September 29, 2017

Adam Smith’s Invisible Hand is No Longer Invisible

By In Articles, Economics

Those who seek to defend the free market against government interventionism or socialism often refer to Adam Smith’s mystical “invisible hand” which somehow and miraculously helps to coordinate the wants and needs of people in society. The critics of unfettered free markets mock the idea, that we simply must “have faith” in the invisible hand, that this mysterious and unseen force will guide resources in a socially beneficial way. Rather, they say, we ought to instead lean on the wisdom of the planners, those who can plan and manage and prepare a great vision for society’s interests and needs. Planning is to be preferred over the “anarchy of production” which characterizes capitalist theories of economic organization. We need planners, not faith in the invisible hand.

For good reason, free marketers stand opposed to central planning– but not enough of these free marketers realize that there is no need to defend the archaic “invisible hand” model in the process. This is because the Austrians have effectively eradicated our need for it. The invisible hand is no longer a mysterious and miraculous force. The Austrians uncovered the fact that the substance of the “invisible hand” is actually the price mechanism. It is the price mechanism that coordinates resources and consumer wants across time. Far from being invisible, prices are very real things and are employed by consumers and entrepreneurs on a daily basis. The implication of this, of course, is that the debate should not be between “Planning” and “anarchy of production” but rather between “central planning” and decentralized or individual planning.

In the era of Adam Smith– whose labor theory of value was later built on by Marx himself– the very idea that resources could be efficiently and effectively allocated without the use of a single plan was something that could not really be explained logically. It was simply relegated to the realms of just trusting that it would work out. The opponents of freedom therefore preached that the modern era should not be economic coordination on faith but rather economic coordination in accords with scientific accuracy. It makes sense then that the interventionists of all stripes– even explicitly non-Marxists such as Keynes– employ the language of science in their planning efforts.

Modern proponents of free markets, especially libertarians, should understand that Adam Smith’s invisible hand has been made visible by the insights of the Austrians. The Austrians replaced the non-explanation of the “invisible hand” with the actual explanation of the price mechanism. Unfortunately, few people even realize this. In Austrian capital theory, prices are not determined by the producers. They are not arbitrary numbers which can be chosen at the discretion of the entrepreneurs. Instead, prices are set as a result of the subjective valuation that consumers place on that good in relation to all other goods at a given time. As consumers express their preference for some goods over others, their increased demand puts a strain on the supply of the goods thus causing their prices to rise. Subsequently, entrepreneurs and capitalists, seeing the profits available in these goods will invest more capital into their production, adding to the supply.

But this process happens at every stage of the production structure. The prices, which reflect consumer desires, are communicated up into the “factors of production,” so that those factors (the components of the consumer good) also are given prices in accordance with demand. And those factors, which need to be processed, manufactured, pulled from the ground or whatever, are also made from previous or “earlier stage” factors, which receive prices in accordance with demand as well. Thus, for the Austrian capital theorist, as a good trickles down the chain of production, the price is being communicated in the opposite direction– from consumer to late stage production to earlier stage production. The allocation of scarce resources is based not on some mysterious force in the universe, but based on the role of prices in a division of labor society.

As consumer preferences change and profit opportunities reveal themselves as greater in other areas, as calculated via the price mechanism, the need for increased resource allocation to those areas becomes obvious. The resources, “factors of production,” are therefore sent where the price signals communicate they are most needed. Entrepreneurs are therefore planning on a constant basis– not in accordance with the “scientific” plans of a planner, but in accordance with the needs and wants of consumers as communicated via prices.

Only the price mechanism, and definitely not the well-educated mind of the socialist planners, can handle the dynamic and ever-changing nature of consumer preferences. Only entrepreneurs receiving “instruction” from the consumers via prices can properly allocate resources to their most needed ends. Without prices, as Mises pointed out, economic calculation was impossible– there was no other way for the consumers to communicate their needs to those allocating capital. Without prices driven by consumers, there is only artificial coordination, doomed to failure and economic tragedy.

The “invisible hand” which was the metaphor given to the mystery of economic coordination, is no longer mysterious. The Austrians peeled back the veil and discovered the power and foundational nature of prices in civilization.

Written by C.Jay Engel

Editor and creator of The Reformed Libertarian. Living in Northern California with his wife, he writes on everything from politics to theology and from culture to economic theory. You can send an email to reformedlibertarian@gmail.com