FAILURES OF THE “INVISIBLE HAND”

Authors: Rafi Amir-ud-Din & Asad Zaman

Affiliations: International Islamic University of Islamabad.
Corresponding Author Email: asadzaman@alum.mit.edu
ABSTRACT: Despite many failures of the invisible hand both empirically and
theoretically, it continues to be vigorously asserted and widely believed. We document
the failures and explain why it continues to be asserted despite these failures.
Keywords: invisible hand, market economy, traditional society, East Asian financial
crisis, trade barriers
JEL CODES: A13, B41
Contents
1.The Doctrine of the Invisible Hand ............................................................................................. 2
2. Against SI: Evidence for Unselfish Behavior.......................................................................... 3
2.1 Cooperation & Trust: ........................................................................................................... 4
2.2 Trust ................................................................................Error! Bookmark not defined.
2.3 Reciprocity & Gift Exchange ........................................................................................... 6
3. Against FM: Dramatic Failures of Free Markets..................................................................... 7
3.1 The Case of Chile: ............................................................................................................ 8
3.2 The Case of Russia ........................................................................................................... 9
3.3 The Global Financial Crisis of 2007-2008 ..................................................................... 10
4. Against FM:Successes of the Visible Hand .......................................................................... 11
4.1 The East Asian Miracle....................................................................................................... 11
4.2 Successful State interventions after Financial Crises: ....................................................... 14
4.2.1 Government Fiscal Policy Interventions To Create Employment ............................... 14
4.2.3 Successful Regulation of the Banking Industry .......................................................... 14
4.2.4 Management of the East Asian Crisis .......................................................................... 16
5.Against GG: Adverse effects of greed and competition ............................................................ 17
5.1 Greed Creates Capitalist Crises .......................................................................................... 17
5.1 Generosity leads to Happiness ............................................................................................ 18
5.2 Strategic Behavior Causes Harm to Society ....................................................................... 18
6. Against AS: recent vintage of Invisible Hand. ......................................................................... 20
7. Conclusion ............................................................................................................................... 22
1.The Doctrine of the Invisible Hand

One of the central goals of modern economic theory is to establish that free markets work

very well, and the government interventions cause ‘distortions’ and loss of efficiency. An

extremely important tool in achieving this goal is the idea of the “invisible hand” which is

fallaciously attributed to Adam Smith by most modern economists. As a typical illustration,

Mankiw and Taylor (2007, pp. 7-9) write that:

In his 1776 book An Inquiry into the Nature and Causes of the Wealth of
Nations, economist Adam Smith made the most famous observation in all of
economics: Households and firms interacting in markets act as if they are
guided by an "invisible hand" that leads them to desirable market outcomes
that, in many cases, maximize the welfare of society as a whole…
… Why do decentralized market economies work so well? Is it because
people can be counted on to treat each other with love and kindness? Not at all.
Modern interpretation of Smith's "invisible hand" metaphor says that
participants in a market economy are motivated by self-interest, and that the
‘invisible hand’ of the market place guides this self-interest into promoting
general economic well-being. Many of the insights of “invisible hand” theory
remain at the center of modern economics.

This same message is conveyed by the vast majority of popular introductory economics

textbooks. For clarity, we list and label the claims being made in the cited passage; note that as

asserted in the last sentence above, these claims are at the center of modern economics.

1. Participants in market economies are motivated by self-interest. (SI)

2. Decentralized market economies work very well, and maximize the welfare of society as
a whole. (FM: free markets)

3. The reason for excellent functioning of decentralized market economies is that all
participants are motivated by self-interest. This self-interest works better than love and
kindness in terms of promoting social welfare. (GG: greed is good)
4. The principles listed above were summarized in the concept of the “Invisible Hand” by
Adam Smith. (AS)
 Our goal in this paper is to show that all four of these claims are wrong. For convenience,

we will refer to these claims by the initials listed above. In Section 2, we show that people are

not motivated by self-interest only. In fact, they behave according to the social norms which, as a

learned experience, are subject to change using external interventions. In Section 3, we argue

that decentralized market economies do not work very well. In Section 4, we show that

interventions in free markets can produce very good results. In Section 5, we argue that, contrary

to the predictions of the efficacy of invisible hand, greed and competition lead to bad outcomes,

whereas generosity and cooperation contribute much more significantly towards promoting the

collective wellbeing. In Section 6, we show that attributing the “invisible hand” to Adam Smith

is a mistake. The modern day interpretation of Smith’s invisible hand is radically different from

what Smith had in mind when he invoked this metaphor to discuss the unintended consequences

of certain actions. Finally, in Section 7, we conclude by explaining why the invisible hand theory

is still widely believed despite its obvious failures.

2. Against SI: Evidence for Unselfish Behavior

Although, self-interest is one of the most deeply entrenched ideas in the neo-classical

economic thought, several experimental studies have recently challenged this orthodoxy and

have revealed that real people from a wide variety of cultures and environments, systematically

deviate from the textbook representations of homo economicus (Camerer, 2003; Henrich et. al.

2001). Karacuka and Zaman (2012) provide a literature review of the overwhelming amount of

empirical evidence that contradicts neoclassical utility maximization theory, which is a

mathematical embodiment of the selfishness hypothesis.

There is now a huge list of situations where predictions of economic theory based on

utility maximization models conflict with observed human behavior which is strongly influenced
by social norms; see for example, Koehler and Harvey (2004). Bicchieri (2005) writes that “Pro-

social norms of fairness, reciprocity, cooperation, and the like exist precisely because it might

not be in the individual`s immediate self-interest to behave in a socially beneficial way.”

Behavioral economists have not only established the existence of social norms of reciprocity,

cooperation or trust; they have shown that any perceived or real deviation from these norms

invites disapproval and censure. It is this implicit agreement to obey norms and to punish

violations which leads to the creation of social norms.

