Freeman

ARTICLE

The "Invisible Hand" or the Heavy Hand?

DECEMBER 01, 1978 by JOHN MONTGOMERY

Mr. Montgomery is a newspaperman and writer on socioeconomic issues who lives in Closter, N.J.

It will come as no surprise to readers of the Freeman that the national debate over inflation, recession and unemployment rests on a more fundamental issue—what kind of economic system will work best for America? Should it be a continuation of the free-market, capitalistic system which meant unparalleled growth and wealth in the past, or a centrally planned economy directed by government?

There is a superficial plausibility to the argument for central planning. The public is generally inclined to leave problems of national scope to government and to assume that centralized authority is either desirable or inevitable. Looking on the surface of things, people generally think no further than the immediate effects and short-term benefits of government action. Beset and buffeted by the workings of the marketplace, they are taken in by the promise of ideal government action to correct the shortcomings of the market, and they forget that government promises often exceed the results.

In contrast, economic thinking shows that there is good reason to believe that government action can be counterproductive. Economic thinking goes beyond the immediate, visible impact of a policy to foresee the longer-range, secondary effects. And it can recognize the real as opposed to the promised results of a government policy which is based on a misunderstanding of the workings of the market economy.

For example, government‑imposed price controls would seem to offer protection against inflation. But powerful economic forces come into play and cause widespread shortages. Then, government must intervene again. Rationing is imposed. The result of that is the rapid growth of black markets.

What’s more, there is a conflict between successful politics and sound economic policy. Politics can work to serve the interests of powerful pressure groups rather than the general public.

An Invisible Hand

Two centuries ago the first great economist, Adam Smith, explained the operation of the free market by saying it was as though there were an invisible hand directing the efforts of everyone—even though each was pursuing his own gain—in a way that promoted the interests of society as a whole. And that is essentially what the advocates of a free market are saying today, leaving themselves open to the charge that they are clinging to an archaic notion which no longer applies in modern times.

Smith’s great work, The Wealth of Nations, came out in the watershed year of 1776. The industrial revolution was just under way and it was a time of pervasive regulation of production and trade by the king and Parliament. Smith was arguing for a laissez-faire, hands-off policy by government. But it wasn’t that he thought the invisible hand was tugging on puppet strings to guide each producer, merchant and trader. Smith believed that economic affairs were self-regulating, that internal order was inherent in the competitive market process to the extent that it was free of government intervention. He saw an order which, in the words of his contemporary Scottish philosopher, Adam Ferguson, was the "result of human action but not of human design."

In the two hundred years since Adam Smith, economics has developed in many directions. But for our own time only the economists of the so-called Austrian school, named for the place of its beginnings a century ago, have contributed much to that concept of Smith’s. In particular, Friedrich Hayek, Nobel Prize winner and dean of the Austrian economists of today, has drawn on the work of his great teacher, Ludwig von Mises, to address the idea repeatedly over the past 40 years or more. Mises, Hayek and younger "Austrians," mostly in the English-speaking world, have built on Smith’s concept in fundamental ways to show how it can apply to the vastly more complex economy of today.

In attempting to describe some of those ideas here, largely from Hayek’s writings, only the essence of the market process will be focused on. Major forces and mechanisms will go unmentioned and the picture will be somewhat abstract and idealized. But if the advocates of central planning can rhapsodize over the economic utopia to be realized if their designs are carried out, then there would appear to be good reason to portray the workings of a truly competitive market economy, free of the distortions and constraints imposed in these times of big business, big labor and, most of all, big government.

Hayek restates Smith’s concept by saying that the coordination of individual efforts in society is the result of an immensely complicated mechanism which exists, works and solves problems but is not the result of deliberate regulation. Or, as he puts it, "The spontaneous interplay of the actions of individuals may produce something which is not the deliberate object of their actions but an organism in which every part performs a necessary function for the continuance of the whole, without any human mind having devised it."¹

General Rules of Order

The "ordering forces" in such social formations are the general rules for the behavior of individuals in a society. Not that these rules are laid down by the architect of a master plan, or that the rules dictate what each person must do. Rather, the rules are largely negative, prohibitions against certain forms of behavior. Each person knows what he must not do but is left free to choose what he will do from all the remaining alternatives. What these common rules give rise to are patterns of human behavior, a certain range of actions and an over-all order in society.

