Tag: adam smith

Capitalism is Humble

Part four in a series of eight on the morality of capitalism.

In a previous post I talked about the honesty of capitalism; people are not angels. A capitalist economy recognizes this fact, and our greed doesn’t ruin the system. Closely related to the honesty about people’s motives is capitalism’s humility about people’s limits. Humans are not all-knowing, and if force is absent, a free-market is what emerges to deal with this fact and spread valuable and coordinating information the best way possible. Markets are a result of our lack of individual knowledge, and a constant reminder of how fallible we are.

Models vs. reality

It has been well documented, especially during the Socialist Calculation Debate that absent a free-market, there is no way to allocate resources effectively. If we believe that people (or at least some group of elite experts) have near perfect knowledge of what resources and finished goods are valued to what extent by whom at what time in what location, then certainly a centrally planned economy would be superior to the messy market with all its profit and loss. Every time an entrepreneur starts a new venture that ends up failing, resources are wasted. His incorrect knowledge about how much people would value his products cause losses. A ruthlessly efficient economy wouldn’t suffer any such waste.

Indeed, the classical (and still standard in most economics textbooks) model of the ideal economy is one in which “perfect competition” is reached. The condition exists when everyone has perfect knowledge of the availability and cost of all resources and the value to consumers of all goods. There is no profit, no loss, no shortages, no surpluses and no speculation in this idealized economy. Everything is in equilibrium.

Seduced by this economic model, many an economist, statesman, do-gooder, social-reformer and power-hungry despot has attempted to achieve it in practice, and with disastrous results as evidenced in places like the former Soviet Union. The model may be a useful tool for testing some economic theories, but only an ill-informed or incredibly arrogant person would see it as a desirable or possible end-state for the real world economy. No one has perfect knowledge. It is impossible to even imagine a world in which they could. Since economic value is subjective and changing all the time, how can anyone know how much another person will value one good compared to another at any given time, let alone millions of people in a constantly changing world?

A process, not an end-state

Capitalism is humble enough to realize our limited knowledge. It relies on the price system—a spontaneous, organic result of billions of free choices—to convey information. It relies on consumers, producers, entrepreneurs and capitalists to act on that information. When they get it right, value is created, and it generates new price signals that encourage more of the same. When they get it wrong, loss results and puts a quick end to the waste of resources and sends a signal telling others not to do the same.

The price system conveys so much information in such a small bundle that I can scarce think of an analogy to show just how valuable it is. It is the most sophisticated communication system the world has ever known. Leonard Read’s famous, “I, Pencil” details the way in which the price system coordinates the actions of thousands of individuals who don’t know each other and might not even speak the same language, to bring an item as simple as a pencil to the market.

Self-knowledge

Beyond merely helping us know the preferences of others, the market system can actually help us discover our own assets and abilities. A professor once told me of a Canadian man who played the bagpipes and made small metal replacement parts for other bagpipe enthusiasts as a hobby. One day he saw an ad in the classifieds for someone who could make small metal parts for an airplane manufacturer. He could use some extra cash, and it sounded similar to his handcrafted bagpipe fittings so he gave it a shot. He ended up making good money producing airplane components—an industry he knew nothing about and never fancied himself skilled enough to enter.

If a central planner was trying to make the best use of all the labor and resources in Canada, he might conduct a survey of the skills possessed by the people there. This man could not have made known his skill in airplane manufacture, because he didn’t even know he had it! The discovery process of the market revealed to him knowledge about a value he could create for others that was previously hidden. If we don’t even know our own economic value, how can we know the values of others?

Greater than the sum

We can’t produce what the capitalist system produces. It is greater than the sum of its parts. It conveys coordinating information that lets us each go about our business and produce end results that are beyond our own abilities and comprehension.

Capitalism’s features—the price system, failure and success, profit and loss, trade, specialization, even the hated speculator, middle man and advertiser—are the result of and cure for our ignorance. We need them to help us choose actions that are valuable to ourselves and others.

A capitalism system does not require perfect knowledge. Through it, we can produce what no planner ever could. This humble, dynamic, trial-and-error approach produces wealth and innovation like no other system. It also keeps us humble on an individual level. When you contemplate the production of a simple pencil, and how far beyond your own skill level it is, it certainly puts things in perspective. It reveals how much we need our fellow man, and how much more we can accomplish when we allow this organic market process to coordinate our activities.

Want a Better World? Make a Profit

A few days ago, I noticed a post on Fast Company’s Co.Exist titled, “Is Working on Wall Street Actually the Most Ethical Career Choice?”  The post is about a project called 80,000 hours that is trying to get people to think about how best to spend the average 80,000 hours they will be in a career.