Sociologists define social norm as an informal understanding which governs society’s

behavior (Scott & Marshall, 2005) or standard of behavior based on social expectations about

how individuals should behave in a certain situation. The norms vary across cultures and may be

viewed with differing levels of acceptability. Fehr and Fischbacher (2004) say that norms may be

voluntarily obeyed by the group members, or they may be enforced if they are violated.

The process of the norms development starts at a very young age (Rossi, 1993), and

norms are learned from various sources such as school, neighborhood and the media among

other contributory factors (Marantz & Mansfield, 1977). Norms, as a learned behavior, are thus

not immutable and are subject to change through external interventions. As we document briefly

below, there is strong empirical evidence that a variety of social norms govern human behavior,

which cannot be reduced to simple utility maximization even in market contexts. For illustrative

purposes, we discuss cooperation, trust, and reciprocity; these are areas where a substantial

amount of research has established that observed human behavior does not conform to economic

theories.

2.1 Cooperation & Trust:

 Human societies fundamentally differ from all other species with respect to the

cooperation that exists among genetically unrelated individuals (Fehr & Fischbacher, 2004). The

people who tend to cooperate with others often elicit cooperation from them, and attract still

other cooperators, which makes such behavior individually and socially advantageous (Frank,

1987). The existence of cooperation, and its conflict with predictions of neoclassical theories of

human behavior, are now well established via a vast range of strong and robust empirical

evidence; see for example Camerer (2003, p.45-46). A summary of literature on cooperation by

Dawes and Thaler (1988) states that "... the analytically uncomfortable (though humanly

gratifying) fact remains: from the most primitive to the most advanced societies, a higher degree

of cooperation takes place than can be explained … (by selfishness)”.

Uhlhaas (2007) argues that complete strangers swap billions of dollars daily on the

exchange of anything and everything including jets worth up to $4.9 million on eBay, but as a

rule “they are not disappointed.” This “borderline miracle” contradicts the prediction about the

homo economicus who is expected to be a rational buyer (that is, one who pockets the payment

of the buyers, sends nothing in return and hides among the similar agents who are also single-

mindedly engaged in their profit maximization, because the probability of being caught and

punished is very low). Berg, Dickhaut, and McCabe (1995) discuss a trust game in which the

subjects decide to make an investment by putting their money in a mailbox which is tripled then

(representing socially beneficial output). The other subject may take all the investment or repay a

part of it. Experiments show that the second subjects often repaid sufficient amount to make the

investment worthwhile (Berg et al., 1995, p. Chapter 2).

How would economic theory be altered if we took the strong cooperative and social

tendencies of human beings into account? There are many common economic problems
involving public goods, commons, principal agent problems, and externalities, where purely

selfish agents cannot arrive at a first-best solution using market mechanisms. In these situations,

economists assume ab initio that cooperation is impossible and attempt to create incentive

compatible mechanisms, and use other methods designed to work with purely selfish agents.

However, experience with prisoner’s dilemma type games shows that cooperation is not only

possible, but actually easily achieved and sustained with suitable environment design.

Experiments on public goods showed that people did not significantly mis-represent their

benefits and did not free ride to the extent predicted by economic models. Possibilities of

creating trust and cooperation as a means of solving social dilemmas are currently overlooked

by economists.

2.3 Reciprocity & Gift Exchange

Axelrod (2006) argues that reciprocal altruism is one of the many reasons why so much

cooperation is observed in human interactions both inside and outside the laboratory. Reciprocal

altruism suggests that people reciprocate both good and bad behavior. They reciprocate kindness

with kindness, hostility with hostility and cooperation with cooperation.

Reciprocity is one of the most important dimensions of economic behavior of human

beings (Fehr and Gachter, 2000). Behavioral economists have now gathered extensive and robust

empirical evidence that people reciprocate expected cooperation, punish unfair treatment and

demonstrate pure altruism. The rational and selfish economic agent is expected to defect in the

prisoners’ dilemma (PD) game, which closely resembles such real life cases as production of

negative externalities and exchange without binding contracts. However, Dawes (1980) shows

that 50% of the subjects in this experimental game cooperate, which means that they reciprocate

expected cooperation. Ledyard (1994) reached the same conclusion when players contributed
50% of their endowments in a one-shot public goods (PG) game, whereas the rational and selfish

player was expected to contribute nothing. Fehr, Kirchsteiger, and Riedl (1993) show in an

experimental Gift Exchange (GE) game that workers reciprocate generous wage efforts, whereas

employers offer generous wages in expectation of reciprocal greater efforts. This game

resembles the real life situations where the performance cannot be made the subject matter of a

contract between employers and workers, nor is it enforceable. The rational employer is expected

to offer the minimum wage, and the rational worker is expected to put the least amount of effort

in the work which is laid down in the contract. However, the experiment shows that the real

behavior systematically differs from the predicted behavior of a rational economic agent. The

theory of labor market as well as the principal-agent literature rests on an unsound theory human

behavior. Realistic accounts of human motivation would have dramatic impact, and lead to

substantial reconsideration of these theories. See Saima Mahmood (2011) for a survey and a

guide to the literature.

3. Against FM: Dramatic Failures of Free Markets

The idea of the invisible hand (IH) is that if government does not interfere, free markets will

automatically generate great outcomes. In this section we show several cases where attempts to

implement the invisible hand have led to disaster. In a later section, we discuss cases showing

that the opposite is true: careful government planning has led to excellent economic outcomes.

We briefly discuss three cases where free markets were allowed to operate under nearly ideal

conditions. Contrary to predications of free market enthusiasts, all of these cases ended in

disastrous failures. A much larger and more detailed catalog of cases has been presented by

Klein (2007) in her excellent book The Shock Doctrine.

