I once had a friend, a rather supercilious fellow (some would say "arrogant"), who tended to look down upon the simpletons he believed populated the earth. I remember that he once described a mutual friend as "so stupid she would tell you the three causes of World War II, as if there were only three." His point being that large, global conflagrations whether political or economic or both are more often than not complex, both in cause and in effect. In response to comments to my last post, I'm going to offer some thoughts on the disproportionate growth in the financial sector over the last 30 years. The memory of my friend bids me caution you that there was much more going on than what I will write about here.
I'm going to talk about self-interest and risk and I'm going to start with my favorite moral philosopher and economist, Adam Smith. Smith should be roto-rootering out of his grave, he has so oft been misquoted, misinterpreted, and mistaken for a proponent of unfettered self-interest, very narrowly defined. Moreover, his single reference to an "invisible hand" in Wealth of Nations has been abused beyond recognition, taken to mean that all self-interest will advance the public interest everywhere and always. It's true that he wrote about how prudent, temperate self-interest will tend to promote the public interest, but he also acknowledged that special interests often collude with each other or with government in ways that benefit the special interests and that harm the welfare of the public. It seems pretty clear that he regards this last also to be a consequence of self-interest.
The quote about an invisible hand that started it all is from Book IV, Chapter II, of his book, An Inquiry into the Nature and Causes of the Wealth of Nations. The chapter title is Of Restraints upon the Importation from Foreign Countries of such Goods as can be Produced at Home. I hope the irony of the title is not lost on you. Smith was describing how commercial interests and investors preferred to keep production and investment within the confines of their own country. Here's the passage that started it all:
But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable 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. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. 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. Nor is it always the worse for the society that it 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. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.
I urge you to read the entire section linked to above. What you will discover is that Smith was writing about how those who deploy capital in pursuit of profits are constrained in where they deploy it by their aversion to losing said capital. Even if there had been a possibility of higher profits by deploying capital outside of their own country, the higher profits entailed higher risks back then, just as higher returns signal higher risk today. Smith describes how (at the time he was writing) returns within a country might be lower than if the same capital were invested outside the country, but this reflected a risk differential. He also noted that within a country, merchants, manufacturers and investors are likely to have better information about critical aspects of other market players, including that glue of commercial enterprise: trustworthiness.
The key feature here is that risk was more easily evaluated within one's own country than was risk incurred outside of one's country. Add to that differences in legal systems when capital left a country, which could make it harder to resolve disputes or recover capital, slower communications and travel and their impacts both on resolving disputes and in transmitting information, the greater relative ease with which information could be gained within the boundaries of one's own country and it is clear that in Smith's time keeping one's capital at home was beneficial both to oneself and, as a side effect, to one's country.
Smith's invisible hand was risk aversion.
Now fast forward to the 20th century and imagine a financial sector that has discovered that it can obscure risk. Not only can it obscure it by slicing and dicing it in ways that even they (apparently) don't understand, it has discovered ways to obscure risk, package and sell it to their clients, and then bet against those same clients that the inevitable collapse will occur. All that they have done has promoted their own self-interest. It has done little to promote the public interest or even, in some cases, their clients' interests. And as long as taxpayers and their elected officials remain willing and able to rescue imprudent, intermperate investment bankers or as long as those same bankers believe that taxpayers will do so, there is no brake, no "invisible hand" of risk aversion that will prevent recurrences of the same bad, high-risk behavior.
If fear of losing money is the brake on bad behavior, then risk needs to be preserved and communicated very accurately. Risk should not be eliminated by government policies such as no-strings-attached bailouts. An effective invisible hand requires that agents and principals anticipate real financial loss.
I will say it again: Smith's invisible hand as used in Wealth of Nations was risk aversion. Not unfettered self-interest aimed at making more money than anyone else in the world. The invisible hand was a constraint on avarice.
The problem is that for the last 30 years we have heard that unfettered self-interest alone was sufficient to assure properly functioning markets, financial and otherwise. That premise was instrumental in dismantling regulation that would have acted as brake on short-term, short-sighted, self-serving self-interest that does not serve the public interest. The result has been a series of bubbles and financial collapses, including a savings and loan crisis, the failure of a major hedge fund (Long Term Capital Management), a tech/dot.com bubble, and now a housing bubble.
I want to make it clear. A crippled risk-averse invisible hand is not the only reason for the concentration of wealth and power in the financial sector, but it is one of the reasons and an important one. That's why a no-strings, no-pain bailout of the same wonderful guys who gave us the most recent crisis was such a mistake. It amputates the invisible hand of risk aversion. With no down side, they're pretty much free to deliver more of the same. The only solution to this particular aspect of finance is wiser, more risk averse investors; wiser, more risk averse shareholders; and wiser, more risk averse managment. This almost certainly means that if even an arthritic invisible hand is to work there must be higher personal and business risks (as in bankruptcy) for the captains of industry and finance and those who aid and abet them in deceiving investors and the public.
And we need regulation, especially regulation that fosters risk aversion or creates it when markets do not. The irony is that effective regulation would actually reduce risk and allow prudent, temperate investors to be more confident that they were not being duped into a Ponzi scheme or into financial instruments that the seller is at the same time betting against. There would be fewer flights to safety, fewer high demands for liquidity, and more financial stability for the rest of us.
We live in a strange world. A world where the avarice of mythical "welfare queens" is accepted blindly and without question and ornate public policies are formulated to guard against it, but the demonstrated avarice (or incompetence if you really believe they didn't understand what they were doing) of real investment bankers, avarice that has done far more harm to all of us, produces public policies, public sentiments, and public rhetoric (at least among some) that encourage more of the same.
For a much better explication of the misinterpretation of Smith's invisible hand, including his use of the phrase in other contexts (and in other books), please visit Professor Gavin Kennedy's blog, Adam Smith's Lost Legacy.
Thanks to Louis for suggesting a serif font. I had been thinking the same thing for some time. Thanks to Eric for suggesting a larger serif font. :-)