How the "Invisible Hand" of the Market Does, and Does Not, Work

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There are few concepts in the history of economics that have been misunderstood, and misused, more often than the "invisible hand." For this, we can mostly thank the person who coined this phrase: the 18th-century Scottish economist Adam Smith, in his influential books The Theory of Moral Sentiments and (much more importantly) The Wealth of Nations.

In The Theory of Moral Sentiments, published in 1759, Smith describes how wealthy individuals are "led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society." What led Smith to this remarkable conclusion was his recognition that wealthy people don't live in a vacuum: they need to pay (and thus feed) the individuals who grow their food, manufacture their household items, and toil as their servants.

Simply put, they can't keep all the money for themselves!

By the time he wrote The Wealth of Nations, published in 1776, Smith had vastly generalized his conception of the "invisible hand": a wealthy individual, by "directing...industry in such a manner as its produce may be of the greatest value, 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." To pare down the ornate 18th-century language, what Smith is saying is that people who pursue their own selfish ends in the market (charging top prices for their goods, for example, or paying as little as possible to their workers) actually and unknowingly contribute to a larger economic pattern in which everybody benefits, poor as well as rich.

You can probably see where we're going with this. Taken naively, at face value, the "invisible hand" is an all-purpose argument against the regulation of free markets.

Is a factory owner underpaying his employees, making them work long hours, and compelling them to live in substandard housing? The "invisible hand" will eventually redress this injustice, as the market corrects itself and the employer has no choice but to provide better wages and benefits, or go out of business.

And not only will the invisible hand come to the rescue, but it will do so much more rationally, fairly and efficiently than any "top-down" regulations imposed by government (say, a law mandating time-and-a-half pay for overtime work).

Does the "Invisible Hand" Really Work?

At the time Adam Smith wrote The Wealth of Nations, England was on the brink of the greatest economic expansion in the history of the world, the "industrial revolution" that blanketed the country with factories and mills (and resulted in both widespread wealth and widespread poverty). It's extremely difficult to understand a historical phenomenon when you're living smack in the middle of it, and in fact, historians and economists still argue today about the proximate causes (and long-term effects) of the Industrial Revolution.

In retrospect, though, we can identify some gaping holes in Smith's "invisible hand" argument. It's unlikely that the Industrial Revolution was fueled solely by individual self-interest and lack of government intervention; other key factors (at least in England) were an accelerated pace of scientific innovation and an explosion in population, which provided more human "grist" for those hulking, technologically advanced mills and factories.

It's also unclear how well-equipped the "invisible hand" was to deal with then-nascent phenomena like high finance (bonds, mortgages, currency manipulation, etc.) and sophisticated marketing and advertising techniques, which are designed to appeal to the irrational side of human nature (whereas the "invisible hand" presumably operates in strictly rational territory).

There is also the indisputable fact that no two nations are alike, and in the 18th and 19th centuries England had some natural advantages not enjoyed by other countries, which also contributed to its economic success. An island nation with a powerful navy, fueled by a Protestant work ethic, with a constitutional monarchy gradually yielding ground to a parliamentary democracy, England existed in a unique set of circumstances, none of which are easily accounted for by "invisible hand" economics.

Taken uncharitably, then, Smith's "invisible hand" often seems more like a rationalization for the successes (and failures) of capitalism than a genuine explanation.

The "Invisible Hand" in the Modern Era

Today, there is only one country in the world that has taken the concept of the "invisible hand" and run with it, and that's the United States. As Mitt Romney said during his 2012 campaign, "the invisible hand of the market always moves faster and better than the heavy hand of government," and that is one of the basic tenets of the Republican party. For the most extreme conservatives (and some libertarians), any form of regulation is unnatural, since any inequalities in the market can be counted on to sort themselves out, sooner or later. (England, meanwhile, even though it has separated from the European Union, still maintains fairly high levels of regulation.)

But does the "invisible hand" really work in a modern economy? For a telling example, you need look no further than the health-care system. There are many healthy young people in the U.S. who, acting out of sheer self-interest, choose not to purchase health insurance—thus saving themselves hundreds, and possibly thousands, of dollars per month. This results in a higher standard of living for them, but also higher premiums for comparably healthy people who choose to protect themselves with health insurance, and extremely high (and often unaffordable) premiums for elderly and unwell people for whom insurance is literally a matter of life and death.

Will the "invisible hand" of the market work this all out? Almost certainly—but it will doubtless take decades to do so, and many thousands of people will suffer and die in the interim, just as many thousands would suffer and die if there was no regulatory oversight of our food supply or if laws prohibiting certain types of pollution were repealed. The fact is that our global economy is too complicated, and there are too many people in the world, for the "invisible hand" to do its magic except on the longest time scales. A concept that may (or may not) have applied to 18th-century England simply has no applicability, at least in its purest form, to the world we live in today.