3.1 The Case of Chile:

A free market economy was implemented in Chile under the Chicago Boys but resulted
in disaster. The “Chicago boys” was a label given to a group of Chilean economists who had
been trained at the University of Chicago by Milton Friedman and Arnold Harberger. They
implemented without much modification the theoretical model they had been taught in Chicago.
The economic model of the Chicago Boys, also called the “shock treatment,” was based on a
number of free market principles: the only possible framework for economic development was
one in which the private sector could freely operate; prices should fluctuate freely according to
the laws of the competition; and eliminating inflation was possible only by a drastic reduction of
government spending.

Kangas (2013) summarizes the consequences of the policies followed by the Chicago
Boys in the following words: "The Chicago School of Economics got that chance for 16 years in
Chile, under near-laboratory conditions. Between 1973 and 1989, a government team of
economists trained at the University of Chicago dismantled or decentralized the Chilean state as
far as was humanly possible. Their program included privatizing welfare and social programs,
deregulating the market, liberalizing trade, rolling back trade unions, and rewriting its
constitution and laws. The consequences of this unconstrained experiment in free market
economics were labeled “Economic Genocide” by Andre Gunder Frank (1976) in an open letter
to Friedman and Harberger.

Letelier (1976) graphically pictures the havocs wreaked by the Chicago Boys. Adopting
a total free-market policy in a framework of extreme inequality and a high degree of economic
monopoly had dire consequences for Chilean economy. Sharp rise in the consumer prices and a
steep drop in the prices paid for the producers ensued. There were only a few manufacturing
units which controlled the whole market. The crux of Friedman's "shock treatment" was to
control the inflation by reducing government deficit and stopping monetary expansion. The
Chicago Boys were particularly unrelenting in achieving the goal of controlling inflation, but
ironically by the end of 1975, Chile's annual rate of inflation had reached 341% higher than the
inflation rate in the pre-coup era, the consumer prices increased by 375% and wholesale prices
rose by 440%. The unemployment rate before Pinochet's coup was 3.1%, but by the end of 1974
jobless rate was more than 10% and by the end of 1975 it was more than 18.7% and in 1976
about 25% of the population was unemployed. No invisible hand came to the rescue of the
suffering people. Ironically, the unemployed people survived thanks to the food and clothing
distributed by church and other humanitarian organizations.

3.2 The Case of Russia

The case of Russia is also an unmitigated disaster where an IMF team led by Jeffrey

Sachs implemented policies of rapid transition to a free market. Ignorance of history led to a

repetition, as Jeffrey Sachs also advocated “shock therapy” for the Russian economy. The basic

idea was to change everything about Russian economy in one fell swoop rather than adopting a

gradual approach which had been successfully pursued by Chinese policymakers earlier. Russia

was required to "liberate prices, to privatize state property, slash taxes, cut public budgets, and

downsize the state to minimal proportions” (Greenhouse, 2011).

Forcing Russia to make a hasty transition to free markets turned out to be one of the

greatest blunders in the history of world economy (Mankiw, 2003, p. 257). Huygen (2012)

documents the consequences of adopting shock therapy: food prices rose 400% in a month,

inflation increased by 2500%, real wages fell and unemployment swelled. Social safety net

guaranteeing basic access to health care, education and pensions for elderly Russians evaporated

as efforts to eliminate budget deficits depleted social spending. Russian society became stratified

between the very rich, the benefactors of privatization, and the poverty-stricken working classes.

Begging, migration to the urban centers, alcoholism, proliferated as cuts to social benefit

programs created destitution among the most vulnerable social groups. A clear correlation can be

made between higher mortality rates and the implementation of the shock therapy, and social

safety nets folded under economic pressures precisely when they were most needed most. Higher

education was victimized by budget cuts and mirroring the economic disparity of society, private

schools were established for the children of wealthy new Russians, providing high-quality
education, while the majority of working-class Russians are priced out of their means by the

inflated prices of shock therapy. Contrary to expectations of free market ideologues, no invisible

hand was present to cushion the fall.

3.3 The Global Financial Crisis of 2007-2008

Many firm believers in free markets were shocked by the global Financial Crisis of 2007-2008,

which flew in the face of theories of rational behavior. The failure of economic theory was so

obvious that a congressional committee formed to investigate it. In written testimony for this

committee, Solow wrote “A thoughtful person, faced with the thought that economic policy was

being pursued on this basis (DSGE models), might reasonably wonder what planet he or she is

on.”

The stock market is one of the markets which comes as close as possible to the idealization of the

free market. There are uniform goods, large numbers of buyers and sellers, large amounts of

information freely available, and other ideal conditions. Many major firms collapsed, and many

had stock values reduced by factors of two or even more. One of the fundamentals of free market

theory is that prices determined in free markets create efficient allocations. For instance,

Manikiw (2007, p. 17) writes that markets work their magic through prices, which reflect both

the social value of the goods, as well as the costs of producing these goods. The financial crisis

immediately creates the question of which price – pre crisis or post crisis – was the one which

reflected the costs and values. Since both could not be accurate reflections of costs and values,

one of them was necessarily drastically wrong, and hence guiding the society towards the wrong

decisions regarding production and consumption.

Two major Nobel Prize winning economic theories which collapsed together with the

financial markets are the Real Business Cycle (RBC) theories of Prescott and Kydland, and the
Rational Expectations theories of Lucas. Both of these theories support the invisible hand and

show that self-interested individuals will lead the market to efficient outcomes. The RBC

theories minimize the role of money and finance, and attribute ups and down in the economy to

real factors – something which was manifestly proven wrong by the global financial crisis. In

2003, Robert Lucas of the University of Chicago, in his presidential address to the American

Economic Association, declared that the “central problem of depression-prevention has been

solved, for all practical purposes.” Unfortunately, the global financial crisis showed that

individuals maximizing private benefits could not foresee the future as the rational expectations

models assume. Many warning signs of impending crisis were ignored because these theories

predicted that a crisis of this type could not happen.

