demonstrate that his “system of natural liberty” produces the maximum possible benefit from the point of view of increasing the wealth of a nation, Smith argues that it is totally unnecessary to force upon business owners a direction of their capital to the home market. Smith’s reasoning behind this gives occasion for his use of the “invisible hand” metaphor.
Despite numerous references in the professional literature, this aspect of how Smith actually uses the “invisible hand” concept is not emphasized in the major treatises on the History of Economic Thought and is completely ignored in casual usage. In Principles textbooks and in popularizations [Smith’s purported application of his “invisible hand” metaphor to a broad range of propositions, such as foreign investment] is stated as the essence of the invisible hand analysis. This is despite the existence of an excellent article by Joseph Persky from the 1989 Journal of Economic Perspectives. Thus, an extensive quotation to revisit this issue is very much in order.
‘No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain. It can only divert a part of it into a direction into which it might not otherwise have gone: and it is by no means certain that this artificial direction is likely to be more advantageous to the society than that into which it would have gone of its own accord. Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command … the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society. First, every individual endeavours to employ his capital as near home as he can, and consequently as much as he can in the support of domestic industry … Secondly, every individual who employs his capital in the support of domestic industry, necessarily endeavours so to direct that industry, that its produce may be of the greatest possible value … As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. … By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.’ (I: 475-7)14
It is clear from this passage what Smith does NOT mean when he refers to the invisible hand. Instead of suggesting that international capital flows in search of foreign investments would be a perfectly acceptable method by which to enhance the wealth of a particular nation, Smith is making a detailed practical argument that because of the costs of supervising investments overseas, because of the time involved in turning over capital employed in foreign trade as opposed to domestic trade, the operation of the invisible hand in the context of the 18th century would naturally tend to favor domestic investment and therefore the economic development of the nation. Examining Smith’s discussion of the rare occurrence which will naturally draw capital to what he calls “distant” employments, we can see the main reason why he favors domestic investments over foreign. His standard for investment from the point of view of society is the amount of “productive labor” that is “maintained” by that capital.”
14The author consulted 10 Principles textbooks and every one of them mentioned the invisible hand as illustrating the role of competition in guiding private interests to serve public ends without revealing what Smith actually said. Some utilize the well-known quote by Smith; “It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard for their own interest.”(I: 18) This quote is specifically identified as illustrating the invisible hand principle even though Smith’s reference to the invisible hand is hundreds of pages later in a different context. The reference to the businessman’s preference for domestic investment is excised from all direct quotes from Smith and in some instances the earlier quote is run together with the truncated “invisible hand” quote. See for example, N. Gregory Mankiw, Principles of Microeconomics (NY: The Dryden Press, 1998, 145), Joseph E. Stiglitz and Carl E. Walsh Economics (3rd Edition) (NY: W.W. Norton and Company, 2002): 204 and Arthur O’Sullivan and Steven M. Sheffrin Microeconomics: Principles and Tools (3rd Edition) (Upper Saddle River, NJ: Prentice-Hall, 2003): 6. Sometimes there is just a simple statement that “… the invisible hand of the marketplace leads the economy to produce an efficient variety of goods and services, with efficient production methods as well.” Ronald M. Ayers and Robert A Collinge Microeconomics: Explore and Apply (Upper Saddle River, NJ: Prentice-Hall, 2004): 7. See also Karl E. Case and Ray C. Fair Principles of Microeconomics (7th Edition) (Upper Saddle River, NJ: Prentice-Hall, 2004): 67, William A. McEachern Microeconomics (6th Edition) (Mason, Ohio: Thomson Southwestern, 2003): 39, William J. Baumol and Alan S. Blinder Economics (8th Edition) (NY: Harcourt College Publishers, 2001): 67-68, Roger A. Arnold, Economics (4th Edition) (Cincinnati, Ohio: South-Western College Publishing, 1998): 436, Paul A. Samuelson and William Nordhaus, Economics (16th Edition) (NY: Irwin, McGraw-Hill, 1998): 30-31 and especially 201, and Campbell R. McConnell and Stanley L. Brue Economics, Principles Problems and Policies (14th Edition) (NY: Irwin, McGraw-Hill, 1999): 73. The failure of any Principles text to pick up on Persky’s article, despite the fact that it appeared in the most accessible of the American Economic Association journals