Mugged By The Invisible Hand
By Pete Lester, Sr.
February 11, 2009
Let me state outright that I believe in the free market. I also believe that Adam Smith was right when he described his notion of the “Invisible Hand” and its power in the every day exchange of goods and services as well as on a Macro scale in the economy as-a-whole.
So, if this is the case, haven’t we all been mugged by the invisible hand? I think the answer, as any good economist would suggest, is just not that simple.
First, I think it is important to make sure we have a common understanding of what Adam Smith meant when he first described the “Invisible Hand”. In this analogy, he describes individual action as being efficient because as economic beings, we will act in a way as to maximize our own personal gain and, for this reason, individuals will typically act in an economically responsible way. “By pursing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”
Each individual striving to accumulate wealth for himself “intending only his own gain”. But here is the rub: that individual must eventually exchange the goods and services that he produces with others who are also acting to maximize their own gain. Only Robinson Caruso lives isolated on an island. This is why we have division of labor, so that we can each immerse ourselves in that economic work to which we are best suited and maximize our lives, fortune and social position.
Later, Ayn Rand would describe this as “the Nobility of Selfishness”. Gordon Gekko, the character in the movie Wall Street would give this idea horns, tail and a trident when he stated “Greed is Good.”
The Current Crisis:
In President Obama’s first National Presidential Press Conference held this week, he stated that the crisis was caused by “tax cuts that are targeted to the wealthiest few Americans.”
I would disagree and if President Obama does not like the current tax structure, he and the Congress should be working to change it. The fact is the current tax structure has nothing to do with the current crisis and the stimulus package does nothing to correct this perceived problem. So, if President Obama thinks the tax code is the problem, he/they are not addressing it in the Stimulus Package.
The current crisis had its roots in the fact that people where lending money to consumers who could not repay those amounts if steady economic growth did not continue. Once the housing market stalled, repayment of those loans stalled as well. Consumers then had to come to terms with the fact that they either paid too much for their home or leveraged it in too many ways, pulling equity out of the asset. When the value of that asset dropped, the debt-heavy consumers then came to terms with the fact that they now owed more on a piece of property than it was worth. Not only that, but those who had underwritten the loans and securitized them – they had to come to terms with that fact too.
So, if the invisible hand is to be expected to work in all of our best interests, what happened? Why is it we all feel like our 401(k)s were robbed, mugged by the invisible hand?
Frankly, it is the combination of two things:
1) Man has unlimited wants
2) Easy credit - not just in the Housing Market.
Man Has Unlimited Wants:
Most of us want better situations. Offer us a nicer house at a monthly payment that seems reasonable and we will reach for the improved lifestyle. The fact that so many did this over a period of time and so far beyond their means only exacerbates the problem. We end up with a society, certainly a housing market that is over extended.
By Pete Lester, Sr.
February 11, 2009
Let me state outright that I believe in the free market. I also believe that Adam Smith was right when he described his notion of the “Invisible Hand” and its power in the every day exchange of goods and services as well as on a Macro scale in the economy as-a-whole.
So, if this is the case, haven’t we all been mugged by the invisible hand? I think the answer, as any good economist would suggest, is just not that simple.
First, I think it is important to make sure we have a common understanding of what Adam Smith meant when he first described the “Invisible Hand”. In this analogy, he describes individual action as being efficient because as economic beings, we will act in a way as to maximize our own personal gain and, for this reason, individuals will typically act in an economically responsible way. “By pursing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”
Each individual striving to accumulate wealth for himself “intending only his own gain”. But here is the rub: that individual must eventually exchange the goods and services that he produces with others who are also acting to maximize their own gain. Only Robinson Caruso lives isolated on an island. This is why we have division of labor, so that we can each immerse ourselves in that economic work to which we are best suited and maximize our lives, fortune and social position.
Later, Ayn Rand would describe this as “the Nobility of Selfishness”. Gordon Gekko, the character in the movie Wall Street would give this idea horns, tail and a trident when he stated “Greed is Good.”
The Current Crisis:
In President Obama’s first National Presidential Press Conference held this week, he stated that the crisis was caused by “tax cuts that are targeted to the wealthiest few Americans.”
I would disagree and if President Obama does not like the current tax structure, he and the Congress should be working to change it. The fact is the current tax structure has nothing to do with the current crisis and the stimulus package does nothing to correct this perceived problem. So, if President Obama thinks the tax code is the problem, he/they are not addressing it in the Stimulus Package.