To summarize, the global financial crisis of 2007 provided a dramatic demonstration of the

failure of the invisible hand, as well as many fancy economic theories developed in support of

the invisible hand.

4. Against FM: Successes of the Visible Hand

In the previous section, we documented how simply allowing free markets to operate has

not led to success, despite confident claims and expectations of some free market ideologues. In

this section, we describe several cases where exactly the opposite has happened. Carefully

planned government interventions have led to improved economic performance in many

situations. Some of these are listed below.

4.1 The East Asian Miracle

Government Interventions Led to Growth: The World Bank economists write in the

opening paragraphs of The East Asian Miracle (p. 5,6) that “In most of these economies, in one
form or another, the government intervened systematically and through multiple channels-to

foster development, and in some cases the development of specific industries. …. Our judgment

is that … government interventions resulted in higher and more equal growth.” The success of

the visible hand of the government in fostering growth is further documented in Rodrik (1994).

Interventions Created Macroeconomic Stability: The governments in the East Asian

region played a significant role in successfully transforming the economies into “tigers.” During

the years before the East Asian countries began to be known as the tigers, the governments had

been able to establish stable economies. The fiscal deficits were under tight control. The inflation

rate fluctuated around 10 percent in most of the East Asian countries in the 70s and 80s, and it

rarely exceeded 15-20 per cent. The governments successfully established stable exchange rates.

Except in Philippines where foreign borrowing assumed the shape of a crisis, governments in the

East Asia did not generally have to resort to foreign borrowing. Interestingly, the East Asian

region was witnessing this economic stability at a time when a number of developing countries

in other parts of the world were experiencing serious macroeconomic problems compounded by

sluggish economic growth in the 80s (Hermes, 1997). The policies by the governments in East

Asia thus achieved what decentralized free markets could not do.

Interventions led to Industrialization: The first agrarian economy to achieve

industrialization in the twentieth century was Russia; the process was entirely led by the

government. The East Asian tigers were the second to replicate this achievement. Many analysts

have noted that industrialization is a complex process which requires co-ordinated action on

several fronts, as well as heavy financing over a long period. Free markets with competitive

agents are inherently incapable of achieving co-ordination. For example, Korea established a

semiconductor industry whereas there was no chance of a free market spontaneously establishing
such an industry. Korea is now the third biggest producer of large capacity memory chips after

Japan and the US. The huge investment needed for this miracle was reflected in Samsung

Group's debt/equity ratio which was 7:1 in 1987. The state-run banks provided the required loans

as a part of the government strategy for industrialization (Wade, 1990). Similarly, the

shipbuilding, electronics and automobile industries in Korea were launched with heavy

government involvement, and would have been impossible under free market conditions; see

Amsden (1992) for documentation.

Interventions led to universal education: Because of the massive positive externalities,

even die hard liberals like Milton Friedman have acknowledged a role for the government in

provision of education to the masses. Rodrik (1994) has documented the important role of

education in the East Asian miracle. More generally, Barro (2001) has provided strong empirical

evidence for the crucial importance of education as a determinant of long term growth. See also

Steeg (2005) for a literature survey of equity and efficiency based arguments in favor of

government provision of education. The free markets cannot provide optimal levels of education

for several reasons. Firstly the social returns to education are far higher than private returns, so

markets will under-invest in education. Secondly, the returns are long term and risky, and the

poor will be unable to purchase education due to poor financial markets and unavailability of

credit. This is widely observed, and leads to great inequities in societies throughout the world.

Thirdly, education itself creates social transformations which are resisted by local powers, and

changes require powerful interventions by the government.

4.2 Successful State interventions after Financial Crises:

In the aftermath of crises, liberals with faith in the invisible hand continue to argue for laissez-

faire policies as the best solutions to the crisis. For example, Hayek argued that government

interventions after the Great Depression would only deepen and worsen it – short term temporary

relief would be paid for by even worse conditions later. There is strong evidence that appropriate

interventions do resolve crises in a much more efficient way than the invisible hand. Some of

this evidence is presented below.

4.2.1 Government Fiscal Policy Interventions To Create Employment

One of the clearest demonstrations of the failure of free markets was furnished by the

Great Depression of 1929. Keynesian macroeconomics provides theoretical justification for

fiscal policy to increase aggregate demand, in order to eliminate unemployment. This obvious

violation of the invisible hand was forced by the observance of widespread and persistent

unemployment in many economies including the USA. Keynesian economics provides a partial

answer to the question of why the forces of supply and demand fail to reduce real wages and

wipe out unemployment, even in the long run. This became dominant orthodoxy justifying the

necessity of government intervention, and the free market theorists were considered a fringe

minority until the monetarist counter-revolution following stagflation in the 1970’s.

4.2.3 Successful Regulation of the Banking Industry

Apart from the demonstrable effectiveness of Keynesian style demand management

policies, bank failures led to a set of post-depression governmental regulations which tied the

invisible hand of competition in the banking industry:

 1. Ceilings were placed on interest rates, to prevent competition

2. Banks could not cross state boundaries, again restricting competition.

3. Banks were not allowed to invest in risky stocks.

The lesson learnt from Great Depression was that unregulated markets were inherently unstable,

amenable to maneuvering, could trigger financial crises and hence required strict government

oversight. This understanding paved way for putting in place a strict regulatory system in US

which worked successfully to prevent system wide banking crises for several decades.

Stagflation in wake of the oil crisis in 1970’s led to re-examination of Keynesian ideas.

Resurgence of free market ideas, made possible by dying out of the generation which had

experienced the Great Depression, led to the Reagan-Thatcher free market era. The Garn-St.

