Invisible hand or chaos

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Perhaps the invisible hand of Adam Smith is not as important in free market economies as the freedom for unsuccessful experiments to fail.

Economists always disagree with each other. Commentators have been quick to connect the appointment of one prominent American economist (Larry Summers) as US Treasury Secretary with the departure of another, Joe Stiglitz, from the World Bank. Mr Stiglitz’s opponents feel he had been injudicious in criticising western policies towards Russia, and even more injudicious in suggesting that the rantings against global capital markets by the Prime Minister of Malaysia were anything other than ridiculous.

Yet behind these alleged personality clashes lie some deep, technical arguments about economic theory. And although arcane they raise issues of significant practical importance. They concern our understanding of how markets work. Not whether they work, which is taken for granted.

Exactly why has the economic performance of market institutions been so much superior to that of central planning? Amongst economists, there are two principal explanations. One is that market mechanisms are efficient because they provide a system of signalling – prices adjust to demonstrate where resources are required, and where they are not. The other explanation is that market mechanisms represent a process of natural selection amongst ideas in business and economics. Innovations can be tried, some with success, some without. Those which succeed persist and are emulated.

Those who emphasise signalling, and draw attention to the role of the price system in driving resource allocation in market economies, draw their inspiration from Adam Smith’s metaphor of the invisible hand. Smith claimed that individually selfish behaviour could lead to collectively desirable outcomes. His successors prefer mathematical sophistication to literary effusion. Nearly two hundred years later, Kenneth Arrow and Gerard Debreu received the Nobel prize in economics for their development of general equilibrium theory. Essentially, what they did was to elaborate Smith’s insights with the aid of advanced topology.

General equilibrium theory encapsulates the idea of markets as signalling mechanisms, in which prices rise and fall to reflect scarcities and surpluses. The most important conclusions of general equilibrium theory for market efficiency are known as the fundamental theorems of welfare economics. These theorems claim that any socially desirable outcome can be achieved by a competitive market provided the initial distribution of rights and resources is appropriate. Here appears to be the intellectual underpinning for a laissez faire approach to market economies. So long as government ensures an initial level playing field and enforces the rules of a competitive economy, no further intervention is required or appropriate. Rarely does algebra have such powerful ideological content.

Like all economic models, the fundamental theorems of welfare economics depend on assumptions. And both sides of the debate I am describing acknowledge that some important assumptions are required. The invisible hand requires some guidance if the activities of Smith’s self-interested baker or butcher have environmental consequences: this is known as the externality problem. The theorems require that markets are competitive. But some cannot be competitive, because economies of scale mean there can only be few producers, and others are just not competitive. The assumptions of the fundamental theorems of welfare economics also insist that both buyers and sellers agree on what it is that they are buying and selling. If there are differences in the knowledge each party brings to the transaction – what economists call asymmetric information – then these basic results of general equilibrium theory may not hold.

Those economists who believe that the signalling function of the price mechanism is the main explanation of how markets work hold that the assumptions of the Arrow-Debreu model are sufficiently close to reality for the model to fit the observed facts. Now no model will ever provide a perfect description. Take a physical model, such as the laws of motion of falling bodies to objects in the atmosphere. Strictly speaking these laws explain motion in a vacuum. But for cannonballs or bird droppings the air we breathe is sufficiently like a vacuum for the difference not to matter.

Now Mr Stiglitz, and other economists like him, believe that these assumptions of general equilibrium theory are way off the mark. Mr Stiglitz’ work is best brought together in his Whither Socialism?, published in 1994. In this, he argues there that problems of information and management of information are pervasive, and become more so as the knowledge economy grows. Most trading in financial markets has nothing to do with efficient resource allocation. It is based on real or imagined differences in information – which the booms and busts of South East Asia, or post-Communist Russia, illustrate well. To deal effectively with these problems of imperfect information, we need a complex range of social and economic institutions. In successful market economies, such a range has evolved over time. So there is no single universal model of how markets function, and the attempt to prescribe one for countries around the world will lead to inevitable disaster.

Adherents to this position are unconvinced by the invisible hand metaphor. They think constant fluctuations in asset prices have very little to do with the division of resources and much to do with irrational changes in expectations. They see economic progress as a chaotic, unpredictable system. The effectiveness of markets comes because good decisions are rewarded more often than bad ones. As in biological natural selection, the reward system is imperfect and only slightly favours the fittest and the best. But over time, that small margin is enough to secure continuous improvement.

We don’t have to choose one story rather than the other. Both signalling and selection contribute to our understanding of the efficiency of market economies. Still, if I had to choose, I would back Mr Stiglitz and put more money on the selection school than on the signalling explanation.

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