I’ve been thinking recently about Adam Smith, his Wealth of Nations (1776), and the concept of the “invisible hand.”  This idea is that in a world where everyone acts in his own rational self-interest, somehow the “invisible hand” of the market arranges affairs so that a favorable outcome, if not the most favorable outcome, results.

The concept of the “invisible hand” has been used in modern finance and economics to justify such prominent ideas as the (supposed) self-adjusting, self-regulating character of financial markets, the stabilizing nature of speculative activity in commodities markets and the efficient markets hypothesis.  In other words, it has spawned some of the most misguided and counterfactual theorizing ever.

So I decided to go back and look at what Smith actually had to say.  I was surprised by what I found.

Wealth of Nations

Smith introduces the idea of the ‘invisible hand’ in an indirect way.  The only general statement he makes is that he distrusts the motives of those who claim to be acting in the public interest, saying no good comes from this.  Rather, he says, the best economic results usually come from those who are acting in their own economic self-interest.  He also offers the example of the decision whether to manufacture gods in the home country or abroad.  The best result comes, not from those who claim patriotic motives for their trade, but from those who buy and sell the most commercially viable products, no matter what their country of origin.  In so doing, he is led by an “invisible hand” to achieve a result which he doesn’t intend, but which benefits society as a whole–namely, putting capital into the control of people who can use it most productively.

Smith, however, doesn’t assert that self-interested action always or generally achieves a favorable result, although he clearly seems to believe that it does.  He’s much more certain that the claim to be acting in the public interest is a bogus one.

Leibniz’ Theodicy (1710)

What really strikes me about Smith, however, is how he seems to frame his discussion in terms of the eighteenth-century theological debate about how to reconcile the existence of evil in a world created by an all-powerful and benevolent God.   That shouldn’t come as a particular surprise (although it did to me), since Smith started out studying and later teaching ethics at the university in Glasgow.

The state-of-the-art  of this topic was, I think, Leibniz’ Theodicy. His twist on the issue was to say that the world we live in, created by God, is the best of all possible worlds.  One may well be able to envision better worlds than ours, but this isn’t an argument that God has created a relative clunker.  Any such imagined world simply isn’t possible.

Today, we’d probably call this a linguistic trick.  And Leibniz was parodied by Voltaire’s Dr. Pangloss in Candide. But Leibniz’ conclusion that the sum total of all human activity in the world, everyone acting in his own self-interest and without knowledge of God’s master plan, creates the maximum possible good was okay for eighteenth-century Europe.

Compare Leibniz with Smith.

Smith certainly knew the Leibniz argument.  HIs is basically the same.  But he presents his “invisible hand” as a generalization from experience, rather than a law–as one might expect from a colleague of David Hume.  And he omits the part of the argument, such as it is, that gives it its logical force–that a transcendent being made the world so it works this way.  In its place, Smith offers the notion that at some basic level people feel empathy toward one another and wish each other well.

Fine for the eighteenth century, not for the twentieth or twenty-first.

Schopenhauer and Freud

Also not fine for the nineteenth century.  That’s when a series of thinkers, the first of whom was Arthur Schopenhauer in his World as Will and Representation (1818), began to take seriouly the possibility that the world was not open book previously thought, but instead a place where unconscious deception could color all we see and do.

These ideas were refined and popularized by a number medical practitioners toward the end of the century, of whom the most famous was Sigmund Freud.

The nineteenth century, then, opened the intellectual door for theorists to consider a world where mass delusions, wars, panics, manias and bubbles–all irrational, destabilizing movements–are possible.  In other words, they opened the door to the real world.

Oddly enough, it’s only in the last generation that academic economists have begun to factor these nineteenth-century achievements into their thinking.  Finance professors have not yet come to the party.

what does this have to do with investing?

Maybe nothing.

To me, what I’ve written above suggests that academic practitioners of economics and finance are long on mathematical technique, but short on knowledge of cultural and intellectual historical developments of the past two or three centuries.

Since dubious academic ideas have given a patina of respectability to the regulatory laxity that has produced the financial crisis we’re struggling our way out of, maybe it’s time for a more general rethink of the presuppositions regulators are using.  Maybe it’s also time for universities to supplement their stables of equation jockeys with people having more well-rounded intellectual backgrounds–maybe even with people who have practical experience in economics or finance.  If so, maybe we wouldn’t have a repeat of Mr. Greenspan testifying before Congress that he was shocked that financial markets didn’t heal themselves.  After all, God did create the best of all possible worlds.