Economists’ Secret: There Is No Invisible Hand

From Harvard Business Review:

One of the best-kept secrets in economics is that there is no case for the invisible hand. After more than a century trying to prove the opposite, economic theorists investigating the matter finally concluded in the 1970s that there is no reason to believe markets are led, as if by an invisible hand, to an optimal equilibrium — or any equilibrium at all. But the message never got through to their supposedly practical colleagues who so eagerly push advice about almost anything. Most never even heard what the theorists said, or else resolutely ignored it.

Of course, the dynamic but turbulent history of capitalism belies any invisible hand. The financial crisis that erupted in 2008 and the debt crises threatening Europe are just the latest evidence. Having lived in Mexico in the wake of its 1994 crisis and studied its politics, I just saw the absence of any invisible hand as a practical fact. What shocked me, when I later delved into economic theory, was to discover that, at least on this matter, theory supports practical evidence.

Adam Smith suggested the invisible hand in an otherwise obscure passage in his Inquiry Into the Nature and Causes of the Wealth of Nations in 1776. He mentioned it only once in the book, while he repeatedly noted situations where “natural liberty” does not work. Let banks charge much more than 5% interest, and they will lend to “prodigals and projectors,” precipitating bubbles and crashes. Let “people of the same trade” meet, and their conversation turns to “some contrivance to raise prices.” Let market competition continue to drive the division of labor, and it produces workers as “stupid and ignorant as it is possible for a human creature to become.”

In the 1870s, academic economists began seriously trying to build “general equilibrium” models to prove the existence of the invisible hand. They hoped to show that market trading among individuals, pursuing self-interest, and firms, maximizing profit, would lead an economy to a stable and optimal equilibrium.

Leon Walras, of the University of Lausanne in Switzerland, thought he had succeeded in 1874 with his Elements of Pure Economics, but economists concluded that he had fallen far short. Finally, in 1954, Kenneth Arrow, at Stanford, and Gerard Debreu, at the Cowles Commission at Yale,developed the canonical “general-equilibrium” model, for which they later won the Nobel Prize. Making assumptions to characterize competitive markets, they proved that there exists some set of prices that would balance supply and demand for all goods. However, no one ever showed that some invisible hand would actually move markets toward that level. It is just a situation that might balance supply and demand if by happenstance it occurred.

In 1960 Herbert Scarf of Yale showed that an Arrow-Debreu economy can cycle unstably. The picture steadily darkened. Seminal papers in the 1970s, one authored by Debreu, eliminated “any last forlorn hope,” as the MIT theorist Franklin Fisher says, of proving that markets would move an economy toward equilibrium. Frank Hahn, a prominent Cambridge University theorist, sums up the matter: “We have no good reason to suppose that there are forces which lead the economy to equilibrium.”

An engineering analogy may help. The invisible hand sees market economies as passenger planes, which, for all the miseries of air travel, are aerodynamically stable. Buffeted by turbulence, they just settle back into a slightly different flight path. General-equilibrium theory, as it developed in the 1960s and 1970s, suggests that economies are more like fighter jets. Buffeted by a gust, they wouldn’t just settle into a slightly different path but would spin out of control and break asunder if “fly-by-wire” computer guidance systems did not continually redirect them to avert disaster.

Economists might call the fighter-jet analogy polemic, but no knowledgeable theorist would say that the so-called “general equilibrium” model is stable. The very word “equilibrium” is deeply misleading in this context because it describes a situation that is not an equilibrium, either in plain English or in engineering. Economic equilibrium — a stable state toward which an economy would move — reveals a hope on the part of economists, not a mechanism captured in an accepted model. Speaking of “equilibrium” allowed economists to fool themselves, and others.

The failure to model the invisible hand is ironically powerful. Any given economic model might well be implausible. But if the brightest economic minds failed for a century to show how some invisible hand could move markets toward equilibrium, can any such mechanism exist? Something outside markets — social norms, economic regulation, Ben Bernanke in his happier moments — must usually avert disaster.

How can some economic models continue to assume stability? Arrow-Debreu treats each individual, firm, and good as distinct. Supposedly practical economists develop models that aggregate — homogenize. They aggregate corn, iPods, and haircuts into one uniform quantity of stuff that they call “commodities” and label “Y.” And they lump all diverse individuals into one “representative agent.” You can easily build stability into such a model by pure assumption. But it is pure assumption. How could decentralized trading move markets to equilibrium if there is only one good?

In a tribute to academic insularity, most supposedly practical economists are dimly aware, if at all, of theorists’ instability results. They might have briefly seen them in one theory course and ignored them as geeky and inconvenient. Others dismiss them. Milton Friedman once told Franklin Fisher he saw no point in studying the stability of general equilibrium because the economy is obviously stable — and if it isn’t, “we are all wasting our time.” Fisher quips that the point about economists’ wasting their time was perceptive. The point about economies being obviously stable was not perceptive.

Believing far too credulously in an invisible hand, the Federal Reserve failed to see the subprime crisis coming. The principal models it used literally assumed that markets are always in instantaneous equilibrium, so how could a crisis occur? But after the crisis exploded, the Fed dropped its high-tech invisible-hand models and responded with full force to support the economy.
The powerful invisible-hand metaphor refused to die. It assured German Chancellor Angela Merkel, even if she grew up in East Germany under Communism, that slashing fiscal budgets and deregulating labor markets would end the euro crisis. Based on thinking dimmed by some invisible-hand fancy, European authorities have again and again been a day late and a euro short in responding to market gales. As a result, they made the euro crisis far worse than it had to be.