Germain Act de-regulated the Savings and Loan industry in 1982 in the USA, and was hailed as

a major move forward towards free markets. As extensively documented in Pizzo, Fricker and

Muolo (1989), within a short period of time, this de-regulation led to the Savings and Loan crisis

of the 1980’s. The extensive bailout required for system wide failure of S&L across the country

was more than the entire earnings of the banking industry since the Great Depression. This

clearly illustrates the necessity of government regulation to restrain the forces of competition

represented by the invisible hand. The same pattern was repeated on a larger scale with the

repeal of the Glass-Steagall act in 1999. This act prevented Banks from speculative investments

in stock markets. Following the repeal, risky investments and loans increased dramatically, and

eventually led to the global financial crisis of 2007. Reporting on Congressional testimony on

October 23, 2008, The New York Times wrote, "a humbled Mr. Greenspan admitted that he had

put too much faith in the self-correcting power of free markets and had failed to anticipate the
self-destructive power of wanton mortgage lending. ... (and) acknowledged that his belief in

deregulation had been shaken."

4.2.4 Management of the East Asian Crisis

The East Asian Crisis in 1997 was caused by liberalization of financial sector, in a move

towards free markets which was supposed to improve economic performance. Miller and Vines

(2006) analyzed the role of deregulation of financial sectors in East Asian countries. Private

capital flow to the developing countries increased six fold from 1990 to 1996. The detachment of

public sector from the private sector decision-making led to increasing vulnerability and ultimate

collapse. The governments did not discourage excessive risk-taking, high degree of leveraged

investment, and currency and maturity mismatch which could prove extremely risky in case of

an abrupt capital outflow. Exactly opposite to the lesson of the invisible hand, relaxing

regulations and allowing free market operation led directly to the crisis.

The successful role of East Asian governments in promptly responding to the crisis in

1997-98 is a proof that selective state interventions in economies are not only desirable, at times

they may be indispensable. Following the onset of East Asia financial crisis in 1997 that

continued unabated through 1998, the IMF predicted that the region will take at least three to

four years to recover (the so-called U-shaped recovery with economies remaining stagnant for

some time before taking on the upward trajectory). However, the recovery of the region was

quicker than expected. Malaysia, the Republic of Korea and Thailand quickly recovered after

1998 (a V-shaped recovery) ( Jomo, 2003). The policies adopted by the governments in East

Asian region to bring about a recovery were exactly the opposite of what IMF had at suggested

at that time. Interest rates were cut down in defiance of IMF prescriptions. The IMF’s prescribed
policies based on free market principles were reversed, preventing corporate failures and

preserving valuable institutional structures which do not receive attention in neoclassical theory

(Jomo, 2009).

5.Against GG: Adverse effects of greed and competition

As is clear from section 2, people are not wholly motivated by self-interest and there are

a number of other variables such as reciprocity, concern for fairness and altruism which affect

their behaviour. In this section, we argue that norms like greed and competition lead to bad

outcomes, whereas generosity and cooperation lead to good outcomes.

5.1 Greed Creates Capitalist Crises

Greed leads to injustice, accentuates inequalities and undermines the qualities such as

generosity and cooperation which are necessary for social cohesion and happiness. A review of

the history of major crises in recent centuries as documented by Kindleberger (1978) and

Reinhart and Rogoff (2009) points to the fact that greed is a major culprit behind all the financial

bubbles. Lo (2012) explains that an unfettered greed leads to the situation where asset prices are

unsustainable. A steep decline in the asset prices which is invariably the result paves way for a

frantic rush to sell the assets which ultimately send financial institutions reel under the impact in

unpredictable ways. It is also noted that greater the size of the bubble, the larger is the number of

affected households which have to suffer the consequences of the greed of a few individuals.

Even the most successful beneficiaries of the laissez faire system are not ignorant of the

havocs wreaked by the greed and selfishness of the rich and the powerful, which euphemistically

pass under the name of cut-throat competition. The havoc played by the greed and selfishness are
reflected in the telling words of iconic capitalist George Soros: “The laissez-faire argument

against income redistribution invokes the doctrine of the survival of the fittest…There is

something wrong with making the survival of the fittest a guiding principle of civilized

society…Cooperation is as much a part of the (economic) system as competition, and the slogan

‘survival of the fittest’ distorts this fact…”(Soros, 1997).

5.1 Generosity leads to Happiness

A large body of literature points to the fact that material possessions are not only largely

irrelevant to human happiness; greed for material possessions actually tends to undermine

happiness. Economists were first introduced to this idea by the means of Easterlin’s (1974, 1995,

2010) paradox, which showed that there was no long run relationship between GNP and

happiness. Cafaro (2005) documents a number of psychological studies which demonstrate that

people with a strong desire to achieve money, possessions and status report lower subjective

wellbeing. In contrast to traditional economic thought, Aknin et al. (2010) find that the reward

experienced from helping others may be deeply ingrained in human nature, emerging in

diverse cultural and economic contexts. Bicchieri (2005) also argues that “pro-social norms of

fairness, reciprocity, cooperation, and the like” prove socially beneficial. Dunn, Aknin, and

Norton (2008) found that spending more of one's income on others predicted greater happiness

both cross-sectionally and longitudinally. In other words, generosity rather than selfishness is

both a common mode of behavior and also promotes both individual and social welfare.

5.2 Strategic Behavior Causes Harm to Society

Finally, contrary to the predictions of the Invisible Hand, a number of studies prove that

generosity and cooperation lead to far more desirable outcomes for the society. The classic

example is the “Social Dilemma” created by Prisoner’s Dilemma type games requiring trust and
cooperation for efficient outcomes. Selfish behavior by all players leads to inferior outcomes for

all, while cooperation and trust lead to improved outcomes for all. Kollock (1998) considers that

many of the most challenging problems we face share this characteristic: “individual rationality

behavior leads to collective irrationality.”

