Issue Briefs

The palsied hand of capitalism

The palsied hand of capitalism

Martin Hutchinson

October 04th, 2021

“Every individual… neither intends to promote the public interest, nor knows how much he is promoting it… he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention”

So wrote Adam Smith. This is one of several “Invisible Hand” quotes in his celebrated book: The Wealth of Nations. Regrettably, Smith’s model is just a model. It breaks down in extreme situations, and the complexities of modernity, particularly the meddling of governments, have rendered the Invisible Hand more and more palsied. It is worth examining why, and what to do about it.

Common sense over dogma

Charles Jenkinson, by then 1st Earl of Liverpool, father of the future prime minister and President of the Board of Trade, identified one major flaw during the corn dearth of 1800, in a letter to Sir Joseph Banks, President of the Royal Society: “In time of distress the Seller becomes Master of the Market” and it then becomes absurd to rest one’s confidence in Adam Smith, who “has Pushed his Principles to an extravagant Length, and in some respects, has erred.”

Jenkinson’s preference for common sense and observation over dogma was essential then and now. In 1800, allowing the free market to work without any government intervention, as many Whigs wanted, would have caused mass starvation in the same way as it was to do in Ireland in the late 1840s (albeit for a less prolonged period – the better 1801 harvest would have alleviated the problem). Jenkinson’s solution, imposed by the Pitt government as a whole, was for government-subsidized imports of grain from areas such as Poland where famine was less severe, together with government bakeries (authorized by legislation steered through the Commons by the young Liverpool) which would bake a coarser variety of bread with less grain and distribute it to the poor, thus making supplies stretch further. Overall, led by Pitt and Jenkinson, the government’s policy in 1800 was far more enlightened and pragmatic than would be Sir Charles Trevelyan’s dismal Whiggish strictures of the late 1840s.

Widely publicized BP letter caused a gasoline supply panic in the UK

Modern media and the Internet, and still more social media, have greatly exacerbated the potential for dubious information to throw off the smooth working of the market. To take a fairly recent example, BP, anxious to loosen British visa restrictions still further, appears to have set off a panic in the U.K gasoline distribution market by publicizing a claim to the government that it was unable to recruit more delivery drivers. Whatever the truth of the employment market for drivers – an employer cartel appears to have pulled in drivers extensively from Eastern Europe, driving down wages to a point where such employment is unattractive for British nationals — the BP letter, publicized by the British media, caused panic gasoline buying that produced a genuine shortage.

Market distorted by sensational news and regulations

Thus, the smoothly working British gasoline market was sent into a shortage position, apparently without any genuine cause for the shortage. Lengthy supply chains and political interference with supply chains will always tend to create such artificial shortages. Businesses must be encouraged to source locally wherever possible. A substantial “home bias” is both humanly natural and economically efficient.

Modern media represent only one of several distorting factors that are far more destructive to the Invisible Hand than in Adam Smith’s day. Another is the force of government regulation. Such regulations existed back in 1776. For example, Smith himself was suitably dismissive of the 1563 Statute of Artificers, highly distortive of the labor market in Smith’s time and repealed by Liverpool’s government in 1814. There was a general trend towards deregulation in the late 18th and early 19th Century under both Whig and Tory governments until the death of Lord Palmerston, the last truly economically sound Prime Minister (and one of only two with an economics degree, taught at Edinburgh by Smith’s acolyte Dugald Stewart) in 1865. However, since Gladstone’s accession to power in 1868 the trend has been in the other direction, with regulation reaching a blizzard at certain points in both Britain and the United States.

Bad policy decisions affect markets

The result of excess regulation is that the Invisible Hand is prevented from operating, or sometimes pulled in two directions at once. When the economically sound and profitable Keystone XL pipeline that would have carried Canadian oil to US refineries is first held up for a decade and then canceled altogether, at the whim of an economically illiterate President on the first day of his administration, the free market has no chance to operate. God knows how many other productive investments have been deterred by the Keystone XL decision. It is impossible to do the Invisible Hand’s work and reach an economically rational decision if you have to factor in some unknown probability that Big Brother will suddenly cancel your project, after hundreds of millions have already been spent. If a competitor damaged your interests in this way, you could sue them; but there is no point whatever in sending a bill of say $5 billion to Greta Thunberg, who appears to inspire most of government’s environmental decisions. 

Gaming public procurement

Government purchases are another modern fashion that palsies the Invisible Hand, because those decisions are taken for non-market reasons. To be fair, such purchases existed in Smith’s time in the military sector; and indeed, he criticizes them. Long wars of a well-established type were not such a problem; purchasing relationships were set up to satisfy them, which could be activated when a new war broke out. However, short wars that broke out unexpectedly often involved spectacular waste. For example, Sir Lawrence Dundas built suddenly one of the largest fortunes of the 18th Century by being the only loyal Scotsman the Crown could trust to arrange supplies for the Duke of Cumberland’s forces marching into Scotland to defeat Bonnie Prince Charlie in 1745-46 – the combination of monopoly and speed was an irresistible one! Today of course government is much larger, and Sir Lawrence Dundases exist all over the world palsying the Invisible Hand whenever they can.

Funny Money distorts markets  

However, the biggest barrier to the Invisible Hand’s efficient operation is “funny money” monetary policies. These damage its workings in two ways. First, they distort the market towards capital goods and away from other goods. Thus, a London house that cost £400 in the 1930s now costs £800,000, (rather than the £60,000 it would cost if adjusted for inflation), making it unaffordable whatever the financing interest rate for the modest type of buyer for which it was built. Second, they produce artificial scarcities, so that as Jenkinson put it “the Seller is Master of the Market” for all kinds of goods and services for which a proper market would be balanced.

Artificial scarcity causes housing bubbles

The increase in U.S. house prices in the past year of 19.7%, in a year to August in which GDP has barely budged, has been accompanied by all kinds of seller bad behavior that makes the market itself dysfunctional. In Britain, there could be a housing scarcity. It is a small island, and the planning regulations are so grossly intrusive that building new housing to match demand is impossibly paperwork- and time-intensive. In the United States, with an entire continent to play with and generally more sensible planning regulations (except in California) there is no such reason why a housing scarcity bubble could exist, except for lunatic Fed policy.

More regulation is not the answer

The left’s solution to failures of markets is to have the government regulate the problem. As we have seen above, this simply worsens the market failures. A much better solution is to go in the opposite direction, seeking always to make the Invisible Hand less palsied and better functioning. Reduce regulations that impede markets, allowing markets to determine the optimal allocation of resources, given the regulation that remains. Alleviate scarcities, so that the pathological behaviors of markets in cases of such scarcities are alleviated. Above all, cease the artificial allocation of capital through ultra-low interest rates and Fed bond purchases. That alone would both make market resource allocation more natural and would prevent the pathological behavior that occurs when allocation is forced in a particular direction through monetary policy.

The Invisible Hand is our friend. We must seek to make policy in such a way that its ability to help us is maximized.

This article was originally published on the True Blue Will Never Stain

The views and opinions expressed in this issue brief are those of the author.

Martin Hutchinson is a GPI Fellow and was a merchant banker with more than 25 years’ experience before moving into financial journalism. Since October 2000 he has been writing “The Bear’s Lair,” a weekly financial and economic column. He earned his undergraduate degree in mathematics from Trinity College, Cambridge, and an MBA from Harvard Business School.