Irrationality is the real invisible hand
Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating. The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so. This is a beautiful idea, but the question of course is how closely it represents reality.
In 2008, a massive earthquake reduced the financial world to rubble. Standing in the smoke and ash, Alan Greenspan, the former chairman of the Federal Reserve Bank once hailed as “the greatest banker who ever lived,” confessed to Congress that he was “shocked” that the markets did not operate according to his lifelong expectations. He had “made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders.”
We are now paying a terrible price for our unblinking faith in the power of the invisible hand.
In my mind this experience has taught us that Adam Smith ‘s version of invisible hand does not exist, but that a different version of the invisible hand that is very real, very active, and very dangerous if we don’t learn to recognize it. Perhaps a more accurate description of the invisible hand is that it represents human irrationality. In terms of irrationality the hand that guides our behavior is clearly invisible — after all recent events have demonstrated that we are largely blinded to the ways rationality plays in our lives and our institutions. Moreover it is also clear that irrationality does shape our behavior in many ways, pushing and prodding us along a path can lead to destruction. Whether we’re procrastinating on our medical check-ups, letting our emotions get the best of us, or letting conflicts of interest and short term time horizon ruin the financial market, irrationality is certainly involved.
In Adam Smith’s world the invisible hand was a wonderful force, and the fact it was invisible made no difference whatsoever. The irrational invisible hand is a different story altogether – here we must identify the ways in which irrationality plays tricks on us and make the invisible hand visible!
The Honest Truth About Dishonesty: How We Lie to Everyone - Especially Ourselves
I am concerned that the media are confusing the proximate and ultimate causes of the problems. The world seems to focus on the proximate causes (greedy bankers) when the real issue is the federal reserve system and fractional reserve banking which makes it inevitable. This focus is as misguided as blaming plane crashes on gravity.
1, The current system has failed so spectacualrly because the free market (which at it’s simplest is a system of voluntary co-operation and exchange), is not free. For it to work properly it needs to offer reward and risk as they balance eachother and deter excesses. Over the last 50 yrs the system has offered reward for the participants (depositors) but no risk because of govt insurance for banks. In such a system the excesses we have seen recently are inevitable. Until reward and risk are restored to the system, it will just keep happening. 100% reserve banking
and keeping the Fed away from distorting interest rates would solve these problems overnight. The invisible hand is truly an incredible phenomenon, but will not work properly when it is interfered with (for those that aren’t aware our fractional reserve banking system is equivalent to your local dry cleaner renting out your clothes).
2, The proximate issue of CEOs not protecting the interests of shareholders is a problem, but it would have been a very small problem without the issues raised above, and simply part of the evolutionary learning process of the free market system. Businesses learn from their mistakes all the time and continually improve how they run their business – governance is just another, albeit important, element of this.
Paul
You probably want to read Gavin Kennedy on Adam Smith, http://adamsmithslostlegacy.com/ASLLBlog.htm
Adam Smith did not use the term “invisible hand” as metaphor for the price system of the market, was well aware of the need for government intervention, but was also skeptical about the actual role government did play.
I think it’s early to judge whether or not Adam Smith’s version of the “invisible hand” is valid. We may, as a collective, have been working for the greater good, in the long run.
It reminds me of the Taoist story of the farmer:
One day an old farmers horse horse ran away. Hearing the news, his neighbors came to visit.
“Such bad luck,” they said sympathetically.
“We’ll see,” the farmer replied.
The next morning the horse returned, bringing with it three other wild horses.
“How wonderful,” the neighbors exclaimed.
“We’ll see,” replied the old man.
The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. The neighbors again came to offer their sympathy on his misfortune.
“We’ll see,” said the farmer.
The day after, military officials came to the village to draft young men into the army. Seeing that the son’s leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out.
“We’ll see” said the farmer.
Perhaps our “irrationality” is part of our own self preservation.
Bryan
First of all, thank you Dan for your terrific book and blog.
Secondly, I agree with most of your article, but I strongly disagree with this phrase: “We are now paying a terrible price for our unblinking faith in the power of the invisible hand”.
Why do you consider it a “terrible price”? I strongly believe in this famous quote: “If your life is free of failures, you’re not taking enough risks.” I am serial entrepreneur. I have founded four Internet startups. Some of them have succeeded and some of them not. But something is a fact: I have learned a lot from each regardless of how successful it was. I think that the quote also applies to the overall economy. We need to take risks –and fail every now and then– in order to learn and improve.
A 4% increase in unemployment and a decrease in the values of most stocks is, in fact, a failure; but should it be consider “a terrible price” when we can learn so much from it? Knowledge is expensive and we have to pay the price one way or another. We are paying for it right now and, if we are smart, this investment in knowledge will offer a good return of investment the future. That is, of course, until the next recession hits us
I love your book.
In this particular case though, I think the people involved did this on purpose, to fill their pockets with a total disregard to other human beings.
Smith was writing about market forces in a capitalistic society, such as we had in this country in the latter part of the 19th century. Our political system put an end to that experiment many years ago. It is as irrational to try to refute Smith’s work by what has happened economically in this and other hybrid economies around the world during the past two years as it would be to try to refute it by what happened in the Soviet Union or Cuba in the 20th century.
Dear Dan,
First of all thanks for such an effort to make us human being see our inner cores so clearly.
Most of your experiments are fantastic and are designed to show what you expect them to show.
In one of your experiment of duke’s basketball on price of ownership I have four observations.