Somewhat refreshingly, the project encourages people to consider going into high-income careers rather than the non-profit world.  It describes the outsized impact you can have by funding several causes vs. working in one.  But the premise remains: to do good, it’s nonprofits that provide the boots on the ground.  You might have to bite the bullet and take a high-paying job so that you can support such efforts, but it’s very clear that aid and charitable organizations are what make the world a better place.

What’s so odd about this perspective is that all the evidence in world history reveals just the opposite.  There has not been a single, massively transformative development driven by charity work.  But millions upon millions have seen the end of poverty, disease and plague; we’ve seen lifespans extended, air and water cleaned, culture, art and beauty preserved and enhanced, and lives saved by profit-seeking enterprises.

Working for profit is, in a free-market, always a win for others.  Profit is a signal.  It reveals when value has been added to society, as measured by the subjective values of those in society.  Resources are purchased for a price.  That price is what the resources are valued at for their next best use.  Profit-seekers then do something to the resources.  They apply ideas, time, other resources and labor.  What comes out the other end is sold.  If consumers willingly pay a price high enough to cover the cost of inputs plus some, profit is made.  What does that profit signify?  It signifies value created.  It shows how much more valuable the resources are after the transformation than before.  It shows, in dollars, how much better off people are because of the enterprise.

Of course dollars are not a perfect measurement of value.  And of course economic value is subjective and changing.  But there is no perfect measurement, and there is none clearer, cleaner, or fairer.  You can ask people what they value, but when they willingly trade their dollars for it, it speaks volumes.  Any uncoerced exchange that generates profit should be hailed as a wonderful benefit to the world.

Sure, you can make a bunch of money so you can give lots away to causes you believe in.  That’s a wonderful thing.  It feels good.  It can help some people in tangible ways that are fulfilling to be a part of.  The truth is, whether you like it or not, you’re doing more good for the world by the activity that makes you the money (so long as it’s not subsidy, tax, or regulation supported) than by the activities you support in giving it away.

I highly recommend this excellent article by F.A. Harper on “The Greatest Economic Charity“.

Review: Madmen, Intellectuals, and Academic Scribblers

Any book that uses an Oxford comma in the title is immediately in my good graces. Add the nicely designed cover, the slim size, and the intriguing topic, and Edward Lopez and Wayne Leighton would have had to commit heinous rhetorical or logical crimes to turn me off of their new book, Madmen, Intellectuals, and Academic Scribblers. Fortunately, they commit no such crimes but present a sweeping and readable examination of the forces that generate social change.

I have long been obsessed with the question of how to change the world. In my personal life, this question took me from humanitarian mission trips, to politics, to policy advocacy, to education, to developing educators, to raising support to develop educators. To borrow the old adage, I found I could do more in teaching a man to fish than giving a man a fish…then I took it further: Now I raise the capital to build the factories to make the rope to produce the nets to give the teachers to teach people to catch millions of fish.

This doesn’t mean I’ve discovered once for all the secret of changing the world; far from it. Every day my approach changes as I gain experience and learn new ideas. Madmen is, in many ways, a clear articulation of many of the ideas I’ve come to hold about social change. It details how Public Choice Theory reveals that governments have all the wrong incentives for positive change. It discusses the role of ideas, and how they are able to overcome the vested interests that Public Choice makes seem so insurmountable. It lays out Hayek’s description of social change coming from intellectuals, and spreading through the general public. But Madmen adds a new dimension, one I have not been able to integrate into my worldview until recently: the bottom-up role of culture, and the circumstance of time and place.

It is not only coherent, conscious ideology that determines what institutions will be tolerated, and therefore what incentives exist and what outcomes result. The conscious beliefs of individuals in society do play a major role, and are something we focus on perhaps because we feel capable of altering them through education and persuasion. But there is also a role for bottom-up, experiential, subconscious or tacit knowledge. The kind of knowledge that culture carries from generation to generation, passing on when it produces better outcomes.

Often no one is aware the valuable function of such cultural trends or norms. Economist Peter Leeson has done research on a variety of bizarre superstitions and practices embedded in various cultures; memes that seem to have no value. If you asked the members of that culture what the purpose was, they would likely provide an answer steeped in their religion or mythology. Yet time and again, the practices have proven efficient means of achieving desirable ends, at least compared with the known alternatives. Such cultural norms needn’t be recognized for what they are even by the people that benefit from them in order to have influence over institutions, incentives, and outcomes – good or bad.

I’ve come to believe that, when it comes to bringing about a better world, valuing freedom because we’ve experienced it and consider it normal is just as important as valuing freedom because it makes sense in the moral or utilitarian abstract. A generation that believes in the power of voluntary cooperation because they take part in it every day is no less valuable than one that reads libertarian theory.

