You are hereBiting the Invisible Hand—I
Biting the Invisible Hand—I
by John Evans
The Democrats’ victory in November, in combination with the prevalence of such phenomena as the widespread tendency to ignore what it is about Islam that conditions so many of its practitioners to behave violently and the pervasiveness of the belief that the modest rise in average world temperatures in recent years must be attributed to human activity have caused me to worry, of late, that we have become a less rational society than we were, say, fifty years ago. In some respects, I find Western culture today to be uncomfortably remindful of a scary book that I read a little over fifty years ago, Aldous Huxley’s Brave New World, one of whose themes was the suppression of rational thought processes in the world of the future. The Democrats’ victory in November, in combination with the prevalence of such phenomena as the widespread tendency to ignore what it is about Islam that conditions so many of its practitioners to behave violently and the pervasiveness of the belief that the modest rise in average world temperatures in recent years must be attributed to human activity have caused me to worry, of late, that we have become a less rational society than we were, say, fifty years ago. In some respects, I find Western culture today to be uncomfortably remindful of a scary book that I read a little over fifty years ago, Aldous Huxley’s Brave New World, one of whose themes was the suppression of rational thought processes in the world of the future. As regular visitors to this site know, my professional background is that of an academic economist. For over forty years, I was in close contact with the great American undergraduate and had the opportunity to observe first-hand the trends that were at work in what is often termed “higher education.” By the windup of my professional career, I had come to the firm conclusion that there had been some deterioration of academic standards during my career and that “grade inflation” had most definitely occurred. Although I made a conscious effort to lower my own standards after the Vietnam War era spawned an irresistible movement to concede students greater control over their education, I found that I had difficulty keeping up with the competition. As a result, toward the very end of my career, I was succeeding in alienating a higher percentage of my students in introductory courses than I had in earlier years. To some extent, no doubt, this problem resulted from my becoming a grumpy old man looking forward to retirement, but I feel that most of it came from my difficulty in lowering standards fast enough and such factors as the rise of the self-esteem movement in education. Some students who were accustomed to making As in high school could not cope psychologically with receiving a C from me. In any event, I fully retired in 2000, just in time to miss being able to participate in the sharp rise in the salaries of academics specializing in economics and finance that have occurred during the past few years.
Before you conclude that I am indeed a grumpy old man who thinks the world is going to hell, let me assure you that I am not at all sure that the social trends are all in one direction, namely downward. After all, I am by training an economist, not a psychologist or a dispensationalist anticipating the joy of Armageddon. Perhaps the trends in education are not all for the worse, and when it comes to explaining why large numbers of people behave irrationally, it is best that I stay close to familiar territory. When I do so, I find a mixed picture. A great many people obviously have views about economics that seem inexplicable from the perspective of choosing between what works and what does not, but when I look at economic history, I find that this has always been the case. Moreover, I also find that people do continue to learn from experience—though the learning process often seems to be excruciatingly slow in light of the empirical evidence. Ideology, including religion, obviously has a great impact upon the ability of people to evaluate evidence, and it is obvious that some ideologies have been more conducive to the use of reason than others.
This article is the first of three that I propose to present here in which I shall be attempting to apply the concept of rationality to economic analysis. In this article, I offer a brief explanation and justification of economists’ common assumption that people behave rationally when acting as consumers and income earners and offer some suggestions for the improvement of the operation of market forces in the American economy. In the second and third articles, I shall investigate the problem of why it is that in the conduct of economic policy, governments so often achieve suboptimal results. Article number two will examine this matter by offering an overview of the world as a whole, and the third article will examine a few instances of what I consider to be irrational economic policymaking in the United States.
Evaluating the rationality of governments’ economic policymaking is greatly complicated by the fact that in their conduct of economic policy, governments may have other objectives than the maximization of the economic well-being of the people subject to their authority. Furthermore, their actual objectives are often different from their announced objectives. Among these other objectives there stands out the retention of political power. Thus, it happens all the time that governments claim they are taking certain actions in order to maximize the economic well-being of the people when those in charge know that this is not the case. Such behavior may be perfectly rational, however, from the perspective of the decision makers. On the other hand, it often happens that when governments genuinely try to conduct economic policy so as to provide the maximum benefits to the people, they misapply economic theory and fail to heed the empirical evidence that is available to them. From my perspective, this is irrational behavior, and I shall be offering numerous examples of it.