1. The seller might be adding the cost of effort that he has made in order to win the ticket where as the buyer might think that he has already paid that cost. so there is a chance that the big diff is coz of that.
2. The seller might be thinking that he has got it for being lucky so he is adding cost of luck as well which normally in general posessions we would not.
3. Since now we have put it on sale in lieu of money the buyer would compare it with the other things available for the same amount of money where as the seller would add on what efforts went into it from his side.
4. Now as it is available for a price tag the excitement angle to win the ticket is not there.
If we could add the excitment angle somehow by asking the participants that they would be given a chance to compete in some game and the 4-5 winners would be given a ticket kind of thing,then probably to gain entry to that competition they would be ready to pay more in my opinion ( refer to achievement motivation experiments).
I am not sure if i am qualified to make that comment but still i feel this experiment cannot lead us to concluding results as your other experiments have, otherwise there are many things that would never be sold but they still sell because the asking and paying price gap is not as high as your experiment has shown.
Perhaps a simpler explanation of the failure of The Invisible Hand is that another fundamental change occurred in the 1980s: executive compensation levels that disconnect their interest from that of their shareholders. How interested should very highly paid executives (who make more money in a few years than they and their heirs could ever spend in their lifetimes), be in the long-term success of their companies? The irrationality is in that of Boards of Directors that establish such compensation schemes without recognizing the potential impact on the future of their companies.
Well said Mr. Ariely! Our ignorance of our own irrationality is like a physically blind person who does not believe himself to be physically blind! What trouble that person would get into if he never came to know and accept his visual impairment.
Many believe that Adam Smith was a great thinker and an even greater economist. I don’t dispute this but we cannot hold on to his ideas of the “invisible hand.” In fact, many of us have long since abandoned it and we have only to look at the fact that most if not all of the economies in the “industrialized” world are actually mixed economies. If all policy-makers believed whole-heartedly in Smith’s “invisible hand” theory, public health care, public education, and all forms of publicly funded security (eg. police officers) would have all been turned over to the “private” sector.
Oh what a wonderful web we weave when first we practice to deceive…
Let’s keep a firm distinction between the Reagan era propaganda using Adam Smith’s name and what the man actually wrote. Anybody who’s actually *read* the book abbreviated as, “The Wealth of Nations” could not come away with the idea that Smith thought markets an unvarnished force for good.
You make an excellent point, again, about irrationality driving decision making and how we should be aware of it. I was thinking of this blog post when I saw an article today about gender discrimination: http://www.indystar.com/article/20090423/BUSINESS/904230409
Do you have any thoughts to share as to why companies would irrationally practice gender discrimination when the penalties are so great and the rewards (at least from this study) very small, just 4% to 6% savings on the payroll of female workers?
Dan
I really enjoyed meeting you in St. Louis the other morning and our discussion. I guess you did not notice that I was wearing the official Adam Smith Society tie!
Unfortunately I must disagree with your conclusions as well of those of Mr. Greenspan’s. Mr. Smiths’ invisible hand works perfectly. Unfortunately, at least since the founding of our country, the government has not liked the outcome of the invisible hand when these outcomes caused political problems. Since the Revolutionary War, the Conventions, Congresses and Presidents have intervened in the markets with sincere intentions of funding the conflicts, honoring the debt, and improving the credit availability for its citizens. History has demonstrated that these series of interventions only pushed the problems off on later generations and administrations creating larger and larger issues The result was these cumulative government interventions and actions over 230 years actually culminated when the impact and complexity of this activity actually froze the free markets this past fall. The potential buyers were confounded and disappeared! Not because the market did not work – it was because the weight and complexity of the cumulative government interventions was too much for the market to digest. Now it appears that the free markets have been “shocked” into a new paradigm of determining what the government is going to do next.
Every time the government intervened over the past 230 years people and businesses modified their behavior to “game” the system to enrich their interest. Isn’t this behavior modification perfect evidence that the invisible hand not only works but is formative and real force?
Take Care
Jim
hi,
The above thought is smart and doesn’t require any further addition. It’s perfect thought from my side.
Garcia
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Congratulations for the book!
I often say that the quality of a book is proportional to the speed which reads (in days straight), and this is proof!
There were several funny experiences along the reading, from unknown people who here reading and using on dailly work some of the ideias, to create a small publicity to my friends.
If you mix an anchor, a free concept and”-A”, more than demonstrate the irrationality of human behavior, proved its weakness against the predatory advertising.
How to combat the Pareto Principle?
20% of bankers, insurers, pharmaceutical, governors, education control 80% are responsible to people behaviou, information.
How do we protect ourselves from our “protectors”?
Irrational Daniel
Porto, Portugal
I just got a copy of The Wealth of Nations and thought it was a very interesting read. As for The Invisible Hand, I believe there are a lot of invisible hands manipulating us to act in certain ways that would benefit certain companies or individuals. Wealth and power are dangerous when possessed by the wrong people and it is our responsibility to be more aware and analytical of what’s happening around us.
Bob
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For me, neither the invisible hand (whether it was or wasn’t Adam Smith’s notion) or the irrational world of behavioral finance perfectly describes the world. For me, both concepts seem to apply, with us being more rational under some circumstances and more prone to cognitive bias under others (i.e. we’re predictably irrational). Perhaps Simon’s old “bounded rationality” construct should be expanded to include cognitive bias and emphasize the word “bounded” more.
It is as irrational to try to refute Smith’s work by what has happened economically in this and other hybrid economies around the world during the past two years as it would be to try to refute it by what happened in the Soviet Union or Cuba in the 20th century.
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