Madmen integrates the top-down flow of ideas from intellectuals to the general public with the bottom up influence of learned cultural memes, and uses the combined forces to explain where the ideas come from that shape the institutions in which (as Public Choice reveals) incentives will lead to predictable outcomes. To create this integrated view of social change, Leighton and Lopez ask and answer three questions:

1. Why do democracies generate policies that are wasteful and unjust?

2. Why do failed policies persist over long periods, even when they are known to be socially wasteful and even when better alternatives exist?

3. Why do some wasteful policies get repealed (airline and telephone regulations) while others endure (sugar subsidies, tariffs)?

They offer answers in less than 200 pages, yet somehow manage to work in an expansive history of economic and political thought, beginning with the earliest philosophers and ending with the most current economists. This is an excellent tour of political economy as a discipline: what questions it asks, what personalities populate the field, and what competing and complimentary theories they present. There is enough detail to satisfy the wannabe economist in me, and enough colorful storytelling to sate my inner layman.

The book opens with a story of the shot-clock that saved basketball, and closes with a story of hybrid wheat that saved millions of lives. It is full of examples of social change, both good and bad, and the authors’ thoughts on why it happened when and how it did. If you are interested in how the world works from a ten thousand foot vantage point, I cannot recommend Madmen, Intellectuals, and Academic Scribblers enough.

Why Corporations Don’t Support Freedom

There is a common assumption that advocacy of free-market ideas is funded in large part by big corporations.  As much as I wish the many great organizations and projects that are educating in liberty received financial support from large corporations, almost none of them do, and when they do it is in very small amounts when compared to the other things such firms support.

But why?  Businesses are constantly hampered and harassed by government regulation, taxation, and the uncertainty of the legal landscape one day to the next.  Don’t they stand to gain from laissez faire?  Well, yes, businesses stand to gain tremendously from market freedom.  Entrepreneurs, owners, employees, consumers, and every other market participant stands to gain.  Businesses of all sizes stand to gain, provided they can produce what consumers demand.

Aye, there’s the rub.

You see, while business stands to gain from free exchange, nobody knows which specific businesses will be most successful in a competitive environment.  Consumers are a tough bunch to please.  It takes a lot of work, and there’s a lot of uncertainty.  The creative destruction of the market is a little daunting to a businessperson who dwells on it for long.  It’s easier, for those who can afford it, to cozy up to the state and ensure that it’s restrictions and interventions hurt you a little less than they harm your competitors.  If you have resources enough and play your cards right, you might even be able to get policies that make you more profitable or put your competitors out of business entirely.

The result?  Bigger businesses tend to support state intervention, because they have the lawyers and money and can hire the guns of government.  It is entirely possible that some of these very businesses would fare better under economic freedom, but they don’t know for sure, so they go the somewhat safer route of state cronyism.  Smaller businesses typically aren’t organized enough and lack the resources to manipulate policy in their favor.  Worse still, the unimaginable number of new ventures that would have been created were it not for government impediments have no voice at all; we don’t even know who would have created them.

In short, freedom is good for business, but scary to businesses.

Smith, Smith Everywhere

Everywhere I turn I see a theme: decentralized, unplanned order is superior to rigid top-down plans.

Popular economist Nassim Talib’s new book, Antifragile is about, “Things that gain from disorder”.  Historian James C. Scott’s latest book is called, Two Cheers for Anarchism.  A few years back I read a pop-business book called, The Starfish and the Spider, about the “Unstoppable power of leaderless organizations.”   Then there’s this discussion of the 2004 book, Sync, on, “The emerging science of spontaneous order.”

What do these have in common?  None of the authors describe themselves as libertarians, and only some of them reference F.A. Hayek or other libertarian thinkers who are known for the idea of spontaneous order.  This is exciting.

At first I noticed this trend and thought it was interesting how Hayek’s ideas are so fundamental that they are being explored in all disciplines by all kinds of thinkers.  But really, it goes back to Adam Smith (who doubtless drew on ideas from many others before him).  One of Smith’s core insights was that individuals pursuing their own interests unwittingly produce a broader order that benefits all.  It seems simple.  Yet this observation is so deep and rich with explanatory power that we might easily overlook it’s staggering implications.  Hayek’s work, among others, extended this insight and asked more questions about why and how unplanned order is superior to top-down dictates.

Today we see not only an extension of this idea in theory, but widespread application. Websites like Wikipedia were founded on this insight.  User-generated content and the network based framework of the web are live experiments in decentralized order.  The self-policing of blogs and forums and the customers reviews on Amazon and Yelp put the idea to test for all to see.  It’s increasingly difficult to be unaware of the “invisible hand”; it’s becoming more visible every day.

Many who are tapping the power of this insight don’t necessarily extend it to society at large.  As I said, most of the works referenced above are not full-fledged calls for libertarianism.  Still, the power of decentralization, the clunkiness of monopolistic bureaucracy, and the beauty of the unknown and emergent are more understood than ever.  Understanding breeds acceptance.