Empirically it has been observed both in experimental economics and in the real world

that people trust each other far more than economic models of selfish behavior predict. Steinel

and De Dreu (2004) show that selfish maximization strategies of deception and

misrepresentation proves counterproductive because the individuals who engage in strategic

misrepresentation trick their competitive counterparts into doing exactly the opposite of what

they want which results in poor outcomes for the deceivers. Trust generates trust and leads to

better outcomes for all; this has substantial importance for the entire Principal/Agent literature

which is fundamentally based on the assumption that trust cannot be achieved. In absence of

trust, only second best outcomes are possible, while trust makes possible fully optimal outcomes.

The classic study of Zak and Knack (2001) shows how important trust is for growth and

has spawned a huge literature confirming the basic idea. Social capital is generated by trust,

which is created by social norms of cooperation and mutual responsibility. This social capital

reduces friction in transactions and provides myriad economic benefits to improve economic

growth. In contrast, the single minded pursuit of profits recommended by hardcore free market

ideologues such as Milton Friedman erodes social capital and causes substantial social damage.

A striking testimony to this damage is furnished by Harvard Professor Zuboff (2009) who taught

cut-throat competition for more than 25 years to MBA’s: “I have come to believe that much of

what my colleagues and I taught has caused real suffering, suppressed wealth creation,
destabilized the world economy, and accelerated the demise of the 20th.” century capitalism in

which the U.S. played the leading role.”

6. Against AS: recent vintage of Invisible Hand.

The main goal of this section is to show that the modern interpretation of the invisible

hand is relatively recent. The idea that Manikiw (together with other modern economists)

attribute to Smith is not actually present in Smith’s writings. In fact, modern writers borrow the

authority of Adam Smith to provide weight to a very dubious idea of recent coinage.

We first note that modern interpretation of the “Invisible Hand” is radically different

from any interpretation of this concept that existed before the second half of the 20th century.

There is a growing body of literature (e.g. Grampp 2000, Minowitz 2004) which insists that the

metaphor used by Smith was never meant to be anything more than a metaphor, and that the

meanings inferred from Smith’s idea of invisible hand by the modern economists support only

their own interpretation of economic policies. Kennedy (2009) shows that three leading modern

economists laud the invisible hand as the “profoundest” and “most influential” contribution of

Adam Smith. Nonethless, their interpretation of the term and its significance is not supported

either by Adam Smith or by readers of Adam Smith until the late nineteenth century.

In a corpus of over a million words, the terms invisible hand appears only twice in the

economic writings of Adam Smith. It is used only once in the Wealth of Nations in very limited

and narrow context. Rothschild (1994) analyses the controversy surrounding the meaning of

invisible hand and concludes that what Smith meant by this metaphor was only a “mildly ironic

joke.” Blaug (2007) also shows that Adam Smith cannot be blamed for these ideas. He cites

other references which state that:

 "Some economists regarded the Arrow-Debreu results [on the existence of
general equilibrium] and the fundamental theorems of welfare economics as the
modern expression of Smith's invisible hand…. But Smith would be surprised at
what is attributed to him today…. On careful reading Smith does not say that
selfish behavior is praiseworthy, is bound to pay, or necessarily promotes the best
interests of society…. The passage containing the invisible hand metaphor is not
about general equilibrium theory: its purpose is to explain why merchants would
continue to buy British products even if tariffs were removed".
Ashraf, Camerer, and Loewenstein (2007) make a detailed analysis of Smith’s pioneering

work The Theory of Moral Sentiments to conclude that “For Adam Smith, a mixture of concern

about fairness … and altruism played an essential role in market interactions, allowing trust,

repeated transactions and material gains to occur.” In sharp contrast to the modern economists’

unwarranted understanding of the invisible hand metaphor as a sanction for selfish behavior,

Smith explains that justice is in fact only a rational behavior. Fear of retribution is likely to deter

the people from committing injustice. He says: "Nature has implanted in the human breast, that

consciousness of ill-desert, those terrors of merited punishment which attend upon its violation,

as the great safe-guards of the association of mankind, to protect the weak, to curb the violent,

and to chastise the guilty." See Smith (1759, pp. II, ii, iii, 125). Realizing the crucial role of

justice, especially in ensuring just behavior, he believes that justice is the "main pillar that

upholds the whole edifice. If it is removed, the great, the immense fabric of human society . . .

must in a moment crumble to atoms." Fairness and justice have only recently attracted the

attention of economists as providing justifications for many observed human behaviors in

conflict with standard utility maximization theories; see Karacuka and Zaman (2012) for a brief

survey.

As further evidence against the attribution of the modern interpretation of the Invisible

Hand to Adam, there are 60 instances in Books I and II of the Wealth of Nations in which Smith

discusses malign consequences of self-interested actions (Kennedy, 2009). Why a passing

remark could be elevated to the status of a “theory”, a ground-breaking “paradigm” which

justified selfishness and greed, qualities held in low esteem from ancient time, requires a separate

explanation, furnished later. Zaman (2013) documents the historical conditions which led to the

adoption of obnoxious moral defects like selfishness and greed as the basis for collective

wellbeing.

The attribution of the modern interpretation of the Invisible Hand to Adam Smith is in

fact related to the unique position of Smith as a pioneer and founder of the discipline of

economics. Smith is by far the most influential thinker in the history of economic literature. As

in many fields of knowledge, relating modern claims to seminal works of the pioneers adds to

credibility. Similarly, claims of modern economic theory acquire the aura of authenticity if it is

traced back to Adam Smith himself.

7. Conclusion

Contrary to the “Invisible Hand” idea generally taught in economic textbooks (that self-

interested behavior leads to best possible outcomes), norms of generosity, fairness, kindness,

reciprocity and justice produce far better social outcomes. In the aftermath of the Great

Depression, it became clear to nearly all economists that the free market does not provide the

best possible outcomes. We have discussed several cases where transitions to free market led to

disastrous economic outcomes. In contrast, the visible hand of planned government interventions

can drive economies to perform well and even "miraculously". Given such obvious and clear

failures of the invisible hand, what accounts for its current popularity, and indeed, its central role

as a core concept of modern economic theory? We provide two brief answers.