During one summer when I was a student at the University of Texas, where I earned my BA and MA degrees before joining the U.S. Army at a place with the intriguing name of Fort Bliss, I succeeded in reading all of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations. In those days, I had not yet come to realize that if you wanted to get ahead as an academic economist, it was dangerous to spend time reading original sources when doing so offered little payoff potential in terms of helping you write articles in professional publications that few people read but which are invaluable in padding resumes. Although I thought of myself as a kind of Hubert Humphrey liberal; i.e. having a generous heart and wanting to see other peoples’ money spent abundantly for what I considered good purposes, Smith’s book made a deep impact on me that proved to be permanent.
The most important idea in Smith’s great book is, of course, the conviction that economic progress hinges vitally upon the existence of free markets. Smith perceived that although altruism is one facet of human character, it tends to be overrated and is all too easily distorted by other influences. In fact, he believed, it is self-interest that serves as the dominant motivational factor in determining behavior, and he thought of self-interest primarily in material terms. My favorite quotation from Smith is this: “Rarely do men of the same trade or profession come together, even for purposes of merriment and diversion, but the conversation turns into a conspiracy against the public and an agreement to fix prices.” He added that although government should not prohibit such individuals from meeting socially, neither should it promote their gatherings.
Notice that Smith refers here to “men of the same trade or profession,” not corporate executives. In his day (1776), the great industrial corporations had not yet come into existence. By contrast, in our society, those politicians and media spokespeople who address issues of market rigging generally refer to the nefarious activities of industrial, mercantile, and financial corporations (other than media companies) while treading lightly upon similar activity indulged in by unions, professional associations, and government. A great scholar like Adam Smith would never have shown such partiality. And were he alive today, you can rest assured that he would be insisting that most public servants are no less motivated by self-interest than the top executives of Wal-Mart.
Depending on how a society is constructed, the pursuit of self-interest can be very damaging to the social fabric, so there is the question of how self-interest can be guided into socially beneficial channels. In large part, Smith’s answer was through the existence of market competition, which, he argued, forces an individual, “as if by an invisible hand to promote an end which was no part of his intention”; i.e. the market preferences of consumers (emphasis added). That, however, was not his entire answer. He also recognized that if free markets are to bring about optimal results, they need to operate within a social framework that has the proper moral constraints and offers a legal system that protects human rights, including property rights. He took it for granted that the United Kingdom of his day had such a social framework and consequently placed relatively light emphasis upon the non-market aspects of social organization in The Wealth of Nations. This fact has misled some would-be interpreters of Smith into thinking that the moral issues associated with free markets did not concern him. Smith, after all, had authored a book entitled The Theory of Moral Sentiments in 1759, in which he argued that people are born with a conscience that orients them toward distinguishing right from wrong. With the proper social environment, he perceived, the existence of the conscience can exercise a desirable restraining influence upon self-interest.
The Wealth of Nations, as its full title makes clear, is devoted to the subject of economic growth and development. The way to achieve such progress, Smith argued, is to establish the proper social framework for the operation of the invisible hand and allow free markets to operate to the maximum feasible extent. In arguing for this position, he assumed, of course, that when acting as producers and consumers, people behave rationally. He recognized, however, that some of the things that people choose to spend their money on are harmful to them and to society and that some restraints on the exercise of consumer choices are therefore desirable, but he also warned against allowing excessive restrictions on consumer choice at the discretion of government officials. After all, he indicated, those officials will, if given the opportunity, indulge themselves in wasteful spending that conforms to their own preferences.
In an economic system like that endorsed by Adam Smith, some consumer spending admittedly occurs that is irrational because it does society at large more harm than good and is injurious to the buyers themselves. Clearly, for example, people who shorten their lives through alcoholism, overeating, or smoking cigarettes are behaving irrationally. Economists who walk in the path cleared by Smith argue, however, that social restraints imposed on consumer sovereignty can easily become excessive and that even if consumers do not always choose wisely, the opportunity to choose freely is a tremendous motivator. Thus, while citizen X may be unwise in how he chooses to spend some of his income, the motivation to acquire that income may stimulate him to work hard and efficiently.
