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Beyond the Invisible Hand (book review)

Published in Economic Record (Sydney), Vol. 88, No. 280, pp. 156-158, March 2012

Beyond the Invisible Hand: Groundwork for a New Economics, by Kaushik Basu (Princeton University Press, Princeton, NJ, 2011), pp. 273.

In the immediate years before the Global Financial Crisis, many economists believed that the big questions of their discipline had been answered once and for all. The collapse of communism in 1989, marked most visibly by the fall of the Berlin Wall, had left the market as the only credible system to generate prosperity.

Periods of economic stagnation and inflation, which used to trouble many Western economies in the 1970s and 1980s, also seemed to be a thing of the past. The 1990s and early 2000s were a period characterised by low inflation rates and steady economic growth, facilitated not least by new forms of electronic communication and correspondingly increased trade.

Economists working in this time of ‘Great Moderation’ were satisfied that their theories and policy advice had created a better world. They also believed that they had the necessary tools to fine-tune the economy to lead it to steady growth, low unemployment and monetary stability.

This bubble of professional smugness burst together with the market for US mortgages in 2007. The ensuing trouble on international financial markets, culminating in but certainly not concluding with the default of Lehman Brothers the following year, demonstrated that the ‘Great Moderation’ was at least in part an illusion — as was the belief that economics as a discipline had reached a state of perfection.

With this great disillusionment in mind, it was only to be expected that some economists would be turning a critical eye to the state of their discipline. Clearly, if most mainstream economists could not foresee the greatest economic disruption in generations, something must be wrong with economics. So any root-and-branch critique of economics published these days is likely to find a receptive audience.

On the one hand, Kaushik Basu’s Beyond the Invisible Hand — Groundwork for a New Economics belongs to the genre of such fundamental critiques of economics. On the other hand, however, Basu’s critique of economics is relatively silent on the seminal events in financial markets which have kept economists busy over the past 4 years. Instead, the author, an economics professor at Cornell University and chief advisor to the Indian Ministry of Finance, offers us a more philosophical approach to the question of what is wrong with economics.

The title’s reference to the ‘invisible hand’ of course refers to Adam Smith’s notion, first proposed in the Wealth of Nations (1776), that individuals pursuing their own interests would also achieve outcomes that are beneficial to society at large.

Basu is careful to point out that Smith’s original idea contained qualifiers and warnings, which were left out by later generations of economists building on the concept of ‘the invisible hand’. This is most welcome since it has become commonplace, both by his admirers and his adversaries, to turn Smith into a caricature of himself. Basu recognises that Smith’s theories were far more elaborate and nuanced than perhaps suggested by the metaphor of the invisible hand.

However, having given this initial disclaimer, Basu falls into the same trap by identifying Smith’s original insight too closely with what neoclassical economics had made of his idea. First of all, it would have been worth a discussion of whether there is not in fact a distinction between self-interest and greed. Throughout Basu’s reflections, the two concepts of self-interest and greed seem almost interchangeable.

Second, and more importantly, Basu takes Smith’s concept of the invisible hand, which is very much an evolutionary concept of a dynamic market economy, and deals with it in a static perspective of equilibrium:

If we have a competitive economy, where all individuals choose freely according to their respective rational self-interest, then (given a few technical conditions) the equilibrium that will arise will be Pareto optimal. With a little bit of investment in algebra, this result can be proved as rigorously as any theorem in mathematics or axiomatic geometry. … This formalization was a major breakthrough in economics. (p. 19)

In this way, a metaphor from the colourful, non-mathematical world of classical economics is used as a synonym for the sterile and technical worldview of neoclassical economics. Poor Adam Smith!

What thus makes Basu’s critique of neoclassical economics odd is that the author himself remains locked in precisely the same methodology. Neoclassical economists frequently attempted to design models to render Smith’s ‘invisible hand’ more precise — arguably destroying its dynamic connotations in the process.

Basu attempts the opposite. In his book, he modifies the models in a way so as to show how Smith’s invisible hand fails to produce socially optimal outcomes. In doing so, he operates in precisely the same kind of equilibrium framework.