One is that laissez-faire is a theory which is tremendously favorable to the rich and

powerful. As Foucault’s Power/Knowledge philosophy suggests, power structures are sustained

by “knowledge” designed to support them. The idea that all are free to act as they please has the

appearance of equality and fairness to all – in reality, the poor and oppressed have no choices.

They are only free to sell their labor on the open market, and become wage slaves of the rich.

Many authors have commented on tremendous inequality hidden within the apparently

egalitarian proposition that capitalists bring their capital and laborers bring their labor to the

same market. Empirically, the operation of the free market has led to great and widening gulf

between the bottom 99% and the top 1%. The tremendous costs to society of this divide have

been documented by Stiglitz (2012)in his book, the Price of Inequality.

The second is that there has been an active campaign to promote the idea of laissez faire,

since it favors the rich. Details of the campaign are available in Alkire and Ritchie (2007). Some

of the key elements involved creating and providing moral and financial support to intellectual

communities favoring free market ideology. Also, fostering talent by different types of

educational programs, and engaging on the political front were crucial factors in its eventual

success. The impact of free market ideas on shaping the history of the twentieth century is

detailed in a brilliant study by Naomi Klein(2007). A deeper and more fundamental analysis is

presented by Polanyi (2001), who considers the emergence of free market ideologies as a

necessary accompaniment of the victory of market economies over other more traditional ways

of organizing economic affairs.

REFERENCES

Aknin, L. B.; Barrington-Leigh, C. P.; Dunn, E. W.; Helliwell, J. F.; Burns, J.; Biswas-Diener,
R.; Kemeza,I.; Nyende, P.; Ashton-James, C. E; Norton, M. I. "Prosocial Spending and Well-
Being: Cross-Cultural Evidence for a Psychological Universal." Cambridge, MA: NBER
Working Paper 16415, Sep. 2010

Alkire, S., & Ritchie, A. "Winning Ideas: Lessons from Free Market Economics." Oxford, UK:
OPHI Working Paper 6, 2007
Amsden, A. H. Asia's Next Giant: South Korea and Late Industrialization: Oxford, UK: Oxford
University Press, 1992

Ashraf, N.; Camerer, C. F.; Loewenstein, G. "Adam Smith, Behavioral Economist."

International Library of Critical Writings in Economics, 204, 3. 2007

Axelrod, R. The Evolution of Cooperation: Revised Edition. New York: Basic Books, 2006

Barro, R. J. "Human Capital and Growth," The American Economic Review Vol. 91, No. 2,
Papers and Proceedings of the Hundred Thirteenth Annual Meeting of the American Economic
Association (May, 2001), pp. 12-17

Berg, J.; Dickhaut, J.; McCabe, K. "Trust, Reciprocity, and Social History." Games and
Economic Behavior, Vol. 10(1), 1995, 122-142.

Bicchieri, C. The Grammar of Society: The Nature and Dynamics of Social Norms, Cambridge,
UK: Cambridge University Press, 2005

Blaug, M. "The Fundamental Theorems of Modern Welfare Economics, Historically

Contemplated." History of Political Economy, 39(2), 2007, 185.

Cafaro, P. J. "Gluttony, Arrogance, Greed, and Apathy: An Exploration of Environmental Vice."

Environmental Virtue Ethics. Lanham, MD: Rowman & Littlefield Publishers, 2005, 135-158.

Camerer, C. Behavioral Game Theory: Experiments in Strategic Interaction, Princeton NJ:

Princeton University Press, 2003

Dawes, R. M. "Social Dilemmas." Annual Review of Psychology,Vol 31(1), 1980, 169-193.

Dawes, R. M., and Thaler, R. H. "Anomalies: Cooperation." The Journal Of Economic

Perspectives, 2(3), 1988, 187-197.

Dunn, E. W.; Aknin, L. B.; Norton, M. I. "Spending Money on Others Promotes Happiness."
Science, 319(5870), 2008, 1687-1688.

Easterlin, R. A. “Does Economic Growth Improve the Human Lot? Some Empirical Evidence”,
in Nations and Households in Economic Growth ed. P.A. David, W.R. Melvin (ed.'s), New
York: Academic Press, 1974, pp. 89–125.

Easterlin, R. A. "Will Raising the Incomes of All Increase the Happiness of All?" Journal of
Economic Behavior & Organization, 27 (1), 1995, 35-47.

Easterlin, R. A.; McVey, L. A.; Switek, M.; Sawangfa, O.; Smith-Zweig, J. " The Happiness-
Income Paradox Revisited." Proceedings of the National Academy of Sciences, 107 (52), 2010,
22463-22468

Fehr, E., and Fischbacher, U. "Third-Party Punishment and Social Norms." Evolution and
Human Behavior, 25(2), 2004, 63-87.
Fehr, E., & Gächter, S. "Fairness and Retaliation: the Economics of Reciprocity." The Journal of
Economic Perspectives, 14(3), 2000, 159-181.

Fehr, E.; Kirchsteiger, G.; Riedl, A. "Does Fairness Prevent Market Clearing? An Experimental
Investigation." The Quarterly Journal of Economics, 108(2), 1993, 437-459.

Frank, A. G. "Economic Genocide in Chile: Open Letter to Milton Friedman and Arnold
Harberger." Economic and Political Weekly Vol. 11, No. 24 (Jun. 12, 1976), pp. 880-888

Frank, R. H. "If homo economicus could Choose His Own Utility Function, Would He Want One
With a Conscience?" The American Economic Review, 77(4), 1987, 593-604.

Grampp, W. D. "What did Smith mean by the Invisible Hand?" Journal of Political Economy,
108(3), 2000, 441-465.

Greenhouse, C. Ethnographies of Neoliberalism. Philadelphia, PA: University of Pennsylvania

Press, 2011.