Although The Wealth of Nations quickly began to exercise enormous influence upon the thinking of the relatively well educated people, its ideas have always been hotly debated among what I shall term “the thinking classes.” For one thing, Smith’s book was a vigorous repudiation of many of the economic policies that governments had pursued, and that meant that it clashed head-on with powerful “vested interests” (Thorstein Veblen’s term). For another, Smith did not single out the members of the thinking classes who elected to become academics; i.e. people like himself, as being especially worthy of being on the receiving end of government largesse. Incidentally, although Smith was an academic and taught for many years at the University of Glasgow, he also had wealthy patrons, one of whom hired him to tutor his son and took Smith with him on a lengthy visit to France. During the nineteenth century, as publicly financed universities gained in prominence and academics became less dependent upon private patrons and privately run universities, they tended as a group to become more hostile to Smith’s ideas. In doing so, they validated his belief that people tend to be motivated by considerations of self-interest. Unfortunately for academics, the operation of market forces has never put them into the same income category as business tycoons, successful entertainers, and outstanding professional athletes. Thanks to their ability to obtain funds from government, however, they have been able to move up considerably on the relative income ladder.
Smith’s belief in the efficacy of the invisible hand will always be vulnerable to attack because of its assumption of the validity of consumer preferences. As I noted earlier, it is obvious that some individuals are not good judges of how they should spend their income for their own benefit, and we all obviously fall short of having perfect judgment in this regard. Moreover, with the enormous increases in per capita real income that have occurred since 1776, the fraction of income that has to be spent to provide the basic necessities of food, shelter, clothing, and health care has greatly diminished (I am a little uncertain about including health care here because government’s intrusion into that field has greatly increased its cost.). This means that people have far more income that can be spent in discretionary fashion than was formerly the case. That they spend this discretionary income rationally as opposed to indulging in conspicuous consumption and conspicuous waste (more Veblenian terms) and being suckered by modern advertising—what John Kenneth Galbraith called “bamboozlement”—can readily be questioned. Consequently, many politically liberal economists; i.e., people like Galbraith, have not hesitated to suggest that governments’ economic policies should sharply curtail the invisible hand’s freedom of movement.
But if the validity of relying upon the invisible hand can be questioned, then what is the alternative? Theoretically, in democratic countries, people can elect representatives who will pass appropriate legislation to protect them from themselves. We all know, however, that legislation is heavily influenced by special interest groups and that how legislation is implemented depends upon bureaucratic decisions and the whims of judges. It seems reasonable to conclude, therefore, that trying to constrain the exercise of consumer preferences through legislation has its limitations. And while Professor Galbraith was a likable man who wrote with elegance and wit, I shudder when I think about people like him deciding how to restrict the spending of my income.
An alternative approach, which is certainly not mutually exclusive, is to try to increase the rationality of consumer spending through education. By education, I of course include public and private schools from kindergarten through graduate school, but I also have in mind such things as government testing of products and the dissemination of information about the test results. Unfortunately, a serious problem with much of our formal system for the education of the young is that our educational establishment has become thoroughly liberal politically. This means, among other things, that it has an anti-business, pro big government bias that severely warps the education process and contributes politically to the adoption of policies that limit the scope for the operation of the invisible hand. To substantially reduce this bias will take considerable time and much effort, but it can be done. The key to reducing it is to remove the monopoly power that governments, particularly at the state and local level, have acquired over formal education.
I also include within the scope of education the role of religion in contributing to the education of adults. Churches play an enormously beneficial role in instilling in people the virtuous behavior that is essential for the operation of a free market economy. Unfortunately, for a variety of reasons, many members of the clergy share with other members of “the chattering classes” an anti-business, pro big government bias. Were it not for the fact that many churches are dependent for the financial well-being on people of exceptional means—many of them connected to the business world—this bias would be even more widely expressed among the clergy than it already is. If we are to increase the public’s general understanding of the invisible hand’s operation, we need, therefore, to greatly improve the economic literacy of the clergy.
