Misperceptions on Adam Smith (and F. A. Hayek)

By Peter Boettke at Coordination Problem.

"Many folks inside and outside of academic life believe that Adam Smith "invisible hand" theorem required a strong-version of the rationality and/or self-interest postulate.  Strong rationality assumption is necessary condition for the derivation of a strong version of the invisible hand.  Thus, any demonstration of the deviation from strong rationality indicates that at best only a weak version of the invisible hand could be derived.  Instead, as Joe Stiglitz likes to say we have a "palsied hand" that requires the helping or guiding hand of state.  Such examples of deviations from the strong rationality assumption would be asymmetric information, but also various weaknesses of will that produce myopia in decision making.

But, of course, Adam Smith did not hold any such position no matter how elegant the mid-20th century efforts to rationally reconstruct his system of thought to be consistent with the research program of general competitive equilibrium theory.  Yes, formal equilibrium theory was an elegant way to demonstrate the interconnectedness of economic activity, but NO, it was not an accurate portrayal of Smith's depiction of the coordination of economic activities without any central command. Smith wants to attract his readers with a mystery -- the mystery of cooperation and coordination in anonymity -- as he sets up the puzzle in the beginning pages of An Inquiry into the Nature and Causes of the Wealth of Nations* by capturing our imaginations with two thought experiments -- scarce he argues in our lifetime do we have the opportunity to make but a few close personal friends, yet our daily survival requires the cooperation and coordination of hundreds perhaps thousands of individuals we will never know, let alone meet even in passing; and he asks us to think deeper about this puzzle by demonstrating the numerous number of exchange relationships often at great geographic and social distance that must be realized in order for the day laborer to be able to wear his common-woolen coat.  It is in this context that he make his famous "not from the benevolence of the butcher, baker, brewer" point.  In this context, he is also making a fundamental point about the division of labor, the benefits of specialization, and the mutual advantages brought about through exchange.  The greatest increases in the well-being of mankind are due to increases in real-income, those increases in real-income only result from increases in real-productivity, and the greatest increases in the improvement in real-productivity are due to the division of labor -- its expansion and its refinement.  The division of labor, however, is limited by the extent of the market.  So the questions that any inquiry on development must raise is how does one move from an order defined by subsistence to an order defined by exchange.  And Smith's inquiry, like Hayek's, had little to do with the cognitive capacities of the economic actors being studies, but everything to do with the institutional infrastructure within which these very imperfect beings were attempting to live their lives and perhaps improve their situation, or the situation of their children.  Here is the important point to always stress -- absent that institutional infrastructure even strong rationality can go astray in generating the common-good.  The Smithian inquiry IS an inquiry into institutions and how those institutions impact human well-being.

Hayek understood this and sought to stress at various points.  In his essays "Notes on the Evolution of Systems of Rules of Conduct" footnote 10 (p 72 in his book Studies in Philosophy, Politics and Economics) Hayek points to what he calls "the unprofitable discussions about the degree of 'rationlity' which economic theory is alleged to assume."  And he explains further in his essay "The Results of Human Action but not of Human Design" (p. 100, ibid):

There was perhaps some excuse for the revulsion against Smith's formula because he may have seemed to treat it as too obvious that the order which formed itself spontaneously was also the best order possible.  His implied assumption, however, that the extensive division of labor of a complex society from which we all profited could only have been brought about by spontaneous ordering forces and not by design was largely justified.  At any rate, neither Smith nor any other reputable author I know has ever maintained that there existed some original harmony of interests irrespective of those grown institutions.  What they did maintain, and what one of Smith's contemporaries, indeed, expressed much more clearly than Smith himself ever did, was that institutions had developed by a process of the elimination of the less effective which did bring about a reconciliation of the divergent interests. (emphasis added)

The devil is always in the institutional details.  It is those institutions that determine whether our Hobbesian nature (rape, pillage, plunder) or our Smithian nature (truck, barter, exchange) come to characterize human interaction.  Weak rationality, in fact, very weak rationality, within the right institutional infrastructure will be filtered in a way that leads human beings from subsistence and a life that is nasty, brutish and short, to the extended exchange order that delivers human beings from the bondage of nature and frees them from the oppression of others.  This is why the theory of social cooperation under the division of labor is foundational for understanding economic development, and why the focus on the appropriate institutional infrastructure that enables that social cooperation to be realized is the critical step in the analysis.

Exchange and the institutions within which we engage in exchange, and not the individual decision calculus provides the microfoundations of our inquiry.  Buchanan brilliantly argued this position in "What Should Economists Do?"; Hayek stressed this in various ways throughout his long career; and Adam Smith and David Hume laid the foundation for our understanding of this core insight into the human condition.  We are dealing as social theorists with very imperfect human beings interacting in very imperfect institutional environments, we need to get our methodological and analytical perspective right in order to engage our studies.

*I use the full title because I want to emphasize the word inquiry, Smith's work, like that of Hayek, is an invitation to inquiry, not a catechism on settled doctrine. Awe and wonder, not fear and punishment are the driving attractors."