represents something akin to pedagogical malpractice. It would be much more accurate, and much more revealing of the true nature of Adam Smith’s analysis if textbook writers would say something like: “Even though Adam Smith used the term ‘invisible hand’ to specifically explain the preference of businessmen for domestic over foreign investment, common usage within the economics profession has transformed that concept into a generalized argument in favor of the idea that pursuit of private advantage when constrained by competition will lead to public benefits.” Perhaps it is not too much to hope that textbook writers might be willing to make such a change once the error of their present presentation is pointed out to them. Turning to History of Thought analyses, Blaug’s discussion of the “invisible hand” asserts it is “nothing more than the automatic equilibrating mechanism of the competitive market.” He does allow that Smith’s admitted defects in the “simple system of natural liberty” provide “sufficient ammunition … for several socialist orations,” [p. 58] but he does not specifically identify the focus of the invisible hand on promoting domestic investment. Similarly, J. A. Schumpeter’s History of Economic Analysis (NY: Oxford University Press, 1954: see particularly 185-94) fails to mention this specific focus. No reference to the invisible hand is to be found in the index. Robert L. Heilbroner’s The Worldly Philosophers (NY: Touchstone, Simon and Schuster, 1980) identifies the invisible hand as the process whereby the “‘private interests and passions of men’ are led in the direction ‘which is most agreeable to the interest of the whole society’.” (52). Emma Rothschild’s Economic Sentiments: Adam Smith, Condorcet, and the Enlightenment (Cambridge: Harvard University Press, 2001) devotes an entire chapter to Smith’s use of the idea of an invisible hand (116-156). Though she carefully quotes both of Smith’s references addressed in this article, she does not explicitly develop the points made here and in Persky’s article (but see below, note 39). The entry in the New Palgrave Dictionary of Economics does includes the entire quote with its emphasis on domestic investments but then fails to remark upon it (Palgrave: 997). For popularizations, consider Milton and Rose Friedman’s best-selling Free to Choose (NY: Harcourt Brace Jovanovich, 1979). Right in the beginning of the book they identify the Wealth of Nations as a statement of how “a market system could combine the freedom of individuals to pursue their own objectives with the extensive cooperation and collaboration needed in the economic field to produce our food, our clothing, our housing. … so long as cooperation is strictly voluntary … an individual who ‘intends only his own gain’ is ‘led by an invisible hand to promote an end which was not part of his intentions … By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it…’ ” (1-2)
Mike then goes on to show Smith’s disdain for how the European powers run their colonies, producing massive waste and harm, and Smith’s horror at corporations. In modern economics jargon, Smith opposed corporations as causing acute, insoluble “agency” problems. Smith saw the worst form of these unfaithful agents as occurring when the CEO looted the firm and used it as a weapon to defraud, but he also believed that CEOs tended to be incompetent. Mike rightly concludes that invoking Smith to champion domestic corporations running vast overseas empires is intellectually dishonest.
A Concluding Note about Smith, the Rule of Law, and the TPP
Smith’s argument that voluntary economic actions inherently, without any grand plan, benefited society would later be branded by the Austrian economist Friedrich von Hayek as “spontaneous order.” Smith had multiple formulations of his argument, here is one cited by Mike.
“Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command … the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.”
It is important to remember that Smith, despite this very strong statement, recognized it was not an accurate statement absent an effective rule of law preventing crimes and abuses. I will name only four contexts in which Smith warned that voluntary cooperation by economic actors would lead to actions that were “[dis]advantageous to society” – cartels, corporations, colonies, and the ability of corporate CEOs to get special favors from government (e.g., by their lobbyists secretly drafting the TPP to favor their interests). Smith felt that it was essential that the democratic state adopt and enforce a rule of law preventing voluntary cooperation by criminal CEOs that in his words “ends in a conspiracy against the public, or in some contrivance to raise prices.”
TPP is rife with all four of these forms of actions that are “[dis]advantageous to the society.” There are few formal colonies left, but TPP’s provisions for literally lawless kangaroo courts controlled by lawyers for the most corrupt (and corrupting CEOs) are designed and aimed primarily not at the most powerful nations such as the U.S. and China, but rather as neo-colonial means of destroying meaningful sovereignty and assuring domination by foreign and domestic oligarchs throughout the portions of the world that were once formal colonies.