Henrich, J.; Boyd, R.; Bowles, S.; Camerer, C.; Fehr, E.; Gintis, H.; McElreath, R. "In Search
Of Homo Economicus: Behavioral Experiments in 15 Small-Scale Societies." The American
Economic Review, 91(2), 2001, 73-78.

Hermes, N. "New explanations of the economic success of East Asia: lessons for developing and
Eastern European countries" University of Groningen, Centre for Development Studies (CDS).
1997

Huygen, C. "One Step Forward, Two Steps Back: Boris Yeltsin and the Failure of Shock
Therapy." Constellations, 3(1). 2012

Jomo, K. S. "Reforming East Asia for Sustainable Development." Asian Business &
Management, 2(1), 2003, 7-38.

Jomo, K. S. "Growth After the Asian Crisis: What Remains of the East Asian Model?"
UNCTAD, Harvard University Center for International Development, 2009

Kangas, S. "Chile: The Laboratory Test." unpublished manuscript, downloadable from

http://www.huppi.com/kangaroo/L-chichile.htm accessed July 2013

Karacuka, M., and Zaman, A. "The Empirical Evidence Against Neoclassical Utility Theory: A
Review of the Literature." International Journal of Pluralism and Economics Education, 3(4),
2012, 366-414.

Kennedy, G. "Adam Smith and the Invisible Hand: From Metaphor to Myth." Econ Journal
Watch, 6(2), 2009, 239-263.

Kindleberger, C. P. Economic Response: Comparative Studies in Trade, Finance, and Growth:

Cambridge, Mass.: Harvard University Press., 1978
Klein, N. The Shock Doctrine: The Rise Of Disaster Capitalism: Metropolitan Books, 2007

Koehler, D.J. and Harvey, N. (Eds.) Blackwell Handbook of Judgment and Decision Making,
Boston: Blackwell Publishing, 2004

Kollock, P. "Social Dilemmas: The Anatomy of Cooperation." Annual Review of Sociology,

1998, 183-214.

Ledyard, J. O. "Public Goods: A Survey of Experimental Research," Chapter V in The Handbook

of Experimental Economics, J. Kagel and A. Roth (eds), Princeton, NJ: Princeton University
Press. 1995

Letelier, O. The 'Chicago Boys' in Chile: Economic 'Freedom's' Awful Toll. The Nation,
223(28), 1976, 137-142.

Lo, A. W. "Readings About the financial crisis: A Twenty-one-book Review." Journal of

Economic literature, 50(1), 2012, 151-178.

Mahmood, S. Efficiency Wages and Non-monetary Motivational Strategies: An Experimental

Approach. Ph.D. Thesis, Islamabad: PIDE, 2011

Mankiw, N. G. "Review of: Reinventing the Bazaar (book by John McMillan)." Journal of
Economic literature, 41, 2003, 256-257.

Mankiw, N. G., & Taylor, M. P. (2007). Macroeconomics European Edition (PV) 6th edition:
VA:Worth Publishers.

Marantz, S. A., and Mansfield, A. F. "Maternal Employment and the Development of Sex-Role
Stereotyping in Five-To Eleven-Year-Old Girls." Child Development, 1977, 668-673.

Miller, M., & Vines, D. The Asian Financial Crisis: Causes, Contagion and Consequences (Vol.
2): Cambridge, UK: Cambridge University Press, 2006

Minowitz, P. "Adam Smith’s Invisible Hands." Econ Journal Watch, 1(3), 2004, 381-412.

Pizzo, S.; Fricker,M; and Muolo,P. Inside job: The looting of America's savings and loans. New
York: McGraw-Hill, 1989.

Polanyi, K. The Great Transformation: The Political And Economic Origins Of Our Times PA:
Beacon Press, 2001

Reinhart, C. M., and Rogoff, K. S. "The Aftermath of Financial Crises." National Bureau of
Economic Research WP 14656, 2009

Rodrik, D. "King Kong Meets Godzilla: The World Bank and the East Asian Miracle" CEPR
Discussion Papers No. 944, 1994
Rossi, A. S. "Intergenerational Relations: Gender, Norms, and Behavior." in The Changing
Contract Across Generations, (eds) Bengtson, V. L., and Achenbaum, W.A. NY:Transaction
Books, 1993. 191-212.

Rothschild, E. "Adam Smith and the Invisible Hand." The American Economic Review, 84(2),
1994, 319-322.

Scott, J., and Marshall, G. A Dictionary of Sociology. Oxford, UK: Oxford University Press,
2005

Smith, A. (1759). The Theory of Moral Sentiments. London: A. Millar.

Smith, A. (1776). The Wealth of Nations. Amherst. NY: Prometheus Books.

Soros, G. "The Capitalist Threat," The Atlantic Monthly. February 1997

der Steeg , M. V. "Why Should Governments Intervene in Education and How Effective is
Education Policy? A Review of the Literature." CPB Memorandum 122, CPB Netherlands
Bureau for Economic Policy Analysis, 2005

Steinel, W., & De Dreu, C. K. Social motives and Strategic Misrepresentation in Social Decision
Making. Journal of Personality and Social Psychology, 86(3), 2004, 419-434.

Stiglitz, J. E. The Price of Inequality: How Today's Divided Society Endangers Our Future, NY:
WW Norton & Company. 2012

Uhlhaas, C. "Is Greed Good?" Scientific American Mind, 18(4), 2007, 60-67.

Wade, R. Governing the Market: Economic Theory and the Role of Government in East Asian
Industrialization. Princeton, NJ: Princeton University Press. 1990
Zak, P. J., & Knack, S. "Trust and growth." The economic journal,111(470), 2001, 295-321.
Zaman, A. “Death of a Metaphor: The Invisible Hand,” International Journal of Pluralism &
Economic Education Vol. 4(1), March 2013, p. 15-29
Zuboff, S. “The Old Solutions have become the New Problems,” Bloomberg Business Week,
July, 2009.