Such common rules have come down through the ages, passed on in the cultural traditions of human societies, and represent the accumulated experience of mankind. They have shaped the spontaneous order in human affairs which is now widely recognized in such social institutions as language, law, morals, writing and the use of money. In these cases it is no longer argued that they are the work of inventors, legislators or bodies of wise men.2

In certain ways the idea of central economic planning dates back to Mercantilism, which was dominant in the 17th Century and then went on the decline as capitalism began to take shape. Its economic assumptions were finally put to rout by Adam Smith, but not before England’s Mercantilist policies had goaded the American colonies to revolt. Mercantilism held that the purpose of economic life in a nation was to serve and advance national power; accordingly, it was the right of government to control economic affairs. Throughout that period, the trading nations of western Europe were engaged in commercial warfare with each other, in the struggle drawing on the resources of their colonial possessions without regard to the interests of the colonists and native inhabitants. The most intense international rivalry was in foreign trade, which yielded gold—the source of national wealth and power.

In mobilizing its assets and people in the international struggle, each nation tried to promote a forced growth of its domestic economy, particularly in the small-scale manufacturing of the time and the production of goods and commodities for export. Despite the embryonic state of economic knowledge, each nation resorted to a planned economy, which gave rise to an overgrown thicket of regulations, trade restraints, currency manipulation, impoverishing controls over wages and the movement of labor, grants of monopoly privileges, and subsidies to favored industries. The similarity of the extensive intervention in the economy by the modern welfare state in pursuit of its social goals has suggested the name of neoMercantilism.

Utopian Socialism

But it is not so much that today’s advocates of central planning want a return to Mercantilism. Their sustaining vision came along a bit later, early in the 19th Century. And it was a vision which has had enormous influence, inspiring generations of social scientists, writers and intellectuals to this day. Its patron saint was an impoverished French nobleman, the Comte de Saint Simon. His followers and successors generated the major part of what came to be known as Utopian socialism. Observing the great accomplishments of the physical sciences in 18th Century France, they sought to develop a social science of society in which everyone in it would be directed by an elite group of philosophers and scientists using their knowledge for the common good.

Then, not long after and building at least in part on their ideas, came Marx and Engels who foresaw the downfall of capitalism in the revolt of the workers of the world to take over the means of production from the capitalists who had exploited their labor. But Marx was far from a mere social visionary. Starting with certain flaws in the classical economics of the time, he built his own system which continues to exert a powerful influence on many economists. This influence can be seen in the insistence by many that central planning is necessary to compensate for "inherent" and "structural" weaknesses in the capitalistic system.

There are other reasons for the continuing resistance to the idea of a self-regulating economy. For one thing, it took a long time for man to concede that any system with order, function and apparent purpose was not of human design; the belief in central planning may be the last vestige of that reluctance. But, most important for politics and policy today, Keynesian economic theory which has been so dominant since the Thirties plus the development of mathematical models and statistical data which can be fed into a computer seem to offer ways that the economy can be managed.

Too Complex for Planners

In a recent article, Hayek responded to that idea by saying that "the very complexity which the structure of modern economic systems has assumed provides the strongest argument against central planning. It is becoming progressively less and less imaginable that any one mind or planning authority could picture or survey the millions of connections between the ever more numerous interlocking separate activities which have become indispensable for the efficient use of modern technology and even the maintenance of the standard of life Western man has achieved."³

But, then, if central planning cannot cope with such complexity, how would the free market do any better? It would, of course, have to serve such basic economic functions as the allocation of resources, the organization of production, and the distribution of goods and services. But these things cannot occur in a vacuum. Information is required: about the availability of resources, about how production is progressing and whether adjustments are called for, and about what goods and services people want, and how much, of each.

The crux of the matter, as Hayek puts it, is that the necessary knowledge and information does not exist in concentrated or integrated form but solely as dispersed bits of incomplete and frequently contradictory knowledge possessed by different individuals throughout the economic system.

Market Pricing

So, how is this dispersed information to be conveyed to the decision makers, who are also scattered about the system? And how are the decision makers to know what information of potential use to them is out there somewhere, beyond their purview but available for the asking?

In this connection, Hayek has another observation: knowledge comes in two kinds. First, there is the scientific knowledge vital to an advanced technological society. That knowledge would be easily commanded by the experts, and would even be manageable by the central planners. But then there is the second kind, that important but unorganized knowledge which has to do with the particular circumstances of time and place. Of this latter kind, nearly every participant in the market system possesses knowledge which is unique to his job and location. And, in view of this expertise, who better should make the decisions that that knowledge mandates?