The current crisis had its roots in the fact that people where lending money to consumers who could not repay those amounts if steady economic growth did not continue. Once the housing market stalled, repayment of those loans stalled as well. Consumers then had to come to terms with the fact that they either paid too much for their home or leveraged it in too many ways, pulling equity out of the asset. When the value of that asset dropped, the debt-heavy consumers then came to terms with the fact that they now owed more on a piece of property than it was worth. Not only that, but those who had underwritten the loans and securitized them – they had to come to terms with that fact too.
So, if the invisible hand is to be expected to work in all of our best interests, what happened? Why is it we all feel like our 401(k)s were robbed, mugged by the invisible hand?
Frankly, it is the combination of two things:
1) Man has unlimited wants
2) Easy credit - not just in the Housing Market.
Man Has Unlimited Wants:
Most of us want better situations. Offer us a nicer house at a monthly payment that seems reasonable and we will reach for the improved lifestyle. The fact that so many did this over a period of time and so far beyond their means only exacerbates the problem. We end up with a society, certainly a housing market that is over extended.
Easy Credit Eventually Causes Uneasiness:
How this happened and who is to blame, historians will sort it out once the dust settles. I prefer to blame lending practices that began under the Clinton administration and continued under the Bush Presidency.
Regardless of who is to blame the bottom line is: consumers, informed or not, stepped up to the lending ATM and banks were ready, willing and able to provide the funds to allow people to purchase homes that were “nicer than they could have ever imagined.”
Business owners who for years took risk and anticipated their industry's changes, suddenly were lured to Wall Street. They took on debt, expanded, maybe sought out venture capital and eventually reached for the brass ring through an IPO. What had been a well run, nice business, suddendly was overburdened with debt and advice.
Later, former Federal Reserve Chairman Alan Greenspan would lament in a Congressional hearing (October 23, 2008) that he “made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”
Is this the invisible hand made visible and malicious by one of the Barons of the Free Market? It certainly sounds it.
Too Smart to Ask the Simple Questions:
The truth is: we all should have seen this coming and in a free society, it is up to us:
How this happened and who is to blame, historians will sort it out once the dust settles. I prefer to blame lending practices that began under the Clinton administration and continued under the Bush Presidency.
Regardless of who is to blame the bottom line is: consumers, informed or not, stepped up to the lending ATM and banks were ready, willing and able to provide the funds to allow people to purchase homes that were “nicer than they could have ever imagined.”
Business owners who for years took risk and anticipated their industry's changes, suddenly were lured to Wall Street. They took on debt, expanded, maybe sought out venture capital and eventually reached for the brass ring through an IPO. What had been a well run, nice business, suddendly was overburdened with debt and advice.
Later, former Federal Reserve Chairman Alan Greenspan would lament in a Congressional hearing (October 23, 2008) that he “made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”
Is this the invisible hand made visible and malicious by one of the Barons of the Free Market? It certainly sounds it.
Too Smart to Ask the Simple Questions:
The truth is: we all should have seen this coming and in a free society, it is up to us:
- For years we all heard friends and neighbors (and maybe even uttered it ourselves) that they could just not get over how well the investment in their homes had done.
- The companies making the loans continued to offer all of us credit cards that we could use to purchase a Cadillac.
- The people securitizing those loans who spoke in terms of “alpha” risk had never seen double digit unemployment and the people in the hedge funds seemed oblivious to asking the question: what is this paper really worth if things come to a screeching halt? How will we value a derivative of a derivative?
- As consumers, we relinquished our personal fiscal responsibility in favor of enjoying the ride up, hoping, maybe assuming, that the laws of gravity did not apply to us.
- The Shareholders, who, with the proliferation of mutual funds, are now institutionally owned, have been reluctant to “vote their proxies” and insist on sobriety.
In short, the invisible hand of selfishness, which most often calls us to question – “is this really good for me? For Us?” – that hand fell asleep, numbed under the combined weight of easy credit, steady corporate returns, and the myopic view that we had managed risk out of some investments that normally would have been considered “junk.”
Now stand up. Shake your arms. Feel that sensation – it is blood flowing again. As consumers, make your hands visible by being a responsible and informed consumer.
QUESTIONS for STUDENTS of ECONOMICS:
1) What should the role of government be in containing the growth of personal debt? Protect consumers (borrowers)? Contain lenders? Should it be buyer beware?
2) What can government do to encourage savings rather than spending?
3) In the area of encouraging corporations to act responsibly, what should shareholders do (you and me, mutual funds/institutional investors)?
1 comment:
The role of government should be to protect the consumers because there's are alot of people who are sharks. If we as consumer's aren't being protected for them we are swimming with the sharks.
2) I believe the government can help america save by creating a long CD with an attractive rate as long as there's a monthly deposit of $100.00.
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