Where Basu argues that economists should pay greater attention to social phenomena, history and culture, he echoes demands from institutional economics. Strangely though, these calls for a greater anchoring of economics in the real world do not stop the author from using many highly stylised, artificial models himself. In this way, he can ‘create’ all sorts of artificial societies. A typical such model is then introduced like this: ‘Suppose in a nation there are two races, 1 and 2, two religions, 1 and 2, and two language groups, 1 and 2’ (p. 116). He then goes on to assume all sorts of social attitudes in the society he just developed on his mental blackboard and then shows that it must behave in a certain way. But all he really does is show that his assumptions lead to his preferred outcomes. In this way, many of Basu’s models show signs of circular reasoning.

The main goal of Basu’s modelling exercises is to show how conventional economics with its self-interested homo economicus at the centre is a flawed system. But Basu is wrong to equate such a free market perspective with full-blown anarchy. For example, he writes:

Contrary to what many textbooks teach us, the regions of the world that are economically the biggest disasters are the ones that are in many ways models of the free market, with amoral individuals seeking nothing but their own self-aggrandisement, no trace of law, and a suppression of individual respect of fairness and justice…. With little evidence of any intervention from traffic police, the streets of the third world should be textbook cases of neoclassical efficiency. The fact that they are not should alert us to the possibility that the central message of so many of our textbooks may be wrong. (p. 119)

If Basu were fair to advocates of the free market, he would acknowledge that the vast majority of free marketeers combine their call for economic freedom with an equally strong demand for a freedom-securing legal framework. Economic freedom does not equate anarchy. Even Ludwig von Mises, one of the most ardent defenders of economic liberty in the 20th century, made this distinction in his book Liberalism (1927):

Liberalism is not anarchism, nor has it anything whatsoever to do with anarchism. The liberal understands quite clearly that without resort to compulsion, the existence of society would be endangered and that behind the rules of conduct whose observance is necessary to assure peaceful human cooperation must stand the threat of force if the whole edifice of society is not to be continually at the mercy of any one of its members. One must be in a position to compel the person who will not respect the lives, health, personal freedom, or private property of others to acquiesce in the rules of life in society. This is the function that the liberal doctrine assigns to the state: the protection of property, liberty, and peace. (von Mises, 1985, p. 37)

Basu’s equation of anarchy with perfect liberty is thus misleading. Not even the fiercest proponents of the free market would call for the abolition of traffic rules. In fact, if Basu only had a look at the various empirical attempts to measure economic freedom, he would see that these undertakings now regularly include assessments of the institutional framework.

Basu regards free market economics as a Hobbesian world of ‘homo homini lupus’. Against this, he puts his vision of a society characterised by empathy and altruism. He claims:

If we want society to progress and economic development to occur, we need to nurture our innate sense of social values — such as altruism, trustworthiness, integrity, and a sense of fair play. And if we do not want the world to be fractured and broken up into oppressors and the oppressed, we should try to inculcate these values across all human beings and not just narrow in-groups, defined by race, religion, or nationality. (p. 119)

No further details are given as to how such a global, social re-education should work. But the idea that in order to make the world work better a new and more socially conscious man needs to be created is chilling enough. In fact, he expresses his sympathy for previous such attempts:

I cannot deny a certain admiration for those who have yearned for such a society, and those who have actually tried to achieve it —Karl Marx, Mao Tse-tung, Martin Luther King Jr., Che Guevara, Fidel Castro, Ho Chi Minh, Allende, and Gandhi. (p. 195)

Of course, Basu is quick to point out that most of them failed and that they took ‘perverse paths’ — but they failed ‘not because their target was wrong but rather because they took an impossible path’.

After the turmoil of the Global Financial Crisis, economics needs to escape from the dead ends of neoclassicism. Unfortunately, Basu’s self-proclaimed ‘groundwork for a new economics’ fails to achieve this.

Instead, the author remains lost in the methodological framework of those economists he criticises and he only holds utopian dreaming against the perceived failings of a grossly distorted picture of free market economics.

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