Smith’s Invisible Hand; Its Salience & Fault Lines

This June marks the 300th birth anniversary of Adam Smith, the Scottish philosopher, considered to
be the father of modern economic thinking. Smith witnessed the beginning of the Industrial
Revolution which fundamentally changed the Western World. During this time and the decades that
followed Britain became World’s first industrial economy. This extraordinary period formed the
backdrop for one of the most influential books in economics The Wealth of Nations (1776), which he
took a decade to write. It sets out the concept of the ‘invisible hand ‘which refers to the unforeseen
market forces that set prices by equating supply and demand. He was concerned about distortions
that could cause the market prices to deviate too far from the national price. Both the state and
business could distort prices by interfering with market forces, the former by taxation and the latter
by keeping prices artificially high. He wrote: ‘Upon the whole, it is by far the best government policy
to leave things to their natural course.’ He also hoisted the concept of self-interest as the kernel of
the free market which ‘allows producers and consumers to produce & consume efficiently ‘. He
wrote:’ It is not from the benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their own self-interest.’

In 1759 he wrote The Theory of Moral Sentiments, which made him a well-known figure in the
European Enlightenment along with David Hume. Markets, for him, can function well when there is
free speech, free expression, debate, and dissent. Smith wanted societies to evolve towards more
freedom in an organic consensual way. His book on Moral Sentiments was aimed to influence British
MPs to support a peaceful resolution to the American colonies’ War of Independence. Its serendipity
that America’s independence coincided with the publication of Wealth of Nations the same year. No
wonder his idea of a free market & free speech has the best resonance in America. Ironically USA
also took over the mantle of global hegemon ( Pax Americana) by 1940 from the UK ( Pax Britannica)
& the dollar trumped the pound sterling as the dominant global currency. Alan Greenspan, the
legendary Fed Governor writes in his autobiography ‘The Age of Turbulence’ (2007) ‘one of the
greatest achievements in human intellectual history created the modern vision of people free to
choose to act according to their individual self-interest’.

It was Smith who wrote: The private pursuit of self-interest would lead, as if by an invisible hand, to
the wellbeing of all. When the US economy hit the financial crisis in 2007, the triumphal march of
the free market as an omnipotent idea & the invisible hand promoting the well-being of all met its
most serious challenge. The Stiglitz Report (2009) and in his subsequent book ‘Price of Inequality’
(2012) Stiglitz writes that in the aftermath of the financial crisis, no one today would argue that the
bankers’ self-interest would lead to the well-being of all. When the market works well, it is because
private returns and social benefits are well aligned. Markets by themselves often fail to produce
efficient & desirable outcomes. And there is a role for the government in correcting these market
failures, that is designing taxes and regulations that bring private incentives and social returns into
alignment. Deregulation in the 90s was also a major factor when led to the banking collapse as
Clinton repealed the Glass Steagall Act (1933) which separated the banking function from the
investment function and brought in the Gramm Leach Bliely Act in 1999. The finance sector used its
political muscle to make sure that the market failure was not corrected.

India embraced the free market philosophy of Smith in 1991, by making a U-turn of its economic
ideology of socialism from 1950-1990. The impact of the free market philosophy in determining
prices, interest & deposit rates, foreign exchange rates, lowering of trade barriers, lowering taxes,
and encouraging FDI & FII inflow has doubled the savings rate, doubled GDP growth, significant
increase export, and imports & FDI & FII inflow. On the other hand, wanton privatization of education
& health services has deprived a large number of people to avail of their services because of
unaffordable costs. Similarly scant attention is being paid to improving the nutrition level of children
and adolescent girls, leading to high levels of stunting & anemia. Adam Smith’s quest for wealth
maximization through the free market & invisible hands remains an unfinished & troubled script for
India’s bottom half. In particular, Smith would be troubled by the pathetic learning outcomes in
government schools. The Scottish scholar put a premium on government spending on education and
advocated for universal education.

Smith quite clearly overlooked the distributional aspects of wealth creation. The concept of social
justice and economic equity was brought to the center stage by Karl Marx, who wrote Das Capital
(1867), ninety years after Smith’s magnum opus. For Marx, Capitalism contains the seeds of its own
destruction & will usher in a classless society through revolution. Though the Russian Revolution
happened in 1917 it capsized on its own weight, due to a lack of freedom, choice, incentives &
market signals. Similarly, the global financial crisis of 2007-2008 has unveiled the perils of lax
regulation, free capital mobility without regulation, the proliferation of toxic financial products, and
excessive greed. As Jeffrey Sachs, the poster boy of the Millenium Development Goals writes: Our
greatest illusion is that a healthy society can be built around mindless pursuit of wealth. He could not
have been more prescient, when the US financial crisis struck, and the invisible hand of the free
market made a few unscrupulous bankers, speculators, and regulators have a bonanza at the
expense of a large number of small investors, depositors & common men.

Sadly, free market apostles like Jagdish Bhagawati, believe that the US Financial crisis is transient and
that free markets will fix themselves. This was precisely the pitfall in the theory of classical
economists that automatic equilibrium will be established during the economic depression of the
1930s, which prompted Keynes to observe in his magnum opus ‘General Theory of Income’(1936)
that market equilibrium is not automatic & government intervention is required for creating public
employment in order to lift the economy out of the quagmire of depression. History is witness to the
New Deal program of FDR, the American President, and how the US economy by 1940 had full
employment and a 40% share of global GDP. That sowed the seeds of the welfare state during the
economic crisis. Smith germinated the idea of a free market economy & wealth creation, Marx wrote
about the need for equity & social justice, while Keynes planted the seedling of a welfare state in a
capitalist country like the USA. Smith fired the first intellectual salvo in economic understanding; his
delectable cocktail of the free market, invisible hand & self-interest. His invisible hand concept will
be salient, with its warts & moles.

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