For illustrative purposes in connection with religious education, let us consider the following passage from Matthew 19:23-24: “Then Jesus said to his disciples, “I tell you the truth, it is hard for a rich man to enter the kingdom of heaven. Again I tell you, it is easier for a camel to go through the eye of a needle than for a rich man to enter the kingdom of God.” I have always loved this passage, and I know that it is one which some clerics rely upon to try to make the well-to-do feel guilty and to justify their leanings toward the liberal side of the political spectrum. Now I do believe that it is perfectly o.k. to use Scripture to encourage the “rich” to accept the notion that they have responsibilities toward society at large and should refrain from excessive self-indulgence while giving generously in ways that will benefit people who are less fortunate materially than themselves. I argue that it is often the case that people who are unusually wealthy or receive exceptionally large incomes have benefited from the possession of exceptional market power; i.e. their incomes are greater than they would have been if they had been subject to greater competition. I am persuaded that a strong case can be made for some social actions to restrain the conspicuous consumption of such individuals and to encourage them to become involved in activities that induce them to use their talents and financial ability to help others. I am not persuaded, however, that Matthew 19:23-24 or any other statement attributed to Jesus indicates that He believed that government should attempt to confiscate most of the wealth and income of the richest among us in order to supposedly provide more benefits to the general public. To this I add the observation that the mention of these verses should be accompanied by a discussion that includes their context, the grammatical issues that have been raised about them, and the extensive use of hyperbolic speech throughout Scripture. I am, incidentally, in total disagreement with people who believe that Jesus was doing His best to make the world safe for socialism.
Another thing that can be done in an effort to improve the invisible hand’s operation is to improve the way in which government administers “the rules of the game” that govern the marketplace. Of course we already have such rules, which constitute part of the social framework to which I referred earlier, but there can be no doubt that great improvements can be made in them. I am profoundly of the opinion that a major problem that we have in the operation of our economic system is that we have assigned too many tasks to government rather than seek alternatives. Adam Smith believed that, in principle, the fewer the tasks that government takes on, the more efficiently it is likely to discharge them. I certainly do not recommend that we try to return government to the relative size that it had in the economy of the United Kingdom in 1776, but I also insist that the government sector of our economy is far too large for optimal efficiency. It would be enormously beneficial, for example, if Social Security were privatized and the federal government’s intrusion into medical care were scaled back in favor of greater emphasis on market mechanisms. This could be done in ways that would not be disadvantageous for those in the lower income levels.
An interesting phenomenon that has occurred during the process of economic development in all nations that have achieved it is a growth in the relative size of the public sector; i.e. government, over time. To a large extent, this growth can be explained by simply stating that as people have experienced gains in their real per capita income, they have demanded relatively more of the types of goods and services that government provides. They also have demanded that government assume greater responsibility as a redistributor of income via government “transfer payments,” which are distributions of money, goods, and services to those whom the government favors that are financed by taxation or borrowing. It has often been the case, of course, that political considerations have caused some of the expansion in government spending to ride roughshod over the operation of the invisible hand; but then people like Galbraith have argued that even if some of the money spent by government is spent unwisely, either because of bad choices in what it is spent for or because of inefficiency in the spending process, we need to remember that people spend much of their income frivolously and that the tax revenues required to pay for the expansion of government can be taken from those who are relatively well off. Unfortunately, there comes a point where the expansion of government’s role in the economy severely retards the ability of the private sector to keep expanding, and historically it has been the private sector’s dynamism that has accounted for most of the economic growth that has made the expansion of the public sector possible. Smith, by the way, was a believer in natural law, and I suggest that there is a kind of natural law that operates in economic life that ultimately limits the ability of government to keep on growing.
Finally, I must note that the legal system of a nation plays an enormous role in determining how well markets function. The successful operation of the invisible hand requires a legal system in which personal freedom is respected, property rights are both extensive and well-protected, and those who cause injury to others are held responsible both criminally and civilly. In the ideal legal system, the law will not only be fair and impartial, but also it will be sufficiently settled so that entrepreneurs can know with a great deal of certainty what legal risks they will be subject to if they undertake expenditures that will contribute to the economy’s expansion.
Unfortunately, the American legal system has become severely suboptimal in terms of promoting the efficient operation of the invisible hand. I shall somewhat cynically suggest that the real growth rate of the U.S. economy could be increased somewhat if there were a modest reduction in the number of practicing lawyers. I suspect that most politicians in the United States have a legal background, a fact that inclines the political system as a whole toward operating in ways calculated to improve the overall well-being of the members of the legal profession at the expense of the society as a whole. We have become an incredibly litigious society, one in which many citizens who are not well off economically dream of winning a large award in a personal injury suit. Of course, many of these same people take advantage of the greatly increased opportunities for gambling that our economy now offers, but I shall not devote space to that problem.
I shall close with the observation that our evolution into being such a litigious society is a clear violation of biblical teaching, and I suggest that our preachers should spend as much—or more—time talking about Matthew 18:15-17 as they do about Matthew 19:23-24. That said, I bring this article to an end. I don’t want anyone to sue me.