To illustrate the difference between these two kinds of information, Hayek points out how much there is to learn on a new job even after completion of scientific or technical schooling, and how important to any job is the knowledge of the people involved, of local conditions and special circumstances.

Response to Change

And then there is the problem of change. The market must respond with dispatch to change which can occur anywhere in the economic system: a transportation tie-up in and out of Chicago, a craze for sky blue jeans on the East Coast, and so on. Again, decisions are required where the change has occurred and where the knowledge of possible responses is to be found. It is the man on the spot who must decide and take action. But he needs to know more than the facts of his immediate surroundings. He must know something of the big picture, what is going on out there in the rest of the economic system—so that he can dovetail with the other decision makers and fit in with the workings of the whole system.4

If there were no change, at least one of the insoluble problems confronting the central planners would be done away with. They could draw up long-range plans with precise and detailed instructions for the underlings throughout the system to carry out. There would be no need for adjustment to unforeseen events, for adjustments to eventualities which had not entered into their calculations. But, among other things, there would still be the practical impossibility of obtaining and distilling the enormous quantity of information reflecting local conditions in all the interacting sectors of the economy.

Returning to the market economy, it is not enough that knowledge and the ability to act on it be dispersed throughout the economic system. A mechanism for communicating that knowledge is needed. And there is such a mechanism: the price system.

Prices are a numerical index which determines the value of each thing considered for purchase relative to all other things available to each potential buyer, whether producer, consumer or middleman. Thus he can rank the urgency of his needs as a basis for his decisions without being overwhelmed by all of the information which might conceivably be brought to bear on his choices. Price fluctuations reflect change wherever it has occurred in the market system. The numerical index of prices communicates sufficient information in condensed and distilled form for the market as a whole to be coordinated.

Guidelines to Follow

Hayek illustrates how the price system works as follows: "Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply has been eliminated. It does not matter for our purpose—and it is significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the result will rapidly spread throughout the whole economic system. This influences not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, and so on. . . . The whole acts as one market, not because any of its members surveys the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution. . . .

"We must look at the price system as such a mechanism for communicating information. . . . The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on, and this is passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than their reflection in the price movement.

". . . The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction. . . ."5

The Entrepreneur’s Role

Austrian economist Israel Kirzner, citing the work of Mises, fills in another part of the picture of the market process. He describes three types of market participants: consumers, entrepreneur-producers and the providers of productive resources, including labor. Again, the key to the process is information, with the market participants starting out in ignorance of each other’s intentions and thus unable to join in exchanges as buyers and sellers. Prices estimated and offered are far apart but move closer together as the market process goes on. From the information derived in the process about each other’s expectations, the market participants change plans and set new courses.

The entrepreneur is the driving force in the process. It is he who is on the alert for places in the economy where conditions for exchange exist and who seeks profit in the creation of new business, new production methods and new products. And in his activities he conveys information in the form of successive price offers and estimates, nudging the plans of the market participants into closer and closer alignment until an exchange is achieved. In so doing, he exploits and creates change in the discovery of new resource sources, new technical opportunities and new consumer tastes and preferences. And he exploits such possibilities by changing prices, product specifications and selling effort. Impelled by the goad of competition, he seeks to close a deal, secure a resource or penetrate a market sector before his rivals. The result is growth in business activity, in income and employment, and in the supply of new goods and services.6

Stultifying Bureaucracy

There is no place in the centrally planned economy for the entrepreneur in search of profit. Bureaucrats are after job security and power in the hierarchy. The search for profits is risky and the bureaucrat must play it safe. Besides, he knows the profits are not for him to keep. Thus, another signal required by the self-regulating economy, profit as indicator of the viability of a business enterprise and guide to the use of resources, is forgone.

And there is no place in the free market system for the central planners whose inflexible designs would stifle the free movement and initiative of those who make it work. Paraphrasing Hayek, planning in a society consciously directed from the top could never begin to utilize all the knowledge and energies bound up in the countless individuals who make up the community. Human resources will waste away while all await their marching orders.
 

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Unfortunately, educating people about phenomena that are counterintuitive, not-so-easy to remember, and suggest our individual lack of human control (for starters) can seem like an uphill battle in the war of ideas. So we sally forth into a kind of wilderness, an economic fairyland. We are myth busters in a world where people crave myths more than reality. Why do they so readily embrace untruth? Primarily because the immediate costs of doing so are so low and the psychic benefits are so high.
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