Seeing is believing.  So is doing.  A generation that believes in the power of voluntary cooperation because they take part in it every day is no less valuable than one that reads libertarian theory.  The future is open, unknown, and bright.

Was Adam Smith Wrong?

Here’s an article I originally wrote for the Prometheus Institute.

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Disagreeing with a man whose face appears on the necktie of many a freedom-lover is perhaps dangerous, but sound reason can’t be sacrificed on the altar of great men – and Smith was a great man.

Indeed, Adam Smith, in his depiction of the division of labor in a pin factory and his timeless prose on the invisible hand and the self-interest of the butcher, offers some of the greatest explanations and defenses of capitalism ever written, even some 230 years later. I consider Smith a great thinker, and a hero of liberty. That doesn’t mean he was never wrong; particularly when it comes to the question of value.

Smith’s thoughts on the derivation of value in his Wealth of Nations laid the groundwork in this area for later thinkers like David Ricardo (another brilliant mind who was right about many other things) and eventually Karl Marx. In the case of the latter we have clearly seen how bad ideas can have horrific real-world consequences. As John Maynard Keynes famously remarked,

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

I might add too the bad ideas of otherwise good economists.

Smith essentially, though somewhat confusedly, argued that the value of any good was ultimately derived from the amount of labor it took to produce. Money or commodity prices reflected only the nominal but never the real value of a good. In this way he described the different prices of different goods as a simple formula:

“If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” (The Wealth of Nations, Book I, Chapter VI)

Smith elaborated further by describing other costs of producing a good, including the role of the entrepreneur and capitalist and the profits they require. Unlike Marx, Smith never denigrated the role of the capitalist or the profits they earned, but his conception of value resulting from the cost of production (ultimately labor) opened the door for the idea that anything charged or earned above the cost of real inputs is unnecessary; excellent fodder for anyone anxious to obtain power by appealing to an envious middle class.

The problem with Smith’s analysis is not that the cost of production has no link to the value or money price of a good – indeed, the two are closely connected. He merely had the relationship backwards.

In reality, prices reflect the money equivalent of the value a buyer places on a good. That is to say, an individual who wishes to have a good places an entirely subjective value upon that good as compared to other goods, and the difference is typically expressed in terms of money. If in Smith’s example no one cared for beavers, the cost of killing a beaver wouldn’t matter; the beaver would sell for little or nothing. There is no one value of a good, but each individual values each good differently, as compared to other goods. It is the same for Smith’s supposedly changeless measure of value, labor. An hour of the same kind of labor may be valued (or disdained) to different degrees by different people.

It is for this reason that price is merely the reflection of the amount of money an individual was willing to give up to obtain a given good in the most recent exchange.

However, Smith was correct in seeing a relationship between the cost of production and price: Once a producer or entrepreneur has an indicator of what someone was willing to pay for a good, he can speculate how much others will be willing to pay in the future. He may be incorrect, but he will start with an estimate based on past experience and hope to get an equal or higher price. It is the estimated price (which reflects the value others place on the good) that will dictate how much he can spend on production. If a producer expects a good to sell for $1, he will be willing to spend up to $0.99 to produce it. (This is obviously a simplification, as he may be willing to take short term loss if he expects long term gains, he may want more than a $0.01 profit, etc.) In other words, the amount of labor and other costs of production flow from the expected sale price of the good, not the other way around. No one will spend more to produce an item than they believe others will be willing to pay to buy it.

Smith correctly saw that the various costs which go into production must be paid by the sale price of the final good. What he failed to see is that the costs of production do not create the price of the final good or imbue it with some objective value, but that the subjective value that each consumer places on the good sends signals backwards to producers and tells them how much they can expend on production without suffering a loss.

That Smith saw the factors which go into the production of a good as the cause of the price, rather than the effect, may seem like a small error. But economics, like all attempts to study the behavior of human beings, is a subtle science which requires great attention to the correct logical progression of actions. A misunderstanding between cause and effect can be fatal.

A slight adjustment to the angle of a satellite signal can, when extrapolated over thousands of miles, result in a beam nowhere near its target location. Likewise, looking at an economic phenomenon, such as the price of a good, from an even slightly incorrect angle can result in consequences far greater than imagined when spread over time and by different minds in different cultures. I would never single-handedly blame Adam Smith for the horrors of socialism. But his backwards theory of value contributed, over time and space, to a set of ideas which laid the theoretical groundwork for socialism – a philosophy completely contrary to the views of Smith.

I still admire and respect Adam Smith as one of the world’s great minds and a positive force in the battle for liberty. His conclusions and prescriptions were correct, even though his methodology was sometimes flawed. However, the lessons to be gleaned are to never let admiration for a great mind blind you to areas in which they are in error; and that even correct conclusions, if based on incorrect reasoning, can be dangerous.