If the invisible hand of the free market is dead, has capitalism been buried along with it?

• Author: Marsh, Gerald E.
• Position: Economics

"BIG BANKS Hurt by Struggling Consumers"--so reads a recent l headline on the front page of the Financial Times. Many would be outraged, believing that the headline should be turned on its head: "Straggling Consumers Hurt by Big Banks." How did we get to the point where demonstrations against the banks and financial system have taken place in so many cities around the world? It is not so much the financial instruments and innovations introduced over the last 30 years that are responsible as it is the beliefs held by those who introduced them and those whose responsibility it was to provide oversight. The real origin of the financial crisis is the belief in the absolute supremacy of the market.

The idea that the market needs no regulation, and that an absolutely free market serves the best interests of all, dales back to Adam Smith, widely considered the father of economics, and the author of The Wealth of Nations. In tiffs magisterial tome, he maintains that the economic activity of an individual is "led by an invisible hand to promote an end which was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it."

Max Lerner wrote in his 1937 introduction to the Modern Library edition of this work that the idea "that there is a 'natural order,' whereby the pursuit by each individual of his own self-interest contributes ultimately to the social welfare, that must lie outside the realm of science or of historical verification, and must be set down as a cardinal principle of the faith of the age." Put in modern terms, the idea of an "invisible hand" guiding the market amounts to faith-based economics.

Lerner went on to draw the obvious conclusion: "... Since a natural order exists whereby the enlightened selfishness of all men adds up to the maximum good of society, since there is a 'divine hand' which guides each man in pursuing his own gain to contribute to the social welfare, it must follow that government is superfluous except to preserve order and perform routine functions. The best government is the government that governs least. The best economic policy is that which arises from the spontaneous and unhindered action of individuals."

Sound familiar? This is the fundamental belief of the right wing of the Republican Party and the Tea Party. Of course, Lerner believed no such thing, characterizing it as "anarchy plus a constable."

There is another important contributor to the financial crisis that has a close relation to the invisible hand--the use of financial models that attempt to simulate the market and guide economic policy.

The connection between the invisible hand and financial models has been captured by Sam Ouliaris in his June 2011 article in Finance & Development:. "Today's economists build models--road maps of reality, if you will--to enhance our understanding of the invisible hand." Some models use linear approximations to represent the intrinsically nonlinear nature of economic relationships. Such macroeconomic models have been employed since the mid 1950s. If linear models are used to help formulate economic policy, there is a real danger that the guidance is likely inadequate or wrong.

Nonetheless, as put by James Bullard and Alison Butler in the July 1993 Economic Journal, "Most present day policy advice is linked to linear theories, and while few would claim this approach is exactly correct, many believe that linear specifications provide an approximation to the true law of motion for the macro economy."

However, the fact that the models are linear means that this is true only if the economy is near a stable point, which, as shown by recent events, is not always the case. As a result, much effort is being expended...